Ch5 Mortgage Backed Securities(1)

1. Overview
Definition: a loan that is collateralized with a specific piece of real property
- primary market
- secondary market; securitization
**MBS (mortgage-backed security), pass-through structure

2. Fixed-Rate, Level-Payment Mortgages
2-1. Conventional Mortgage: the most common residential mortgage

2-2. fixed-rate, level payment, fully amortized mortgage loans
*features
- principal increase as time passes
- interest decrease as time passes
- servicing fee declines as time passes
- prepayment risk

e.g.) 30 year, $500,000 level payment, fixed rate of 12%
=> Xmonthly = 500000 x 12% x (1 + 12%) ^ 12 / ((1 + 12%) ^ 12 - 1) = 5,143.06

- scheduled principal repayment (scheduled amortization) -> incremental reduction of outstanding principal
- Mortage Rate = Net Interest (Net Coupon) + Servicing Spread
**reduction in principal is unaffected by the servicing fee

3. Prepayment Risk
3-1. Repayment option
The prepayment option is valuable when mortgage rates have fallen. In the case, the value of an existing mortgage exceeds the principal outstanding.
- borrower: similar to a call option of a collable bond (American call option on an otherwise identical, nonprepayble mortgage); Strike price = outstanding principal amount
- homeowner: very much in the position of an issuer of a callable bond
- current coupon rate: initial principal amount = P.V. of Mortgage CF - Value of Prepayment Option

**due on sale
**lock-in effect: if points, refinancing bank fee, are high, these will discourage the borrower's willingness to refinance

3-2. Main factors to affect prepayments
i. prevailing mortgage rates
- Spreade between the current mortgage rate and the original mortgage rate; Historically mortgate rages fall by more than 2% -> refinancing activity increase (media effect)
- Path of mortgage rates: burnout effect
- Level of mortgage rates: low interest rates increase the affordability of housing and increas housing turnover -> increase refinancing & prepayment rates

ii. characteristics of the underlying mortgage loans
- original mortgage rate
- amount of seasoning
- origination of loan (FHA/VA or conventional)
- type of loan (30-year fixed, 30-year balloon)
- geographical location

iii. seasonal factors

iv. general economic activity

v. others: natural disasters, default