Question

The cash flow for a mortgage pass-through typically is based on some prepayment speed benchmark. Why is the assumed prepayment speed necessary to price the MBS?

Answer 1

Mortgage Backed Security

As the scale of residential mortgage is so large that eliminates the creditors’ asset liquidity significantly, government supported companies like Fannie Mae (FNMA) play a crucial role in promoting the loans liquidity. After lending the loans to obligors, companies put the loans in a large “pool” and pack their future cash flows together into securities backed by obligors’ properties and sell those securities to investors, offering stable monthly payments with some special interest rates. This process of packing the illiquid assets to generate new securities is what we call the securitization. Through this process, we can create more financial instruments to increase the liquidity in the marketplace.

Asset backed securities is the most popular product of securitization. Asset backed securities (ABS) is a security whose income payment is backed on a pool of collateralized underlying asset. In most cases, the asset pool is composed by some small assets with low liquid. Mortgage backed security (MBS) is a kind of ABS whose cash flow is secured by mortgage. It was one of the earliest ABS that appeared in the market. MBS’s basic unit is a pool, during which there are a lot of mortgages similar in characteristics like rate, term structure, credit quality and loan balance. After combining the previous mentioned mortgage loans, the new sizeable and homogenous component MBS will be liquid in the market.

Pricing the Mortgage Backed Security

The valuation of mortgage backed security is crucial in stabilizing the market. Interest rate and prepayment are considered to be the two main factors that will impact MBS’s cash flow, thus we need to find some models that simulate the cash flow’s fluctuation under these two factors.

In order to value a Pass Through Security, it is important to project its cashflows. The difficulty is that the cashflows are unknown because of Prepayments.The only way to project cashflows are to make some assumption about the prepayment rate over the lifeof underlying mortgage tool. The prepayment rate is sometimes referred to as Speed. Two conventions have been used as benchmark for prepayment rate - Conditional Prepayment Rate & Public Securities Association Prepayment benchmark.

Thus it is necessary to assume the prepayment speeed to price the MBS