4.4 Mortgages and Mortgage-Backed Securities

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4.4 Mortgages and Mortgage-Backed Securities

Question 1

How would you describe the typical price behavior of a low premium mortgage pass-through security?

A. It is similar to a U.S. Treasury bond.
B. It is similar to a plain-vanilla corporate bond.
C. When interest rates fall, its price increase would exceed that of a comparable duration U.S. Treasury bond.
D. When interest rates fall, its price increase would lag that of a comparable duration U.S.Treasury bond.

Answer: D
MBSs are unlike regular bonds, Treasuries, or corporates, because of their negative convexity. When rates fall, homeowners prepay early, which means that the price appreciation is less than that of comparable duration regular bonds.

Question 2

PE2018Q57 / PE2019Q57 / PE2020Q57 / PE2021Q57 / PE2022PSQ5 / PE2022Q57
A fixed-income portfolio manager purchases a seasoned $5\%$ agency MBS with a weighted average loan age of $60$ months. The current balance on the loans is USD $32$ million, and the conditional prepayment rate is assumed to be constant at $0.6\%$ per year. Which of the following is closest to the expected principal prepayment this month?

A. USD $3, 210$
B. USD $9, 600$
C. USD $16, 000$
D. USD $16, 045$

Answer: D
Learning Objective:

Calculate a fixed-rate mortgage payment and its principal and interest components.
Describe the mortgage prepayment option and factors that affect it; explain prepayment
modeling and its four components: refinancing, turnover, defaults, and curtailments.

Conditional prepayment rate (CPR) is the annualized single monthly mortality rate (SMM) as follows:

$CPR= 1-(1-SMM)^{12}$

Single monthly mortality (SMM) rate is the percentage of the outstanding principle that was prepaid during a given month.

$SMM=\cfrac{\text{Prepayment }}{\text{Beginning mortgage balance} -\text{Scheduled principal payment}}$

The expected principal prepayment is equal to:

$32000000 \times(1-(1-0.006)^{1/12}) = 16044$ .

Question 3

PE2018Q81
A homeowner has a 30-year, $5\%$ fixed-rate mortgage with a current balance of USD $250, 000$ . Mortgage rates have been decreasing. If the existing mortgage was refinanced into a new 30-years, $4\%$ fixed rate mortgage, What is closest to the amount that the homeowner would save in monthly mortgage payments?

A. USD $145$
B. USD $150$
C. USD $155$
D. USD $160$

Answer: B
Learning Objective: Calculate a fixed rate mortgage payment, and its principal and interest components.

Calculate the mortgage payment factors for the 30-year, 5% and 4% fixed rate mortgages, then calculate the mortgage payment savings.

$N=30\times12$ , $I / Y = 5/12$ , $P V = 250, 000$ , $F V = 0$ , $CPT\;PMT=-1342$

$\times12$ , $1/ Y = 4/12$ , $P V = 250, 000$ , $F V = 0$ , $CPT\;PMT= -1194$

The mortgage payment savings $1342 - 1194 = 148$

Question 4

PE2019Q81 / PE2020Q81 / PE2021Q81 / PE2022Q81
A risk manager asks a junior risk analyst to assess the prepayment risk on a pool of fixed-rate mortgages. In order to calculate the conditional prepayment rate (CPR) for the pool, the analyst begins by estimating the monthly prepayments on one selected mortgage. At origination, the 30-year mortgage was a USD $1, 750, 000$ loan making monthly mortgage payments at a fixed mortgage rate of $8\%$ per year. Assuming the borrower made a total payment on the mortgage of USD $15, 950.00$ in one specific month, and the loan balance at the beginning of that month was USD $1, 644, 235.78$ , what is the correct estimate of the prepayment amount for that month?

A. $3, 060.29$
B. $4, 933.62$
C. $11, 016.38$
D. $14, 076.60$

Answer: A
Learning Objective:

Calculate a fixed rate mortgage payment, and its principal and interest components.
Calculate weighted average coupon, weighted average maturity, and conditional prepayment rate (CPR) for a mortgage pool.

Prepayment for any given month is defined as “principal payment” in excess of “scheduled principal payment” and is computed as:
(i) month’s total payment, less
(ii) month’s scheduled interest payment, less
(iii) month’s scheduled principal payment.

Or,

(i) month’s total payment, less
(ii) month’s scheduled total payment.

To compute scheduled total payment, consider an amortizing fixed-rate loan with particulars as follows:

$P V = 1, 750, 000$ ; $12\times30 = 360$ ; $F V = 0$ ; $8\%/12 = 0.67$ $\to PMT = 12,889.71$ (constant scheduled total payment per month).

