MBS South Africa

E S E A R C H
Mortgage-Backed Securities:
A New Market for South Africa
R
Executive Summary
• Mortgage-Backed Securities are a large potential
R O D U C T
new market for South Africa.
• This document summarises some of the possible

features of these securities.
P
The information and comment provided herein are supplied for informational and illustrative
purposes only. The content herein addresses only certain aspects of mortgage-backed
securities (MBS) and asset-backed securities (ABS) and, thus, does not provide a complete
E W
assessment of such securities. Prospective investors in MBS and ABS should take independent
advice before investing in any product. The Standard Bank of South Africa Limited makes no
representation or warranty regarding the suitability of a product for a particular situation, but is
willing to provide assistance upon request.
N
Contents
OVERVIEW 5
PART I 7
INTRODUCTION TO MORTGAGE-BACKED SECURITIES 7

Mortgage Loans 7
Mortgage Loan Pools 8
A Simple Pass-Through MBS Structure 9
STRUCTURAL CONSIDERATIONS 10
Overview of Structure 10
The Pool of Mortgages and the Resulting Cashflows 11
The Originator/Seller/Servicer 11
The Special Purpose Vehicle 11
Security Trustee 12
Investors 12
Hedging Counterparties and/or Liquidity Providers 12
Credit Enhancement 12
Rating Agency Considerations 13
External Credit Enhancements 13
Back-Up Servicer 14
Internal Credit Enhancements 14
Reserve Funds 14
Overcollateralisation 14
Senior/Subordinated Structure 15
Certain Other Structural Features 15
Clean-Up Call Provisions 15
Step-up and Call Provisions 16
SPECIAL CONSIDERATIONS 17
Prepayment Risk 17
Determinants of Prepayment Rates 17
Measuring Prepayment Rates 18
Pricing of Floating-Rate Mortgage-Backed Securities 18
Effect of Prepayment on Price of Floating-Rate MBS 19
Tax Treatment in Respect of Floating-Rate Mortgage-Backed Securities 20
PART II 22
MEASURING PREPAYMENT 22
Introduction 22
Underlying Mortgages 22
Prepayments 22
Weighted Average Life 24
Prepayment 24
Measurement of Prepayment 24
Scheduled Interest Payment and Scheduled Capital Payment 28
2
The information and comment provided herein are supplied for informational and illustrative purposes only. The content herein
addresses only certain aspects of mortgage-backed securities (MBS) and asset-backed securities (ABS) and, thus, does not provide a
complete assessment of such securities. Prospective investors in MBS and ABS should take independent advice before investing in
any product. The Standard Bank of South Africa Limited makes no representation or warranty regarding the suitability of a product for
a particular situation, but is willing to provide assistance upon request.
MODELLING PREPAYMENT 30
Introduction 30
Constant Prepayment Model 30
PSA Model 31
Other Factors 35
Seasonality 36
Burnout 36
Seasoning (ageing) 36
Interest Rates 36
Other Variables 36
Calibrating the Model 36
STRUCTURAL FEATURES AFFECTING CASHFLOWS 37

Introduction 37
The Base Case – A Simple Pass-Through 37
Step-Up and Call 37
Example 38
Substitution Period 40
Call Plus Step-Up for a Pool with Substitution 43
Tranching 46
Summary 51
SOME REAL WORLD CONSIDERATIONS 52

Introduction 52
Fixed versus Floating 52
Scheduled Payments 52
Length of Loans 54
Servicing Spread 54
Interest Payments 55
Excess Spread and Reserve Fund 55
Prepayment Behaviour and History 55
Defaults 55
PRICING FLOATING-RATE MORTGAGE-BACKED SECURITIES 56

