Mortgage pass-through securities, Financial Management

Assignment Help:

The basic form of a mortgage backed security is that of a mortgage pass-through security. Among the mortgage-related securities, the mortgage pass-through securities form a very large class. Several federally supported (government supported) bodies made these securities popular, provided credit support and standards of uniformity. The support given by these bodies made the pools of mortgages underlying the pass-through more readily marketable. The most popular pass-through securities backed by such entities are Government National Mortgage Association Pass-Through Securities, Federal Home Loan Mortgage Corporation Participation Certificates, and Federal National Mortgage Association Mortgage-Backed Security.

A mortgage pass-through security is a share or participating certificate issued by a collection pool comprising several mortgages. The mortgage is said to be securitized when the mortgage in the pool of mortgages acts as a collateral to mortgage pass-through security. The cash flow to the investors of these securities depends on the cash flow generated by the pool which is in the form of interest payments, planned repayment of principal and any prepayments. The security holders receive monthly payments, whose timings and amount may not be identical to the ones received from the pool. The amount the holders receive is the monthly cash flow from mortgages less the servicing and other fees like the fee charged by the issuer or guarantor.

Since a pool consists of different mortgages which may vary in terms of the mortgage rate and the timing of the cash flows, the pool actually has a Weighted Average Coupon Rate (WAC) and Weighted Average Maturity (WAM). These are calculated by multiplying the mortgage rates and months remaining till maturity with their weights (amount outstanding on a mortgage divided by the total amount outstanding).

These securities are exposed to two risks namely the prepayment risk and the extension risk. As said earlier, the owner of a pass-through does not know the timing and amount of cash flow as these depend on the actual payments and prepayments. This exposes one to prepayment risk. To understand better, lets take an example. Suppose the coupon rate is 8% and the mortgage rate is 9%. A decline in mortgage rates to 5% may result in two adverse consequences. As a pass-through security is like an option-free bond, the price of the security rises. However, security price rise may not be as great as that of an option-free bond. This is because, when interest rates fall, the borrower will be inclined to prepay the loan and refinance the debt at a lower rate, resulting in an adverse impact to the security holders. The second adverse impact is that the cash flows may have to be reinvested at lower rates. These effects are mainly due to the shortening of the timing of cash flows.

In case of an increase in the mortgage rates, say in the above example, to 14%, the price of the security declines. Since the rates are higher, the prepayments will decline, in reality increasing the amount invested at coupon rate (this rate is lower than the market rate). This adverse consequence is called as extension risk. These adverse effects are due to the lengthening of the timing of cash flows.

These risks make the pass-through securities unattractive to hold for the financial institutions.


Related Discussions:- Mortgage pass-through securities

Five cs of obtaining credit, Five Cs of Obtaining Credit The five ...

Five Cs of Obtaining Credit The five crucial parts lenders examine previously issuing credit include: 1. Character.    This is a calculation of the borrower's integrit

Active portfolio strategy, Active Portfolio Strategy: An active portfo...

Active Portfolio Strategy: An active portfolio strategy is tracked by most aggressive investors and investment professionals who strive to make superior returns, after adjustm

Strong form level of efficiency, Strong form level of Efficiency This l...

Strong form level of Efficiency This level states that price reflects all the available public and private information (past, present and future information). If the hypothesis

What is the tolerable error, What is the Tolerable error In addition t...

What is the Tolerable error In addition to looking at material differences individually the auditor must list all the differences (material or not) and consider in total wheth

Relationship between financial decision making and risk , Discuss the relat...

Discuss the relationship between financial decision making and risk and return. Would all financial managers view risk-return tradeoffs similarly

currency options, Do you guys provide Currency Options assignment help? I ...

Do you guys provide Currency Options assignment help? I need writing a report on Currency Options and it is about 2000 words. Let me know. I need to buy your solution.

Interest rate anticipation strategies, Active bond management depends...

Active bond management depends on an economic scenario in order to forecast the movements of yield curve. A portfolio manager skillfully builds a portfolio wit

Cost of capital, The Nu-Nu Brothers Inc. (NNBI) has the following capital s...

The Nu-Nu Brothers Inc. (NNBI) has the following capital structure, which it considers to be optional: Debt 25% Preferred Stock 15% Common Equity 60% NNBI''''s expected net income

Define the term- cost of capital, Define the term- Cost of capital Cost...

Define the term- Cost of capital Cost of capital is the rate of return a firm should earn on its investments for the market value of the firm to remain unchanged. Acceptance of

Financial capital, Assume that you have just "run out of money" and are una...

Assume that you have just "run out of money" and are unable to move your "idea" from its development stage to production and the startup stage.  However, you remain convinced that

Write Your Message!

Captcha
Free Assignment Quote

Assured A++ Grade

Get guaranteed satisfaction & time on delivery in every assignment order you paid with us! We ensure premium quality solution document along with free turntin report!

All rights reserved! Copyrights ©2019-2020 ExpertsMind IT Educational Pvt Ltd