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Introduction to Securitization by VINOD KOTHARI, FRANK J. FABOZZI

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KEY POINTS OF THE CHAPTER

In structuring agency mortgage-backed securities it is necessary to understand prepayment risk.
Different types of loans may permit the borrower to prepay the loans in whole or in part at any time prior to the scheduled principal repayment date.
A prepayment is a payment made by the borrower in excess of the scheduled principal payment.
Prepayment risk means that there is uncertainty in the cash flow because the rate of future prepayments is unknown.
Prepayment risk can be divided into extension risk and contraction risk.
In order to estimate the cash flow from collateral that allows prepayments an assumption about future prepayments is required.
In the agency mortgage-backed securities market, the prepayment benchmarks used are the conditional prepayment rate and the Public Securities Association (PSA) prepayment benchmark.
The conditional prepayment rate (CPR) as a measure of the speed of prepayments assumes that some fraction of the remaining principal in the mortgage pool is prepaid each month for the remaining term of the collateral.
The CPR is an annual prepayment rate and its corresponding monthly rate is called the single monthly mortality (SMM) rate.
The PSA prepayment benchmark is expressed as a monthly series of annual prepayment rates that assumes that prepayment rates are (1) low for newly originated loans; (2) will then speed up as the mortgages become seasoned; and (3) reach a plateau and remain at that level.

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