Whether the mortgage is a first lien, a second lien, or a subsequent lien will greatly impact the lender’s ability to recover the balance owed in the event of default.
ORIGINAL LOAN TERM
Mortgage terms of 10 to 30 years are common, with the most popular being 30 years (long term).
Classifying loans between prime and subprime is determined mainly by credit score
INTEREST RATE TYPES
Fixed-rate mortgages have a set rate of interest for the term of the mortgage. Payments are constant for the term and consist of blended amounts of interest and principal.
Adjustable-rate mortgages (ARMs) have rate changes throughout the term of the mortgage. The rate is usually based on a base rate (e.g., prime rate, LIBOR) plus a spread.
PREPAYMENTS & PREPAYMENTS PENALTIES
Prepayments reduce the mortgage balance and amortization period.
To counteract the negative effects of prepayments, many loans contain prepayment penalties. They are amounts payable to the servicer for prepayments within a certain time and/or over a certain amount. Soft penalties are those that may be waived on the sale of the home; hard penalties may not be waived.
The ability to create mortgage-backed securities requires loans that have credit guarantees.
Government loans are those that are backed by federal government agencies .
Conventional loans could be securitized by either government-sponsored enterprises (GSEs): Federal Home Loan Mortgage Corporation (FHLMC) or Federal National Mortgage Association.
Mortgage prepayments come in two forms: (1) increasing the frequency or amount of payments and (2) repaying/refinancing the entire outstanding balance. Prepayments are much more likely to occur when market interest rates fall and borrowers wish to refinance their existing mortgages at a new and lower rate.
Other factors that influence prepayments include seasonality, age of mortgage pool, personal, housing prices, and refinancing burnout.
A mortgage is a loan that is collateralized with a specific piece of real property, either residential or commercial. A level-payment, fixed-rate conventional mortgage has a fixed term, a fixed interest rate, and a fixed monthly payment. Even though the term, rate, and payment are fixed, the cash flows are not known with certainty because the borrower has the right to repay all or any part of the mortgage balance at any time.
Allocation Between Principal and Interest
Fully amortizing fixed-rate mortgage:
To reduce the risk from holding a potentially undiversified portfolio of mortgage loans, a number of financial institutions (originators) will work together to pool residential mortgage loans with similar characteristics into a more diversified portfolio. They will then sell the loans to a separate entity, called a special purpose vehicle (SPV), in exchange for cash. An issuer will purchase those mortgage assets in the SPV and then use the SPV to issue mortgage-backed securities (MBSs) to investors; the securities are backed by the mortgage loans as collateral.
PASS THROUGH SECURITIES
Fixed-rate pass-through securities trade in one of the following ways:
MEASURING PREPAYMENTS SPEED
The value of an MBS is a function of:
Regarding prepayment speeds, the single monthly mortality (SMM) rate is derived from the conditional prepayment rate and is used to estimate monthly prepayments for a mortgage pool:
SMM = 1 – (1 – CPR)1/12
A dollar roll transaction occurs when an MBS market maker buys positions for one settlement month and, at the same time, sells those same positions for another month.
HOW TO VALUE A DOLLAR ROLL
The process involves assessing the income and the expenses related over the holding period. Income is determined by coupon payments, reinvested interest, and principal payments. Expenses are determined by financing costs [i.e., repurchase (repo) market].
Factors that impact dollar roll valuations:
FACTOR CAUSING A DOLLAR ROLL TO TRADE SPECIAL
implied cost of funds, then the dollar roll is trading special. It could be caused by:
Borrowers may prepay a mortgage due to the sale of the property or a desire to refinance at lower prevailing rates. In addition, prepayments may occur when the borrower has defaulted on the mortgage or when the borrower has cash available to make partial prepayments (curtailment).
It’s four components are:
The Monte Carlo methodology is a simulation approach for valuing MBSs. The binomial model is not appropriate for valuing MBSs because MBSs have embedded prepayment options and the historical evolution of interest rates over time impacts prepayments.
A mortgage security is valued using the Monte Carlo methodology by simulating the interest rate path and refinancing path, projecting cash flows for each interest rate path, calculating the present value of cash flows for each interest rate path, and calculating the theoretical value of the mortgage security.
The option-adjusted spread (OAS) is the spread that, when added to all the spot rates of all the interest rate paths, will make the average present value of the paths equal to the actual observed market price plus accrued interest. The zero-volatility spread (^-spread) is the spread that an investor realizes over the entire Treasury spot rate curve, assuming the mortgage security is held to maturity. The option cost is the implied cost of the embedded prepayment option and is calculated as the difference between the z-spread and OAS.
Four major limitations of OASs are related to:
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