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1 Mortgage-Backed Sector of the Bond Market LEARNING OUTCOMES provides a better matching of assets and liabilities for institutional investors; 1. Mortgage Loan: 8. Distinguish among the sequential pay tranche, a. cash flow characteristics of a fixed-rate, the accrual tranche, the planned amortization b. level payment, and class tranche, and the support tranche in a c. fully amortized mortgage loan; CMO; 2. Mortgage Passthrough Securities: 9. Evaluate the risk characteristics and relative a. investment characteristics, performance of each type of CMO tranche, b. payment characteristics, and given changes in the interest rate c. risks; environment; 3. Prepayment amount calculation on a mortgage 10.Explain investment characteristics of stripped passthrough security for a month, given the mortgage-backed securities; single monthly mortality rate; 11.Compare agency and nonagency mortgage- 4. Compare the conditional prepayment rate backed securities; (CPR) with the Public Securities Association 12.Compare credit risk analysis of commercial and (PSA) prepayment benchmark; residential nonagency mortgage-backed 5. Explain why the average life of a mortgage- securities; backed security is more relevant than the 13.Describe the basic structure of a commercial security's maturity; mortgage-backed security (CMBS), and explain 6. Explain factors that affect prepayments and the ways in which a CMBS investor may realize the types of prepayment risks; call protection at the loan level and by means 7. Explain how a collateralized mortgage of the CMBS structure. obligation (CMO) is created and how it 2 Four important features of fixed-rate, level payment, fully amortized mortgage: 1. The amount of the principal payment increases as time passes. 2. The amount of interest decreases as time passes. 3. The servicing fee also declines as time passes. 4. The ability of the borrower to prepay results in prepayment risk. Prepayments reduces the amount of interest the lender receives over the life of the mortgage and cause the principal to be repaid sooner. Example: A 30-year, $500,000 level payment, fully amortized mortgage with a fixed rate of 12%. Calculate the monthly payment and prepare an amortization schedule for the first three months. 3 Notice that the monthly interest charge is based on the beginning-of-period outstanding principal. As time passes, the proportion of the monthly payment that represents interest decreases, and, since the payment is level, the proportion that goes toward the repayment of principal increases. This process continues until the outstanding principal reaches zero and the loan is paid in full. • Scheduled Amortization = Scheduled Principal Repayment • Prepayments = Payments in excess of the required monthly amount • Prepayment Risk = prepayments will reduce the amount of interest the lender receives over the life of the loan. • The likelihood of Prepayment Risk actually occurring is very real. 4 Mortgage Passthrough Securities: investment characteristics, payment characteristics, & risks • A claim against a pool of mortgages. Any number of mortgages may be used to form the pool, and any mortgage included in the pool is referred to as a securitized mortgage. Mortgage Passthrough Cash Flow • Weighted Average Maturity (WAM) of the pool = the weighted average of all the mortgages in the pool, each weighted by the relative outstanding mortgage balance to the value of the entire pool. • Weighted Average Coupon (WAC) of the pool = the weighted average of the mortgage rates in the pool. • The coupon rate on the passthrough (called Passthrough Rates) < the average coupon rate of the underlying mortgages • Securitization = passthrough securities are traded in the secondary market that effectively convert illiquid mortgages into liquid securities Agency Passthrough Securities in the U.S. 1. Ginnie Mae

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