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In this module we're going to go through the mechanics of mortgage pass through

Â securities. And we will do that within the context of

Â our Excel spreadsheet, which I hope you have with you.

Â You can download that Excel spreadsheet with these modules and mortgage backed

Â securities. We're going to look at the second

Â worksheet in this Excel workbook. It's going to be about mortgage pass

Â throughs. We'll discuss the mechanics of mortgage

Â pass throughs. And see how the, how the cash flows of a

Â mortgage pass through are created, and passed on to investors.

Â The second worksheet on the XL workbook that goes along with these modules, and

Â mortgages, and mortgage backed securities is called pass through.

Â This worksheet shows the mechanics of a simple pass through mortgage backed

Â security. Now, I just want to state in advance.

Â Don't worry too much if it takes you some time to figure out.

Â What the various self formulas are doing. it's not a hugely important part of this

Â course. What I want you to come away with is a

Â basic understanding of the mechanics of how these kinds of securities work.

Â So what we have here is the following. We've assumed that the pass through.

Â Now remember, a pass through mortgage backed security is constructed.

Â From a pool of underlying mortgage loans. So we might assume, for example, that the

Â mortgage balance, or here, the remaining mortgage balance, is 400.

Â That might represent $400 million for example, representing a large pool of

Â underlying mortgages. We're going to assume that the mortgage

Â rate, so if you like, this is the coupon rate on the underlying mortgages.

Â It's 8.125%. The pass through rate is 7.5%.

Â Now, what is the difference between these 2 rates?

Â Well, the pass through rate is the rate that gets passed on to investors.

Â And it will always be less than the mortgage rate.

Â And that difference accounts for the fees associated with servicing.

Â The mortgage-backed security, in this case the pass-through.

Â Somebody has to organize and manage and service the mortgage-backed securities.

Â They need to be paid a fee for doing so. That fee is represented by the difference

Â between the mortgage rate, 8.125%, And the pass thru rate 7.5%.

Â The initial monthly payment, or if you like, the average monthly payment, that

Â the underlying mortgage owners are paying, is 24.989.

Â The seasoning, so this is how old the mortgage pool currently is, it's 3

Â months,and the term of the loan of the underlying mortgages is assumed to be 20

Â months. Now of course this is very unrealistic in

Â realty you would be in a much larger pool certainly for mortgages or mortgage

Â backed securities that have just been initiated.

Â But I've assumed 20 months here, just so that we can see all of the payments on

Â one screen. In reality, this might start off as being

Â 240 or 360, corresponding to 20 or 30 year loans, respectively.

Â We start off in Month 1, and let's work across.

Â So, we have our conditional prepayment rates.

Â So, this is our CPR, which is expressed as an annual rate.

Â It tells you what percentage of the outstanding mortgage at the beginning of

Â the period will be prepaid. Of course, we will need convert this into

Â a single month mortality rate, and that's what we do here.

Â The SMM gives us the percentage of the mortgage balance that is prepaid that

Â month. We have an initial beginning monthly

Â balance of 400. The monthly payment is 24.989 as we

Â caluculated earlier. This is the monthly interest paid in by

Â mortgage holders. And this is the monthly interest paid out

Â to the past through investors. Note that this interest.

Â Payment here 2.5 is less then 2.71 and that's because of the difference 8.125%

Â and 7.5%. Finally the scheduled principle repayment

Â is 22.281. That's equal to E13 minus F13.

Â So that's the monthly payment minus the monthly interest paid in.

Â And then finally there are some prepayments.

Â As I mentioned in the last module. Sometimes mortgage owners prepay, and

Â they might do so for various reasons. Maybe they're selling their house and

Â moving to another location, maybe they've gotten divorced, maybe they've had a

Â flood or a fire, maybe they've defaulted on their payments.

Â And all those situations What the mortgage investors see, investors in

Â mortgage-backed securities see is the mortgage being prepaid.

Â So we're going to assume that these prepayments take place according to this

Â schedule, the cpr. And SMM schedule and we get a prepayment

Â of 2.53. So therefore the total principle payment

Â is .253 plus 22.281 and that gives us 22.533.

Â We can therefore subtract that from the initial mortgage balance of 400 to give

Â an ending mortgage balance of 377.47. We then move on to the next time period,

Â time period two. We see that the conditional pre-payment

Â rate is increased to one percent. We get our single monthly mortality rate

Â and so on. We know our beginning monthly balance is

Â 377, this is the same monthly balance we had at the end of the previous period.

Â We get our monthly payment. Now notice our monthly payments are now

Â no longer the same constant. So in our last module we had a constant B

Â being paid in every period. We would've the same constant B being

Â payed in every period here, if there were no prepayments.

Â But there are prepayments. Those prepayments actually reduce the

Â outstanding principle by more than what you'd expect.

Â And therefore that changes the B in each period.

Â So if you, if you look carefully at the formulas here, you'll see that this

Â formula is the same formula we assume to calculate B.

Â In our earlier module. But of course we have to keep

Â recalculating it in every period to adjust for the fact that prepayments are

Â taking place. So what I want you to get from this

Â spreadsheet is basically just how the repayments are calculated.

Â How the interest payments are calculated. The interest payments paid out to past

Â due investors are calculated. And the fact that prepayments take place

Â and that these prepayments Alter the outstanding mortgage principal that

Â remains at the end of every period. Now this is an idealized world, we don't

Â have any defaults. We don't have any randomness in our

Â prepayments. We're assuming prepayments occur

Â according to this deterministic schedule given to us by the CPR.

Â That's all fine as I said. In the real world of course You have to

Â take these into account, but for our purposes we just want to understand some

Â of the mechanics behind how these mortgage backed securities are created.

Â And the simplest type of mortgage backed security is what is called the mortgage

Â pass through. Where you just pool a whole series of

Â loans together and then you pay out the principle and interest on those loans out

Â to the investors in the pass through security.

Â