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Fixed Income StudyGuide for Final

by: Kwan

Fixed Income StudyGuide for Final BU.232.720.W4.SP16

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Fixed Income
Philip Giles
Study Guide
50 ?




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This 3 page Study Guide was uploaded by Kwan on Saturday March 5, 2016. The Study Guide belongs to BU.232.720.W4.SP16 at Johns Hopkins University taught by Philip Giles in Spring 2016. Since its upload, it has received 55 views. For similar materials see Fixed Income in Finance at Johns Hopkins University.


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Date Created: 03/05/16
Key Points • A mortgage is a pledge of property to secure payment of a debt with the property typically being a form of real estate. • The two general types of real estate properties that can be mortgaged are single-family (one- to four-family) residential and commercial properties. • Residential mortgage loans can be classified according to lien status (first and second liens), credit classification (prime and subprime), interest-rate type (fixed rate and adjustable rate), amortization type (fully amortizing and interest only), credit guarantees (government loans and conventional loans), loan balances, and prepayments and prepayment penalties. • The two GSEs, Fannie Mae and Freddie Mac, can purchase any type of loan; however, the only conventional loans that they can securitize to create a mortgage-backed security are conforming loans, that is, conventional loans that satisfy their underwriting standards. • The cash flow of a mortgage loan consists of interest, scheduled principal repayment, and prepayments. • The lender faces four main risks by investing in residential mortgage loans: (1) credit risk, (2) liquidity risk, (3) price risk, and (4) prepayment risk. • Prepayment risk is the risk associated with a mortgage’s cash flow due to prepayments. • The residential mortgage-backed securities market is divided into two sectors: agency MBS and nonagency MBS. • A residential mortgage-backed security is created when residential loans are pooled and one or more securities are issued whose obligations are to be repaid from the cash flow from the loan pool. • A mortgage pass-through security is one type of RMBS created when one or more mortgage holders of loans pool them and sell a single debt obligation that is to be repaid from the cash flow of the specific loan pool with each investor entitled to a pro rata share of the cash flow. • Agency MBS include agency mortgage pass-through securities, agency collateralized mortgage obligations, and agency stripped mortgage-backed securities. The cash flow of the latter two types of MBS is derived from the first type, and hence, they are referred to as derivative MBS. • The monthly cash flow of a mortgage pass-through security depends on the cash flow of the underlying mortgages and therefore consists of monthly mortgage payments representing interest, the scheduled repayment of principal, and any prepayments. The cash flow is less than that of the underlying mortgages by an amount equal to servicing and any guarantor fees. • As with individual mortgage loans, because of prepayments, the cash flow of a pass- through is not known with certainty. Agency MBS are issued by Ginnie Mae, Fannie Mae, and Freddie Mac. Ginnie Mae pass-through securities are guaranteed by the▯full faith and credit of the U.S. government and consequently are viewed as risk-free in terms of default risk. Freddie Mac and Fannie Mae are government-sponsored enterprises, and therefore, their guarantee does not carry the full faith and credit of the U.S. government. • Estimating the cash flow from a mortgage pass-through security requires forecasting prepayments. The current convention is to use the PSA prepayment benchmark, which is a series of conditional prepayment rates, to obtain the cash flow. • Aprepaymentmodelbeginsbymodelingthestatisticalrelationshipsamongthe factors that are expected to affect prepayments. The key components of an agency’s prepayment model are housing turnover, cash-out refinancing, and rate/term refinancing. • Given the projected cash flow and the market price of a pass-through, a cash▯flow yield can be calculated. Because the PSA prepayment benchmark is only▯a convention enabling market participants to quote yield and/or price, it has many limitations for determining the value of a pass-through. The yield spread is quoted as the difference between the cash flow yield and the yield to maturity of a comparable Treasury. • A measure commonly used to estimate the life of a pass-through is its average life. ▯ • The prepayment risk associated with investing in mortgage pass-through securities can be decomposed into contraction risk and extension risk. Prepayment risk makes mortgage pass-through securities unattractive for certain financial institutions to hold from an asset- liability perspective. • Mortgage pass-through securities are quoted in the same manner as U.S. Treasury coupon securities. • Mortgage pass-through securities are identified by a pool prefix and pool number. A TBA trade occurs while a pool is still unspecified, and therefore, no pool information is known at the time of the trade. The seller has the right in this case to deliver mortgage pass-through securities backed by pools that satisfy the PSA requirements for good delivery.


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