LOS c: Calculate the prepayment amount for a month, given the single monthly mortality rate.

Q1. Given a single monthly mortality rate (SMM) of 0.45%, a mortgage pool with a $200,000 principal balance outstanding at the beginning of the 26^th month, and a scheduled monthly principal payment of $60.00 for the 26^th month, the estimated prepayment is:

A)   $899.73.

B)   $450.00.

C)   $426.38.

Q2. The SMM formula is: SMM = 1 – (1 – CPR)^1/12. Calculate the single monthly mortality rate (SMM) for month 6, 100 PSA:

A)0.000837.

B)0.001006.

C)0.001259.

Q3. Suppose that the single-monthly mortality rate (SMM) is equal to 0.004. The mortgage balance for a certain month is $100 million, and the scheduled principal payment for the same month is $2.5 million. What is the assumed prepayment amount for this month?

A)   $390,000.

B)   $960,000.

C)   $460,000.

Q4. Suppose that the single-monthly mortality rate (SMM) is equal to 0.003. The mortgage balance for a certain month is $250 million, and the scheduled principal payment for the same month is $3 million. What is the assumed prepayment amount for this month?

A)   $741,000.

B)   $356,000.

C)   $672,000.

Q5. Paul Advani, an unemployed telecommunications analyst, is scheduled to interview tomorrow with Manish Preeh, managing partner of the mortgage-banking division of Robust Investors. Since Advani has not worked in mortgage banking and his knowledge of the field is somewhat rusty, he asks to borrow a friend’s Level II CFA Study Notes so he can prepare for the interview.
After a brief introduction and a discussion of Advani’s resume, Preeh tells Advani he is concerned about the candidate’s familiarity with the industry. Preeh asks Advani a series of questions to test his knowledge.
Preeh begins with a question about prepayment rates and benchmarks. He asks Advani to name some conventions used as benchmarks for prepayment rates. Advani comes up with four benchmarks:

• Conditional prepayment rates
• Single monthly mortality (SMM) rates
• Nonconforming mortgage rates
• Public Securities Association (PSA) prepayment benchmarks

Then Preeh asks Advani to describe the use of excess servicing spreads as internal credit enhancements.
Preeh’s next question requires Advani to discuss reasons for using the stated maturity of a mortgage passthrough security versus using the average life measure. Advani responds that the security’s maturity is less valuable to bond analysis than is the average life measure.
Then Preeh turns the questions to Advani’s product knowledge. Preeh gives Advani four characteristics that allegedly apply to stripped mortgage-backed securities (MBS), then asks him which one of the characteristics is accurate. The characteristics are as follows:

• Principal and interest are not allocated on a pro-rata basis.
• Owners of these securities benefit from quick prepayments.
• They pay significantly lower yields than their "whole" counterparts.
• They are less volatile than the passthrough from which they were stripped.

Preeh proceeds to ask Advani how planned amortization class (PAC) bonds are protected against prepayment risk to create products that provide better asset and liability matching for institutional investors.

The interview ends with a question using the following data:

• The single-monthly mortality rate (SMM) is equal to 0.003.
• The mortgage balance for March is $250 million.
• The scheduled principal payment is $3 million in March, and $3 million in April.

Which of the following characteristics best describes stripped MBS?

A)   Owners of these securities benefit from quick prepayments.

B)   Principal and interest are not allocated on a pro-rata basis.

C)   They are less volatile than the passthrough from which they were stripped.

Q6. Which of the following statements regarding excess servicing spreads is most accurate? Excess serving spread accounts involve the allocation of:

A)   expenses into accounts for senior and subordinate tranches.

B)   the servicing fee into a separate reserve account.

C)   surplus cash into a separate reserve account.

Q7. The estimated April prepayment is closest to:

A)   $729,777.

B)   $732,000.

C)   $741,000.

Q8. Which of the following is least likely used as a benchmark for prepayment rates?

A)   Nonconforming mortgage rates.

B)   SMM rates.

C)   Conditional prepayment rates.

Q9. Which of the following responses to Preeh’s question about PAC bonds is most accurate? They:

A)   structure the PAC tranche so it has more contraction risk but less interest-rate risk than the support tranches.

