Question

1. Mortgage markets have developed significantly since the early 1970s through the creation of secondary market instruments in the form of mortgage pass-throughs, collateralized mortgage obligations (CMOs), and REMICs. These collectively have been generally referred to as mortgage backed securities (MBS). In many ways, these instruments carry the characteristics of their underlying assets -- individual mortgages. Mortgages generally carry a no-cost prepayment option. List 6 factors that affect the prepayment speeds on mortgage backed securities and that the prepayment option depends upon and why?

Answer 1

List 6 factors that affect the prepayment speeds on mortgage backed securities :

• MBS are collateralized by a pool of residential mortgages.
• Monthly payments "pass through" the originating bank on to a third-party investor.
• Besides monthly interest payments, mortgages amortize over their life, meaning some amount of principal is paid off with every monthly payment, unlike a bond, which generally pays all principal at maturity.
• In addition to scheduled amortizations, investors receive, on a pro-rata basis, unscheduled prepayments of principal due to refinancing, foreclosure and house sales. While a typical mortgage may have a term of 30 years, quite often mortgages are paid off much sooner. Due to these unscheduled prepayments, predicting the maturity of the MBS is problematic.
• The most commonly used prepayment rate assumption is the standard prepayment experience offered by the Public Securities Association (PSA), an industry trade group. The PSA's goal was to bring standardization to the marketplace. The first 30 months of standard prepayment experience call for a steadily rising CPR, starting at zero and rising 0.2 percent each month; thereafter, a level six percent CPR is used. Sometimes, however, yields are based on a faster or slower prepayment assumption than this standard. This change in prepayment assumption is indicated by designating a percentage above or below 100 percent.
• At the other end of the spectrum is a prepayment specification based on actual experiences of the Federal Housing Administration (FHA). The FHA compiles historical data on the actual incidence of prepayment on the mortgage loans that it insures. This data covers a wide range of origination dates and coupon rates.