University:
California State University, Northridge
Course:
FIN 462 | Fixed Income Securities
Academic year:

2024
Views:

107

Pages:

15
Author:

Kaylah Sullivan

Fixed-Income securities Outline  Mortgages Types  Mortgage Risk   The Mortgage Backed Securities Market History  Types of Securities  Introduction A mortgage is a loan with real estate as collateral. The lender, called the mortgage originator, often charges points as a fee for preparing and placing the mortgage. It is quite common for the lender to sell the mortgage to another party. Mortgages: Types    A fixed rate mortgage is one with payments based on a set interest rate that does not change. An adjustable rate mortgage (ARM), also called a variable rate mortgage, has an interest rate that moves with some market interest rate, such as the Treasury bill rate. Most ARMS have an annual reset to the interest rate. Many also have either a cap or a floor on the interest rate. Mortgage Risk    Default risk is the risk that the borrower is unable or unwilling to repay the debt as agreed. Interest rate risk is the risk that the general level of interest rates rises, such that the value of the mortgage’s cash flow stream declines. Prepayment risk is the risk of an early payment of the original mortgage, such as when the home is sold or when the mortgage is refinanced at a lower rate. The Mortgage Backed Securities Market   The Federal National Mortgage Association (Fannie Mae), the Government National Mortgage Association (Ginnie Mae), & the Federal Home Loan Mortgage Corporation (Freddie Mac) support the US mortgage market by providing liquidity, buying conforming mortgages from banks across the country for resale elsewhere. The term mortgage-backed securities refers to all products based on mortgage loans. Types of Securities  A pass-through security is a share of a pool of mortgages. Individual Mortgages Individual Mortgages Individual Mortgages Mortgage Pool Pass Through Security  The holders receive a monthly check for their portion of the scheduled principal and interest payments, plus their share of any prepayments that may occur. Types of Securities  Pass-through securities may be issued and guaranteed by a government agency, or they may be private label.  Two types of derivative securities that spring from pass-through securities are collateralized mortgage obligations and stripped mortgage-backed securities. Types of Securities   A collateralized mortgage obligation (CMO) is a security backed by a pool of mortgages and structured to transfer prepayment or interest rate risk from one group of security holders to another. A given pool of mortgages backs two or more classes of securities called tranches. Types of Securities Collateralized Mortgage Obligation Individual Mortgages Individual Mortgages Individual Mortgages Mortgage Pool A Tranche B Tranche C Tranche Other Tranches Types of Securities   With a sequential pay CMO, all the tranche holders receive monthly interest payments based on the principal amount outstanding in their tranche. All principal payments go to the A tranche until the A tranche principal is completely returned. Only then will the investors in the next tranche begin to receive principal. Types of Securities  There are two types of stripped mortgage backed securities, or strips. Individual Mortgages Individual Mortgages Individual Mortgages Mortgage Pool Interest Only Security  Principal Only Security All the interest goes to the interest only (IO) security holders, while the entire principal goes to the principal only (PO) holders. Considerations in Pricing Mortgage Backed Securities     The price risk of a MBS comes from the uncertainty about the timing of cash flows. Prepayments can affect the realized return on a M BS substantially. The offering memorandum for a M BS will state the assumptions used in estimating cash flows from the mortgage pool. A benchmark assumption for the rate of mortgage prepayment is offered by the Public Securities Association (PSA). The Risk of Collateralized Mortgage Obligations    Declining interest rates will increase the value of a cash flow stream and will lead to prepayments. If a mortgage pool sells at a discount, prepayments will increase the value of each of the tranches, with the higher duration tranches benefiting the most. If the pool sells at a premium, then prepayments will reduce everyone’s yield, with the effect most pronounced for the holders of the longer duration tranches. The Risk of Stripped Mortgage Backed Securities   Prepayment has different consequences for IO and PO strips. An extension of the mortgage decreases the value of the principal payments but increases the value of the interest payments. Declining interest rates will increase the value of a series of known cash flows, as well as the likelihood of prepayment. Normally, the prepayment effect overwhelms the interest rate effect.

Fixed-Income Securities

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