B)   gain prepayment risk protection as their par value falls relative to that of the support tranche.

C)   accrue the interest for one tranche and redistribute it to the support tranches.

Q10. Advani’s assertion that the maturity is a less-useful analytical tool than the average life measure of a mortgage passthrough security is:

A)   correct because the maturity does not take into account the assumed prepayment rate.

B)   incorrect because the average life measure does not take interest-rate risk into account.

C)   correct because the investor may not know the maturity, but can calculate the average life measure.

LOS c: Calculate the prepayment amount for a month, given the single monthly mortality rate. fficeffice" />

Q1. Given a single monthly mortality rate (SMM) of 0.45%, a mortgage pool with a $200,000 principal balance outstanding at the beginning of the 26^th month, and a scheduled monthly principal payment of $60.00 for the 26^th month, the estimated prepayment is:

A)   $899.73.

B)   $450.00.

C)   $426.38.

Correct answer is A)

Prepayment = (.0045)($200,000 - $60.00) = $899.73.

Q2. The SMM formula is: SMM = 1 – (1 – CPR)^1/12. Calculate the single monthly mortality rate (SMM) for month 6, 100 PSA:

A)0.000837.

B)0.001006.

C)0.001259.

Correct answer is B)

CPR = 0.2% * 6 = 0.012

SMM = 1-(1-0.012)^1/12 = 0.001006

Q3. Suppose that the single-monthly mortality rate (SMM) is equal to 0.004. The mortgage balance for a certain month is $100 million, and the scheduled principal payment for the same month is $2.5 million. What is the assumed prepayment amount for this month?

A)   $390,000.

B)   $960,000.

C)   $460,000.

Correct answer is A)

The prepayment amount is computed as follows:

Prepayment amount = SMM × (beginning mortgage balance for a month ? scheduled principal payment for the month) = 0.004 × ($100 million ? $2.5 million) = $390,000.

Q4. Suppose that the single-monthly mortality rate (SMM) is equal to 0.003. The mortgage balance for a certain month is $250 million, and the scheduled principal payment for the same month is $3 million. What is the assumed prepayment amount for this month?

A)   $741,000.

B)   $356,000.

C)   $672,000.

Correct answer is A)

The prepayment amount is computed as follows:

Prepayment amount = SMM x (beginning mortgage balance for a month - scheduled principal payment for the month) = 0.003 × ($250 million ? $3 million) = $741,000.

Q5. Paul Advani, an unemployed telecommunications analyst, is scheduled to interview tomorrow with Manish Preeh, managing partner of the mortgage-banking division of Robust Investors. Since Advani has not worked in mortgage banking and his knowledge of the field is somewhat rusty, he asks to borrow a friend’s Level II CFA Study Notes so he can prepare for the interview.
After a brief introduction and a discussion of Advani’s resume, Preeh tells Advani he is concerned about the candidate’s familiarity with the industry. Preeh asks Advani a series of questions to test his knowledge.
Preeh begins with a question about prepayment rates and benchmarks. He asks Advani to name some conventions used as benchmarks for prepayment rates. Advani comes up with four benchmarks:

• Conditional prepayment rates
• Single monthly mortality (SMM) rates
• Nonconforming mortgage rates
• Public Securities Association (PSA) prepayment benchmarks

Then Preeh asks Advani to describe the use of excess servicing spreads as internal credit enhancements.
Preeh’s next question requires Advani to discuss reasons for using the stated maturity of a mortgage passthrough security versus using the average life measure. Advani responds that the security’s maturity is less valuable to bond analysis than is the average life measure.
Then Preeh turns the questions to Advani’s product knowledge. Preeh gives Advani four characteristics that allegedly apply to stripped mortgage-backed securities (MBS), then asks him which one of the characteristics is accurate. The characteristics are as follows:

• Principal and interest are not allocated on a pro-rata basis.
• Owners of these securities benefit from quick prepayments.
• They pay significantly lower yields than their "whole" counterparts.
• They are less volatile than the passthrough from which they were stripped.

Preeh proceeds to ask Advani how planned amortization class (PAC) bonds are protected against prepayment risk to create products that provide better asset and liability matching for institutional investors.

