Chapter 8

Multiclass Mortgage Pass-Throughs

The creation of mortgage pass-throughs was an important capital market innovation in the 1970s. Mortgage pass-throughs flourished with rapidly expanding issuance volume in the early 1980s. However, market participants always felt that mortgage pass-throughs could have been more successful and prominent both as an effective tool for housing finance for homebuyers and as an attractive instrument for fixed-income investors. The one thing that held back the full development of mortgage pass-throughs was the undesirable aspect of the cash flows—the prepayment uncertainty, which is an inherent risk for the investor.

This chapter will first briefly explain the prepayment risk of mortgage pass-throughs. It will then discuss the evolution of the market addressing the prepayment risk by creating multiple maturity classes of mortgage-backed securities. This chapter will also describe the rise, collapse, and recovery of the multiclass pass-through market. Finally, it will present the trading and relative value of the multiclass mortgage pass-throughs. Detailed explanations of the factors contributing to prepayment and the calculation of the prepayment rate are provided in Appendix A at the end of the book.

Prepayment of Mortgage Pass-Throughs

While a mortgage is a long-term debt, the mortgagor can retire the debt before maturity. This early retirement of a mortgage debt is called prepayment. Residential mortgages are prepayable at par without penalties. ...

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