Introduction 56
Principles of Pricing any FRN 56
Decomposing a MBS FRN into a Series of Vanilla FRNs 57
Example 1 57
Pricing Methodologies 60
Pricing Methodology 1 60
Simplifying the Formulas 61
Further Examples 64
Example 1 64
Risk 67
3
APPENDIX 1 – PRICING FLOATING-RATE NOTES 70
Introduction 70
Pricing Summary 70
Overview 70
Detailed Formulae 71
Source of Interest Rates in the Formula 72
Example 1 72
Reality Check 75
Pricing and Trading Formulae 75
Introduction 75
FRN and Money Market Equivalence 76
Portfolios 76
Conclusion 76
Swaps 77
Formula 77
Initial Margin and Trading Margin 77
Settlement Dates that are not Coupon Dates 78
APPENDIX 2 – SWAP CURVE AS AT 1 AUGUST 2001 81
4
Overview
Securitisation is a technique that is widely used in international markets to convert assets
with fairly predictable cashflows from generally illiquid assets into tradable securities.
Issuers issue securities that represent an interest in, or are collateralised by, a pool of
assets. Payments on these securities are made from and collateralised by the cashflows
of the underlying assets. These securities are, thus, generally termed asset-backed
securities (ABS).
Securitisation first arose in the United States in the 1960’s when government organisations
issued loans backed by mortgages. The technique then spread throughout the US as
investment banks began to structure pass-through securities that provided entitlement to
the cashflows of assets on a proportional basis. Securitisation of non-mortgage loans only
really took off in the mid-1980’s, but a rampant market has since developed, securitising
a diverse range of cashflows including credit card receipts, auto loans, trade receivables,
aircraft leases, commercial property, equipment leases and corporate loans. In the US, the
size of the mortgage-backed securitisation market now exceeds USD 1.2 trillion and is the
second largest market after that of US treasuries.
Securitisation started to gain popularity in the UK from the late 1980’s and has started to
gain appeal across continental Europe as well as Australia (where the issuance of
mortgage-backed securities (MBS) has been extremely successful), Japan and the
emerging markets.
Given the global size and level of sophistication of the securitisation market, as well as
wide international investor acceptance and demand for ABS and MBS, it seems inevitable
that this market will develop as robustly and rapidly in South Africa as it has in international
markets. The total size of the South African mortgage market is currently estimated at
approximately R250 billion.
The development of a large and sustainable securitisation market in South Africa will
benefit both issuers and investors.
Issuers would benefit from the increased flexibility that access to both the public and
private capital markets would provide, as the diversification in their funding sources would
increase their capacity to originate new loans and, hence, grow their respective
5
businesses. A further advantage to certain issuers may be that they can achieve off-
balance sheet treatment for assets that have been securitised. In the case of banks, this
would permit capital relief as the underlying assets attract regulatory capital charges
resulting in a lower cost of funds than bank funding, while in the case of non-banks, this
would result in more efficient balance sheets. As the securitisation market increases in
volume and sophistication, it should allow issuers to structure certain note classes with
particular risk profiles to match demand by various investors.
From an investor perspective, the issuance of ABS and MBS will allow investors to
participate in markets that have been largely dominated by banks up until this stage.
Through securitisation, investors will gain access to a wide range of new products, thus,
allowing investors to diversify their investments at a time when government supply of new
paper to the market is decreasing. Investment in securitised offerings may provide
investors with yield pick-up over plain vanilla bonds of comparable maturity and credit due
to the relative complexity of the securitisation structures, as well as possible lower liquidity
in the secondary market.
Asset-backed and mortgage-backed securities are backed solely by the pool of underlying
assets owned by the issuer. To the extent that the assets have been properly conveyed to
the issuer and thereby removed from the balance sheet of the originator, disruptive events
like bankruptcies, mergers, take-overs and acquisitions of the originator will not have any
effect on the assets. This factor distinguishes securitisations from secured lending or
corporate debt.
This document serves as an introduction to securitisation and, in particular, focuses on

mortgage-backed securities that may be issued in South Africa. Part I introduces
mortgage-backed securities, discusses some of the structural features of these
instruments and highlights certain risks, such as prepayment, that are important for
investors in mortgage-backed securities to understand. Part II is more quantitative and
deals in more detail with pricing and modelling of mortgage-backed securities with a
strong emphasis on the understanding of prepayment risk.
6
PART I
Introduction to Mortgage-Backed Securities
Mortgage-backed securities (MBS) are securities that are collateralised by a pool of
individual mortgage loans. The issuer of the MBS owns the pool of mortgage loans. The
issuer issues securities in the capital markets that are backed solely by this pool of assets.
The payments on the mortgage-backed securities are made from cash received from the
mortgage borrowers in terms of the individual loans.
This section of Part I highlights the collateral that underlies a MBS. We introduce some of
the key aspects that should be considered when analysing mortgages, discuss how
mortgage pools should be considered, and end this section by presenting a simple pass-
through MBS structure.
Mortgage Loans
As mortgage loans are the collateral that supports the issue of MBS, it is important to
understand some of the key characteristics of these loans.
Under the terms of a mortgage loan, a borrower is obliged to make a series of principal
and interest payments in order to repay the loan. A mortgage is a security interest in the
underlying real estate property financed by the mortgage loan, which security interest
serves as collateral for the borrower’s loan obligation. In the event that the borrower
defaults on its loan obligation (i.e., fails to make the contractual principal and interest
payments), the lender can sell the pledged real estate property and apply the sale
proceeds to extinguish the mortgage debt.
Although mortgage loans can be fixed-rate or floating-rate loans, mortgage loans in South
Africa are almost exclusively of the floating-rate type, referencing either the Prime rate or
JIBAR. The rate that borrowers are charged on their loans is referred to as the “coupon”
on the mortgage.
Typically, mortgage loans have scheduled monthly repayments and terms to maturity of
20-30 years. However, mortgage borrowers have the right to repay either a portion or the
full outstanding amount of their loans at any time. This right to make early repayments is
called prepayment and is discussed in full in the section dealing with special
considerations when investing in MBS.
A further important characteristic of mortgages is the default characteristics of mortgage