The interview ends with a question using the following data:

• The single-monthly mortality rate (SMM) is equal to 0.003.
• The mortgage balance for March is $250 million.
• The scheduled principal payment is $3 million in March, and $3 million in April.

Which of the following characteristics best describes stripped MBS?

A)   Owners of these securities benefit from quick prepayments.

B)   Principal and interest are not allocated on a pro-rata basis.

C)   They are less volatile than the passthrough from which they were stripped.

Correct answer is B)

Stripped MBS differ from conventional MBS in that principal and interest are not allocated on a pro-rata basis, because they come in two flavors, principal-only (ffice:smarttags" />PO) and interest-only (IO). PO and IO strips have different payment policies. Investors who buy interest-only strips want slow prepayments, as fast prepayments reduce the value of the cash flows. PO and IO strips are more volatile than the original security with both principal and interest payments. (Study Session 15, LOS 56.j)

Q6. Which of the following statements regarding excess servicing spreads is most accurate? Excess serving spread accounts involve the allocation of:

A)   expenses into accounts for senior and subordinate tranches.

B)   the servicing fee into a separate reserve account.

C)   surplus cash into a separate reserve account.

Correct answer is C)

Excess cash is paid into the excess servicing spread account in order to cover possible future losses. Servicing fees pay for services, not reserves against default risk. Excess servicing spreads have nothing to do with tranche structures. (Study Session 15, LOS 58.d)

Q7. The estimated April prepayment is closest to:

A)   $729,777.

B)   $732,000.

C)   $741,000.

Correct answer is A)

The prepayment amount is computed as follows:

Prepayment amount = SMM × (beginning mortgage balance for a month ? scheduled principal payment for the month) = For March, the prepayment is 0.003 × ($250 million ? $3 million) = $741,000.
For April, the starting mortgage balance is $250 million ? $3 million ? $741,000 = $246.259 million.
The prepayment is 0.003 × ($246.259 million ? $3 million) = $729,777.

(Study Session 15, LOS 56.c)

Q8. Which of the following is least likely used as a benchmark for prepayment rates?

A)   Nonconforming mortgage rates.

B)   SMM rates.

C)   Conditional prepayment rates.

Correct answer is A)

Two industry conventions have been adopted as benchmarks for prepayment rates:

1. the conditional prepayment rate, which is used to compute SMM.

2. the PSA prepayment benchmark.

(Study Session 15, LOS 56.d)

Q9. Which of the following responses to Preeh’s question about PAC bonds is most accurate? They:

A)   structure the PAC tranche so it has more contraction risk but less interest-rate risk than the support tranches.

B)   gain prepayment risk protection as their par value falls relative to that of the support tranche.

C)   accrue the interest for one tranche and redistribute it to the support tranches.

Correct answer is B)

The PAC tranche has significant protection against prepayment risk at the expense of the support or companion tranches. The more the support tranche’s par value rises relative to that of the PAC bond, the better the protection against prepayment risk. PAC tranches are designed to deal with prepayment risk, and as such pass the contraction or extension risk onto the support tranches. PAC tranches can siphon interest slated for the support tranches, but do not redistribute it. In fact, PAC tranches are designed to provide a minimum guaranteed principal payment by collecting interest targeted for a support tranche when prepayments are low. (Study Session 15, LOS 56.h)

Q10. Advani’s assertion that the maturity is a less-useful analytical tool than the average life measure of a mortgage passthrough security is:

A)   correct because the maturity does not take into account the assumed prepayment rate.

B)   incorrect because the average life measure does not take interest-rate risk into account.

C)   correct because the investor may not know the maturity, but can calculate the average life measure.

Correct answer is A)

The stated maturity of a mortgage pass-through security is unlikely to equal its true life because of prepayments. Average life is used because it represents the average time to receipt of both scheduled principal payments and expected prepayments. The average life measure attempts to reflect changes in prepayment rates, and as such takes into account likely changes in interest rates or the economic climate. Because the average life measure is a better analytical tool than the stated maturity, the answer starting with “incorrect” is wrong. (Study Session 15, LOS 56.b)

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