| Investment Knowledge |
 |
 |
 |
 |
|
Variable Rate MBS Valuation In the simplest sense an MBS is valued according to the current value of an expected series of cash flows for the pool of mortgages that underlie the security. However, predicting the expected cash flows must take into account the characteristics of the underlying mortgages that could alter the cash flows and predict what those changes would be. The calculator used for MBS valuation of FRM assesses the expected cash flows from the mortgages while considering the potential for not earning those cash flows due to early return of principal from prepayments and mortgage refinancing, and determines the appropriate fixed coupon for the MBS accordingly. However, VRM have different characteristics that determine the cash flow behaviour in particular a changing interest rate and the possibility for conversion to a new FRM. An NHA MBS passes through to its holders, the investors, a portion of the cashflows generated by a pool of amortizing insured residential mortgages which are sold on a fully serviced basis. More specifically, an NHA MBS passes through to its holders all principal payments and a portion of the interest payments generated by the underlying mortgage pool. The principal payments include the scheduled monthly payments, partial prepayments, and liquidations. Interest is paid monthly on the outstanding principal at the specified MBS coupon rate. It is proposed that the VRMBS be backed by standard VRM which requires a borrower to make fixed payments regardless of changes to the interest rate on the mortgage. However, the portion of the payment that will go to interest or principal will depend on the interest rate level and particular features of the mortgage. These features typically include the rate movement schedule, the index the rate is based on, the discount offered against the index, any interest rate ceiling that may be offered, and the level of bank prime effective for that month. Depending on the mortgage specifics, penalty interest may also be charged to the borrowers for early prepayment/liquidation of their mortgage, or according to the flexibility surrounding conversion to a FRM mortgage. Certain of the current NHA MBS pool types pass through to its holders all or part of the penalty interest paid by mortgagors when liquidating their fixed rate mortgages. It is critical to establish a means of specifying interest rate movement because the timing and shifts in the rate will determine the future rates of the mortgages. The interest payable on the mortgage principal will serve to determine the coupon for the MBS. Since the mortgage rates float, a valuation model must have a means of specifying the expected future mortgage rates and then determining an appropriate MBS coupon rate.
|