Measurement of Prepayments for Residential Mortgage-Backed Securities

WILLIAM S. BERLINER

Executive Vice President, Manhattan Advisory Services Inc.

FRANK J. FABOZZI, PhD, CFA, CPA

Professor of Finance, EDHEC Business School

ANAND K. BHATTACHARYA, PhD

Professor of Finance Practice, Department of Finance,W. P. Carey School of Business, Arizona State University

Abstract: The valuation of residential mortgage-backed securities begins with a projection of a subject security's cash flow. The monthly cash flow from the underlying pool of mortgage loans includes three components: (1) scheduled principal payments (also referred to as amortization), (2) interest payments, and (3) any prepayments. Prepayments are any payments made by borrowers that are in excess of the scheduled principal payment. Consequently, the cash flow depends on the prepayment behavior of the borrowers in the mortgage pool. In addition to prepayments, the expected credit performance of the underlying loans must be projected to estimate a residential mortgage-backed securities cash flow. The sharp deterioration in mortgage performance that emerged in late 2006 led to the realization that prepayments and defaults often had related effects on the performance of these securities, even though they represent very different phenomena. As a result, new terminology has emerged to clarify the different circumstances that result in the early return of principal to investors. Understanding the terms used in the market to define ...

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