loans. Two factors that have been shown to be related to the default probability of a
mortgage loan and the extent of loss suffered by a lender when granting a mortgage loan
are the loan-to-value ratio of the loan and the payment-to-income ratio of the borrower.
The loan-to-value ratio (LTV) is the ratio of the loan amount to the value of the property
securing the loan. The lower this ratio, the higher the amount of equity the borrower has
in the property. If a borrower has significant equity in the property, the borrower is less
likely to default because it is in the borrower’s interest to sell the property and realise the
equity. Further, if the borrower does default, the amount recovered in the event of a
foreclosure is more likely to cover the outstanding amount on the loan. In South Africa, as
in many other counties internationally, loans with a LTV of below 80% are considered to
be lower risk loans. It should be noted that the amount of equity that borrowers have in
7
their home might vary over time as a result of either a decline in the value of a home or,
alternatively, the removal of equity by the homeowner via access bond facilities.
The payment-to-income ratio (PTI) is the ratio of the required monthly loan instalment to
the borrower’s monthly gross income. The lower the value of this ratio, the less likely the
borrower is to default as a result of financial difficulties. In South Africa, PTI ratios of up
to 30% are considered to be acceptable and loans with PTI ratios below 20% are
considered to be low risk.
The above mentioned characteristics are important to understand as it is often quite useful
to think of the pool of mortgages that form the collateral for a MBS as a single loan with
characteristics that are the weighted average of the underlying individual loans. We will
now consider some of the key pool characteristics used to describe the collateral
underlying a MBS.
Mortgage Loan Pools

Investors consider a number of pool characteristics in order to evaluate the likely
performance of a pool of mortgage loans collateralising a MBS. Below, we discuss some
of the key variables considered.
In many cases, a weighted average of a particular characteristic is considered. In order to

calculate the weighted average, a particular characteristic (e.g., LTV) on each individual
loan is multiplied by the outstanding principal balance of the loan. The sum of all the
results obtained is then divided by the sum of each loan’s outstanding principal.
Some key loan pool characteristics are:

• The weighted average LTV of the pool – the lower the LTV of the pool, the higher the
amount of equity that borrowers in the pool have in their houses. Pools with lower
weighted average LTV ratios are less likely to suffer losses because borrowers are less
likely to default and, in instances where borrowers do default, the loss severity is likely
to be lower.
• The weighted average PTI of the pool – the lower the PTI of the pool, the less likely it
is that loans in the pool will default.
• The geographic spread of the pool – a wide geographic spread of the pool reduces
the effects of localised economic downturns on pool performance.
• The weighted average maturity (WAM) of the pool gives an indication of the maturity
profile of the mortgage loan pool.
• The weighted average coupon (WAC) of the pool indicates the coupon earned on the
pool. In the case of floating-rate mortgages linked to an index, the WAC is often given
as a spread over such index. In the case of floating-rate mortgages, the lower the WAC,
the lower the risk of prepayment of the loan due to the borrower refinancing at a lower
rate with a competitor.
• The originator of the loan pool – the origination standards applied by the originator
may have an influence on the performance of the loan pool.
8
A Simple Pass-Through MBS Structure
Although no longer common, possibly the simplest MBS structure is a simple pass-through
structure. The following diagram illustrates the most basic elements that make up a simple
pass-through MBS structure.
Mortgage
SPV Investors
Loan Pool
Servicer
In order to create the MBS:

