Introduction to Securitization

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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