What Are the Risks in a Mortgage-Backed Security?
Most mortgages are 30 years. An MBS pays monthly principal and interest; the resulting cash flow causes the MBS to have what is called an “average life.” Principal paid back is known as the “pre-payment” rate. On a brand new MBS, that average life is usually 12 years. This is a major caveat in the secondary market because that average life is dynamic – not static. It can and does change. The tongue-in-cheek expression in the investment community is known as “mortgage magic.” This is accomplished by assuming a faster or slower pre-payment rate. This assumption has the result of changing the average life and thus the yield to the investor. These assumptions can be justified by increasing defaults, various parts of the country, economic conditions and so forth. Who is to say these assumptions are wrong? document.getElementById(‘adsense_placeholder_2’).innerHTML = document.getElementById(‘adsense_ad_2_hidden’).innerHTML; Pre-payment Assumptions Compounded Suppose an investor bought a new M