Therefore, prepayment in the specified month: $\text{total payment made} - \text{scheduled total payment} = 15,950.00 - 12,889.71 = 3,060.29$

Also, given the specified month, $\text{Interest payment} = 0.67\% \times \text{beginning balance} = 0.0067 \times1,644,235.78 = 11,016.38$

B is incorrect. USD $4, 933.62$ is the total payment less scheduled interest payment for the month. It is incorrect because it includes the scheduled principal payment.

C is incorrect. USD $11, 016.38$ is the scheduled interest payment for the month $0.0067\times 1,644,235.78$ .

D is incorrect. USD $14, 076.60$ is the total payment made less the scheduled principal payment for the month. $15, 950.00 - (12, 889.71 - 11, 016.38)$ . It is incorrect because it includes the scheduled interest payment.

Question 5

PE2022Q4
A market risk team at a hedge fund is developing stress test scenarios to assess the impact of changes in different market variables on the fund’s portfolio of agency-backed MBS. The team wants to identify potential factors that would likely cause the rate of prepayments on the MBS portfolio to increase. Holding all else constant, which of the following would most likely result in increased prepayments in the portfolio?

A. A decrease in defaults experienced in the mortgage pool
B. A decrease in the average loan-to-value ratio of the mortgage pool
C. An increase in market interest rates
D. An increase in the supply of newly built housing

Answer: B
Learning Objective: Describe the mortgage prepayment option and factors that affect it; explain prepayment modeling and its four components: refinancing, turnover, defaults, and curtailments.

B is correct. A decrease in the average loan-to-value ratio is likely to cause curtailments, which are partial prepayments, therefore increasing prepayments.

A is incorrect. A decrease in defaults usually decreases prepayments.

C is incorrect. An increase in market interest rates usually decreases prepayments.

D is incorrect. An increase in the supply of new houses decreases the value of existing houses, thus slowing down refinancing activity for drawing on home equity.

Question 6

Consider an investor who wants to finance the purchase of a mortgage pool over a one month period. One alternative is to sell an MBS repo, in which case the investor could sell the pool today while simultaneously agreeing to repurchase it after a month. This trade has the same economics as a secured loan: the investor effectively borrows cash today by posting the pool as collateral, and upon paying back the loan with interest after a month, retrieves the collateral. An alternative is the “dollar roll”. In the dollar roll, the buyer of the roll sells a TBA for one settlement month (the “earlier month”) and buys the same TBA for the following settlement month (the “later month”).

For example, the investor who just purchased a 30-year 4% FNMA pool might sell the FNMA 30-year 4% January TBA and buy the FNMA 30-year 4% February TBA. Delivering the pool just purchased through the sale of the January TBA, which raises cash, and purchasing a pool through the February TBA, which returns cash, is very close to the economics of a secured loan. But there are two important differences between dollar roll and repo financing:

I. The buyer of the roll may not get back in the later month the same pool delivered in the earlier month. The buyer of the roll delivers a particular pool, for example, in January but will have to accept whatever eligible pool is delivered in the next February. By contrast, an MBS repo seller is always returned the same pool that was originally posted as collateral.

II. The buyer of the roll does not receive any interest or principal payments from the pool over the roll. For example, the buyer of the Jan/Feb roll, who delivers the pool in January, does not receive the January payments of interest and principal. By contrast, a repo seller receives any payments of interest and principal over the life of the repo. While the prices of TBA contracts reflect the timing of payments, so that the buyer of a roll does not, in any sense, lose a month of payments relative to a repo seller, the risks of the two transactions are different. The buyer of a roll does not have any exposure to prepayments over the month being higher or lower than what had been implied by TBA prices while the repo seller does.

Which of these two differences is (are) correct?

A. Neither is correct.
B. I is true but Il is incorrect.
C. I is incorrect but Il is true.
D. Both are correct.

Answer: D

Question 7

Which of the following about the duration of a mortgage-Backed, interest-only security (IO) is correct?

A. An IO has positive duration.
B. An IO has negative duration.
C. An IO has exactly the same duration as a mortgage-Backed security (MBS) with the same coupon.
D. An IO has exactly the same duration as a mortgage-Backed, principal-only security stripped off the same MRS.

Answer: B
The IO holder benefits from rising rates. If rates are rising, prepays slow. Thus, IOs have negative duration and can be used for hedging purposes. An IO’s price moves in the same direction as interest rate changes, implying negative duration. An MBS has positive duration, as it is inversely proportional to interest rate changes. Likewise, a PO has positive duration, as it is inversely proportional to interest rate changes.

Question 8

A fund holds a portfolio of principal-only strips of mortgage-Backed securities. All other things being equal, which of the following will most likely reduce the weighted average maturity of the portfolio?

A. An increase in interest rates.
B. An increase in prepayment speed.
C. A small decrease in the value of the homes backing the mortgage pool.
D. A small decrease in the real incomes of the underlying mortgage holders.

Answer: B
An increase in prepayment speed will reduce the weighted average maturity of the portfolio, however, the rest of the choices will not have this effect.

