The Business of Investment Banking by K. Thomas Liaw

Author:K. Thomas Liaw
Language: eng
Format: epub
Publisher: Wiley
Published: 2015-01-28T11:00:00+00:00

Stripped Mortgage-Backed Securities

A stripped mortgage-backed security is a pass-through that divides the cash flow from the underlying collateral on a pro rata basis across the security holders. For example, the cash flow on a 6 percent pass-through security could be redistributed to create one new security with an 8 percent coupon (called the premium strip) and another with a 4 percent coupon (called the discount strip).

Securities may also be partially stripped so that each class receives some interest and some principal. When securities are completely stripped, all the interest is allocated to one class of security, known as interests-only (IO), and the entire principal to another, called principals-only (PO). The PO security trades at a discount. The yield an investor will realize depends on the prepayment rate; the faster the prepayments, the higher the yield. When a mortgage is prepaid, it is redeemed in full at par. When mortgage rates decline, prepayments speed up, accelerating payments to the PO investors. The unanticipated larger amount of cash flow will now be discounted at a lower interest rate. As a result, the price of a PO rises with declining mortgage rates. When mortgage rates rise, prepayments slow down, resulting in a lower cash flow. Coupled with a higher discount rate, the price of a PO falls with rising mortgage rates.

In contrast, IO holders receive only interest on the amount of principal outstanding. If mortgage rates decline, prepayments speed up. The smaller amount of principal outstanding will result in a decline in income for IO investors. Although the cash flow will be discounted at a lower rate, the net effect is typically a lower price for the IO. On a reverse interest rate trend, the expected cash flow improves, but the cash flow is discounted at a higher rate. The net effect may be either a rise or a fall in IO value, depending on the magnitude of the change.

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