In this module we're going to go through the mechanics of mortgage pass through securities. And we will do that within the context of our Excel spreadsheet, which I hope you have with you. You can download that Excel spreadsheet with these modules and mortgage backed securities. We're going to look at the second worksheet in this Excel workbook. It's going to be about mortgage pass throughs. We'll discuss the mechanics of mortgage pass throughs. And see how the, how the cash flows of a mortgage pass through are created, and passed on to investors. The second worksheet on the XL workbook that goes along with these modules, and mortgages, and mortgage backed securities is called pass through. This worksheet shows the mechanics of a simple pass through mortgage backed security. Now, I just want to state in advance. Don't worry too much if it takes you some time to figure out. What the various self formulas are doing. it's not a hugely important part of this course. What I want you to come away with is a basic understanding of the mechanics of how these kinds of securities work. So what we have here is the following. We've assumed that the pass through. Now remember, a pass through mortgage backed security is constructed. From a pool of underlying mortgage loans. So we might assume, for example, that the mortgage balance, or here, the remaining mortgage balance, is 400. That might represent $400 million for example, representing a large pool of underlying mortgages. We're going to assume that the mortgage rate, so if you like, this is the coupon rate on the underlying mortgages. It's 8.125%. The pass through rate is 7.5%. Now, what is the difference between these 2 rates? Well, the pass through rate is the rate that gets passed on to investors. And it will always be less than the mortgage rate. And that difference accounts for the fees associated with servicing. The mortgage-backed security, in this case the pass-through. Somebody has to organize and manage and service the mortgage-backed securities. They need to be paid a fee for doing so. That fee is represented by the difference between the mortgage rate, 8.125%, And the pass thru rate 7.5%. The initial monthly payment, or if you like, the average monthly payment, that the underlying mortgage owners are paying, is 24.989. The seasoning, so this is how old the mortgage pool currently is, it's 3 months,and the term of the loan of the underlying mortgages is assumed to be 20 months. Now of course this is very unrealistic in realty you would be in a much larger pool certainly for mortgages or mortgage backed securities that have just been initiated. But I've assumed 20 months here, just so that we can see all of the payments on one screen. In reality, this might start off as being 240 or 360, corresponding to 20 or 30 year loans, respectively. We start off in Month 1, and let's work across. So, we have our conditional prepayment rates. So, this is our CPR, which is expressed as an annual rate. It tells you what percentage of the outstanding mortgage at the beginning of the period will be prepaid. Of course, we will need convert this into a single month mortality rate, and that's what we do here. The SMM gives us the percentage of the mortgage balance that is prepaid that month. We have an initial beginning monthly balance of 400. The monthly payment is 24.989 as we caluculated earlier. This is the monthly interest paid in by mortgage holders. And this is the monthly interest paid out to the past through investors. Note that this interest. Payment here 2.5 is less then 2.71 and that's because of the difference 8.125% and 7.5%. Finally the scheduled principle repayment is 22.281. That's equal to E13 minus F13. So that's the monthly payment minus the monthly interest paid in. And then finally there are some prepayments. As I mentioned in the last module. Sometimes mortgage owners prepay, and they might do so for various reasons. Maybe they're selling their house and moving to another location, maybe they've gotten divorced, maybe they've had a flood or a fire, maybe they've defaulted on their payments. And all those situations What the mortgage investors see, investors in mortgage-backed securities see is the mortgage being prepaid. So we're going to assume that these prepayments take place according to this schedule, the cpr. And SMM schedule and we get a prepayment of 2.53. So therefore the total principle payment is .253 plus 22.281 and that gives us 22.533. We can therefore subtract that from the initial mortgage balance of 400 to give an ending mortgage balance of 377.47. We then move on to the next time period, time period two. We see that the conditional pre-payment rate is increased to one percent. We get our single monthly mortality rate and so on. We know our beginning monthly balance is 377, this is the same monthly balance we had at the end of the previous period. We get our monthly payment. Now notice our monthly payments are now no longer the same constant. So in our last module we had a constant B being paid in every period. We would've the same constant B being payed in every period here, if there were no prepayments. But there are prepayments. Those prepayments actually reduce the outstanding principle by more than what you'd expect. And therefore that changes the B in each period. So if you, if you look carefully at the formulas here, you'll see that this formula is the same formula we assume to calculate B. In our earlier module. But of course we have to keep recalculating it in every period to adjust for the fact that prepayments are taking place. So what I want you to get from this spreadsheet is basically just how the repayments are calculated. How the interest payments are calculated. The interest payments paid out to past due investors are calculated. And the fact that prepayments take place and that these prepayments Alter the outstanding mortgage principal that remains at the end of every period. Now this is an idealized world, we don't have any defaults. We don't have any randomness in our prepayments. We're assuming prepayments occur according to this deterministic schedule given to us by the CPR. That's all fine as I said. In the real world of course You have to take these into account, but for our purposes we just want to understand some of the mechanics behind how these mortgage backed securities are created. And the simplest type of mortgage backed security is what is called the mortgage pass through. Where you just pool a whole series of loans together and then you pay out the principle and interest on those loans out to the investors in the pass through security.