Question 9

Mortgage-Backed securities (MBS) are a class of securities where the underlying is a pool of mortgages. Assume that the mortgages are insured, so that they do not have default risk. The mortgages have prepayment risk because the borrower has the option to repay the loan early (at any time) usually due to favorable interest rate changes. From an investor’s point of view, a mortgage-backed security is equivalent to holding a long position in a non-prepayable mortgage pool and which of the following?

A. A long American call option on the underlying pool of mortgages.
B. A short American call option on the underlying pool of mortgages.
C. A short European put option on the underlying pool of mortgages.
D. A long American put option on the underlying pool of mortgages.

Answer: B
Prepayment risk is equivalent to an American call option because the borrower can repay at any time and the position is short because the option lies with the borrower.

Question 10

Which of the following concerning the role of a support tranche in a planned amortization class (PAC) collateralized mortgage obligation (CMO) is (are) correct?

I. The purpose of a support tranche is to provide prepayment protection for one or more PAC tranches.
II. Support tranches are exposed to high levels of prepayment risk.
III. If prepayments are too low to maintain the PAC schedule, the shortfall is provided by the support tranche.
IV. As prepayments occur, the amount of prepayment protection provided by the support
tranche increases.

A. I only
B. I, Il and IV
C. I, Il and III
D. II, Ill and IV

Answer: C
Support tranches are included in a structure with a PAC specifically to provide prepayment protection for the PAC tranches. Since the support tranches receive prepayments before the PAC tranches, they are exposed to high levels of prepayment risk. Also, if prepayments are slower than expected, cash flows are diverted from the support tranches to keep the PAC tranches on schedule. Note that as prepayments occur and the support tranches gets closer to being paid off, the support tranche will have less capacity for further prepayments and will therefore provide less prepayment protection.

Question 11

Consider a collateralized mortgage obligation (CMO) structure with one planned amortization class (PAC) tranche and one support tranche outstanding. Also, assume that the prepayment speed is higher than the upper collar on the PAC. Which of the following statements
is most accurate? The:

A. PAC tranche has no risk of prepayments.
B. Average life of the support tranche will contract.
C. Average life of the PAC tranche will extend.
D. Average life of the support tranche will extend.

Answer: B
If the prepayment speed is faster than the PAC collar, the support tranche receives a higher level of prepayments (so that the PAC tranche remains at the upper collar of the PAC). The average life of the support tranche will contract (shorten). The PAC tranche could receive higher prepayments if eventually the support tranche is fully repaid its principal (i.e., a busted PAC). However, the question says that the support tranche is still outstanding, which means that hasn’t happened yet.

Question 12

In regard to the prepayment option embedded in a mortgage, the borrower (the homeowner) is most similar to:

A. Corporate issuer of a bond with a put option
B. Corporate issuer of a bond with a call option
C. Corporate issuer of a bond with an interest rate cap
D. Corporate issuer of a bond with an interest rate floor

Answer: B
In a previous section it was noted that mortgage obligors generally have the ability to prepay their loans before they mature either by selling the property or by refinancing the loan to lower their interest rate or monthly payment. For the holder of the mortgage asset, the borrower’s prepayment option creates a unique form of risk. In cases where the obligor refinances the loan in order to capitalize on a drop in market rates, the investor has a high-yielding asset payoff that can be replaced only with an asset carrying a lower yield. Prepayment risk is analogous to “call risk” for a corporate and municipal bond in terms of its impact on returns, and it also creates uncertainty with respect to the timing of investor cash flows.

Question 13

MTGE4. MTGE7. MTGE10 are mortgage-backed securities (MBS) that pay $4\%$ , $7\%$ and $10\%$ coupons, respectively Prevailing mortgage rates are $10\%$ . Assume these securities have the same maturity and coupon frequency, which of the following is correct? (Important)

A. In most cases, convexity is sufficient to approximate MBS price changes resulting from yield changes for the purpose of estimating VaR.
B. In most cases, duration is sufficient to approximate MBS price changes resulting from yield changes for the purpose of estimating VaR.
C. The Optionality embedded in a MBS makes the implementation of the duration-convexity method less appropriate for the purpose of estimating VaR.
D. As rates fall, MTGE10 price change approximations using the duration-convexity method are likely to be better than MTGE4 price change approximations.

Answer: C

Question 14

Which is the primary advantage of the option-adjusted spread (OAS) over the static spread?

A. OAS uses the entire term structure instead of a single point
B. OAS, being a valuation model, is not biased by the market price of the bond
C. OAS allows for cash flow changes due to interest rate changes
D. None, they are the same

Answer: C
This is the key idea: while static (Z) spread treats the term structure of rates as static, the OAS simulates several interest rate paths and therefore can model cash flow changes. In regard to (A), this is not correct because both OAS and static spread use the entire term structure. In regard to (B), this is false: OAS solves for yield that equates to market price.