Mortgage Backed Securities And Their Risks

As compared to the plain vanilla bonds, the Mortgage-backed securities or the MBS can add new risk from its database of unique features.

  1. The Mortgage-backed securities are affected by the residential mortgages and are thus collateralized.
  2. The monthly payments pass to the investor of the third party from the originating bank.
  3. The amortization is carried over the entire life time. More specifically, the principle amount is sometimes paid off with payment made a month wise. On the other hand, the bond has monthly interest payments as compared to the MVS whose principle is paid at maturity.
  4. The investors are the receivers of unscheduled prepayments assuming pro-rata that are of the principals because of refinancing, foreclosure and house sales. The mortgages are paid off much sooner as compared to a typical mortgage may have a term of 30 years.

WAL:

Weighted Average Life

Weighted Average Life or WAL is one of the most effective tools to measure effective maturity of the MBS. The WAL is one of the most common methods as well and is also known as the average life.

In order to calculate WAL, the fraction of the year and the month of each payment to be made are multiplied by the percentage of the total principal. This percentage is paid off at that date which is later added up from the results.

Therefore, when WAL is calculated, it basically calculates the pay downs and its impact over the lifetime throughout its life. In a visual scenario, WAL is a fulcrum that stretches between the origination and the final maturity date on the timeline.

It focuses on balancing the principal payment exactly like balancing several children of different weights on a seesaw after acquiring variant positions. Therefore, the main focus is on balancing the principal payments exactly like balancing a number of children of various weights on different positions of a seesaw.

Yields:

The Mortgage-Backed Securities are traded at premiums discounts or par value that depend upon the changes that occur in the current market. The assumptions arising from the prepayment is thus a highly critical to the mortgage pass-through securities. However, the time and amount are not known, which means that these variables must be identified via projections.

Furthermore, the conservative assumptions are usually not applicable as they have an asymmetric effect.

Assumption:

The number of assumptions built over the years has its own advantages and disadvantages.

Prepaid In 12:

The prepaid in 12 has the assumption of no prepayments until the twelfth year. This happens when all the mortgages in the pool prepay in entirety. The advantage is that this specification has a computational simplicity in it and manages to conform to the reality.

However, this assumption also has is a negative effect. To start with, it neglects the early year prepayments of the mortgage pool. This means that this assumption understates and overstates at the same time. Specifically speaking, when this assumption calculates and quotes, the potential yield becomes highly understated, which is being traded at a deep discount. As for the overstated part, on a premium pass-through, things turn overstated.

FHA:

Moving on, the Federal Housing Authority (FHA) is based on complexity and realism payment specification. It works by gathering the important background of payments made that were carried out for the mortgage loans which it aims to insure. The data thus compiles various dates and cupon rates in its database.

PSA:

PSA

This assumption is probably one of the most commonly used. This prepayment rate assumption is one of the standard prepayment experiences that are offered by the Public Securities Association (PSA). The PSA is an industry trade group that has its name in the prepayment rate assumption.

Overall, the Public Securities Association has only one goal, and that is to bring standardization into the market it works in. The assumptions work with 0 and then slowly and steadily rise to 0.2 percent each month. With the passage of time, this 30 month beginning is an experience that comes with a steady CPR.  After 30 months, the CPR of 6 percent is used.

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