Prepayments speed

Although it is commonly quoted by market participants, the cash flow yield suffers from limitations similar to the yield to maturity. These shortcomings include (1) the projected cash flows assume that the prepayment speed will be realized (2) the projected cash flows are assumed to be reinvested at the cash flow yield and (3) the mortgage-backed or asset-backed security is assumed to be held until the final payoff of all the loans in the pool based on some prepayment assumption. If the cash flows are reinvested at rate lower than the cash flow yield (i.e., reinvestment risk) or if actual prepayments differ from those projected, then the cash flow yield will not be realized. Mortgage-backed and asset-backed securities are particularly sensitive to reinvestment risk since payments are usually monthly and include principal repayments as well as interest. 

EXHIBIT 11.10 Example Paydown Profile at High Prepayment Speeds... 

Prepayments have been more consistent across different MBS transactions than either arrears or losses (see Exhibit 11.21). Traditionally, UK nonconforming MBS transactions have been priced nsing the assumption that the prepayment speed would be at a CPR of 25%. Exhibit 11.21 shows that prepayments have generally started at a mnch slower rate but then have accelerated np to a CPR of 35% by the time the mortgages are approximately 18 months old. As a result, a 25% CPR assumption is likely to underestimate the average life of a fast-pay security but probably overestimate the average life of a longer-life security. 

Following the substitution period, the transaction typically enters the amortisation period, during which principal collected from receivables is passed through to noteholders. This may lead to a degree of variability in the average life of the security if the borrowers repay their loans more quickly or slowly than the modelled prepayment speed used to price the notes. Exhibit 14.10 shows a simplified paydown structure for the FIAT 1 transaction. 

Auto loan pools were some of the earliest to be securitized in the ABS market and still remain a major segment of the U.S. market. Investors have been attracted to the high asset quality involved and fact that that the vehicle offers an easily sellable, tangible asset in the case of obligor default. In addition, since a car is seen as an essential purchase and a short loan exposure (three to flve years) provides a disincentive to finance, no real prepayment culture exists. Prepayment speed is extremely stable and losses are relatively low, particularly in the prime sector. 

The absolute prepayment speed (ABS) is a standard measure for prepayments, comparing actual period prepayments as a proportion to the whole pool balance. As with all prepayment metrics, this measure provides an indication of the expected maturity of the issued ABS and, essentially, the value of the call option on the issued ABS at any time. 

The public securities association (PSA), now part of the SIFMA, has a metric for projecting prepayment that incorporates the rise in prepayments as a pool seasons. A pool of mortgages is said to have 100 percent PSA if its CPR starts at 0 and increases by 0.2 percent each month until it reaches 6 percent in month 30. It is a constant 6 percent after that. Other prepayment scenarios can be specified as multiples of 100 percent PSA. This calculation helps derive an implied prepayment speed assuming mortgages prepay slower during their first 30 months of seasoning. 

Absolute Prepayment Speed (ABS) prepayments/outstanding pool balance auto loans, truck loans... 

In a pass-through transaction, the notes will normally be split into a number of classes that will be redeemed in order of priority. The actual speed at which the notes are redeemed will depend on the underlying repayment schedule of the mortgages in the pool and the rate at which the borrowers prepay their mortgages. (See Exhibit 11.8 for a generic example.)... 

As already noted, the exact term of a mortgage-backed bond cannot be stated with assurance at the time of issue, because of the uncertainty connected with the speed of mortgage prepayments. As a result, it is not possible to analyze these bonds using the same methods as for fixed-coupon bonds. The most common approach is to assume a fixed prepayment rate—recognizing that, in reality, it will fluctuate with changes in mortgage rates and the economic cycle—and use this to project the bond s cash flows and thus its life span. The prepayment rate selected obviously is very important. This section considers some of the ways the rate is arrived at. 

Cash flow profile. CMOs profiles are based on an assumed prepayment rate, known as the pricing speed, which reflects current market expectations for prepayment levels and market interest rates. 

The price of a PO bond fluctuates with mortgage interest rates. As noted earlier, the majority of mortgages are fixed-rate loans. If mortgage rates fall below the PO bond s coupon rate, the volume of prepayments should increase as the individuals holding the underlying loans refinance them, speeding the stream of payments to the bondholder. The PO s price will rise both because of the faster cash flows and because the flows are now discounted at a lower rate. The opposite happens when mortgage rates rise. 

Finally, consider efficiency and speed. Documentation is a prepayment of time. Repairs, rerouting, replacements, and reworking all go faster and smoother with proper documentation. If your installation is one in which any downtime or degradation of service is unacceptable, then budgeting sufficient time for the documentation process is critically important. 

As already noted, the exact term of a mortgage-backed bond cannot be stated with assurance at the time of issue because of the uncertainty connected with the speed of mortgage prepayments. As a result, it is not... 

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