Cash flow risk due to slowing down of interest payments on MBS products ? I can understand refinancing of mortgages in a declining interest rate environment but how can interest payment cash flow reduce in an increasing interest rate environment ? Do homeowners have an option ? In any case shouldn’t this be a credit risk ?

slower prepayments…?

Slower prepayments.

Why would this be a negative for interest only cash flow streams as the answer suggests?

MBS CF = IO + PO From Lvl 2 there is that SMM rate which adds a principal pre pay amount to the principle cash flow from the monthly payments. As rates increase prepayments decrease and smm goes down, thus PO cashflow decreases.

Because when insurance company bought MBS, they figure that the prepayment rate will be 10% (made up number), so that is the assumption they are using for their model, now, since interest rate went up, people are less likely to refi, therefore, prepayment rate will go down to 8%. The drop in prepayment rate can cause CF problem for insurance company since they assumption was using 10%.

CKBond Wrote: ------------------------------------------------------- > Why would this be a negative for interest only > cash flow streams as the answer suggests? why are you suggesting that it is an IO mortgage only? I did not see them mention anything to that regard, unless I am missing something…

Remind me , what is SMM again?

I thought I read IO in the answer …

from the answer key: The large holding in mortgage securities adds uncertainty to cash flows. When interest rates rise, slower prepayment rates reduce cash inflows and associated interest on interest yield. These cash flows are an integral part of the reserve funding formula and a source of surplus growth.

I think what threw you off is the “associated interest on interest yield” which does not, in itself mean that the mortgage is an IO. it means that it is reducing the speed and extending it out essentially…

yes i think i did. By the way what is SMM again?

Single Monthly Mortality - % of reduction of principal each month

Thanks again

cash flows declines, that is it