• The originator sells a pool of mortgage loans to a special purpose vehicle (SPV).
Alternatively, an originator could originate a pool of mortgage loans directly into the
SPV.
• In order for the SPV to fund the purchase of the mortgage loan pool from the originator,
the SPV issues MBS in the market.
• The SPV appoints a servicer (which is often the same entity as the originator) to collect
the monthly cashflows from the mortgage loan borrowers.
In the case of a simple pass-through MBS structure, all interest and principal payments on
the underlying mortgage loans are passed directly to MBS investors after deducting a
servicing fee paid to the servicer and any other fees associated with the administration of
the SPV. Any shortfalls or deficiencies in scheduled mortgage payments are reflected in
proportionately reduced payments to MBS holders. Any prepayments (or other
unscheduled recoveries of principal) on the underlying mortgage loans are reflected in
proportionately increased payments to MBS holders. In this way, the investor has
effectively taken direct risk in the underlying pool.
As many investors would not be prepared to invest in MBS if they were to suffer losses to
the full extent that losses are incurred on the underlying pool, MBS have structural
enhancements in order to modify the risks to investors. The next section considers some
of these structural enhancements.
9
Structural Considerations
In this section, we will examine the structure of MBS more closely. MBS are generally
structured to have cashflow characteristics that mirror those of the underlying collateral
pool. Individual classes of MBS can be structured to have specific cashflow
characteristics, credit risk profiles or average life parameters. By way of structural and/or
credit enhancements, some or all classes of MBS can be designed to minimise certain
risks, including credit risk, liquidity risk, prepayment risk and interest rate risk. We will
begin with an overview of the securitisation structure and will describe the various
parties/entities that form part of the structure.
Overview of Structure
The diagram below shows the process of securitisation:
1
Originator/ Security
Servicer Trustee
3
2
Mortgage Loan 5 SPV
Investors
Pool (Issuer) 5
Liquidity/Swap
Provider
1. The originator grants loans to mortgage loan borrowers. These loans are secured by
a mortgage over the property, thereby giving the owner of the loan the right to
foreclose and sell the property to repay the loan in the event that the borrower
defaults.
2. The SPV issues notes to investors in order to raise funds to purchase a pool of
mortgage loans from the originator.
3. The SPV purchases the pool of mortgage loans from the originator.
4. The SPV appoints a servicer to collect the monthly cashflows on the mortgage pool.
In many cases the servicer is the same entity as the originator.
5. The cash collected by the servicer is used to pay various administration costs of the
SPV, servicing fees and interest and principal to investors.
6. In order to meet any mismatches in cashflows between the cash received by the SPV
and the obligations of the SPV, the SPV may make use of a liquidity facility.
In the sections that follow, we consider the role of the various entities participating in the
structure.
10
The Pool of Mortgages and the Resulting Cashflows
The pool of mortgage loans owned by the SPV produces cashflows in the form of interest
and principal repayments and prepayments by home loan borrowers. MBS are designed
to closely match these cashflows. Thus, as is the case in South Africa, MBS are structured
to be amortising, floating-rate notes as this most closely matches the underlying
mortgages that are of a floating-rate nature. Any mismatches between the cashflows on
the underlying assets and cashflows on the MBS are hedged out to ensure that the SPV
is not subject to any form of interest rate or basis risk.
All the cash that is collected in respect of the mortgage loans is paid out in terms of a
priority of payments or cashflow waterfall established in the MBS transaction documents.
A priority of payments or cashflow waterfall is simply a list instructing the servicer or
trustee to make payments to the various participants in the structure in a specific order.
For example, the priority of payments may state that the servicer must first pay all the
administrative costs of the SPV (e.g., directors’ fees, rating fees and auditor’s fees); then
pay the servicer a servicing fee; then pay investors interest and principal on the MBS and
finally distribute any remaining cash (excess spread) to the originator of the assets.
The Originator/Seller/Servicer
Commonly, the originator of a mortgage loan is also the servicer thereof (although
servicing rights are sometimes sold to third party servicers). The servicer of the mortgage
loans monitors the performance of the loans, collects the principal and interest payments
received on those loans and transfers such payments (less servicing, guarantee and
agreed other fees), to the mortgage-backed security holders, who receive payment on the
MBS in terms of a cashflow waterfall established in the transaction documents.
The Special Purpose Vehicle

One of the most important structural features of a securitisation is the use of an issuer
that is a bankruptcy-remote, special purpose vehicle.
Special purpose vehicles are designed to have limited powers and authorities in order to
minimise the chance that the vehicle will be subject to insolvency proceedings. The special
purpose vehicles are also established as being entirely separate from the seller of the
securitised assets, so that the balance sheet of the SPV would not be consolidated into
the estate of the seller in case such seller were subject to bankruptcy proceedings. Thus,
the SPV is owned by an independent entity such as an Owner Trust. The beneficiaries of
the trust may be a charity or the investors in the MBS.
The assets of a seller are transferred to the SPV by way of a “true sale” in order to ensure
that the assets are legally separated from the seller. This legal separation ensures that the
securitised assets will not be clawed-back into the seller’s estate in the event of the seller’s
bankruptcy. Effectively, these legal separations segregate the credit quality of the
securitised assets from the credit quality of the underlying originator/seller of the assets.
Thus, investors in mortgage-backed securities will not be exposed to any credit

deterioration or bankruptcy of the mortgage loan seller/originator. Investors in mortgage-
backed and asset-backed securities are subject only to the credit quality and performance
of the pool of securitised assets.
11
Security Trustee
The security trustee acts for the benefit of the investors. To further enhance the structure,
the financial assets owned by the SPV are pledged to the security trustee on behalf of
investors. It is the role of the security trustee to monitor the security and, in certain events,
to liquidate the assets and distribute the proceeds to investors. The security trustee may
also have the role of monitoring that all cash received by the SPV is distributed in terms
of the priority of payments.
Investors
Investors in MBS would typically be institutions and banks (particularly in the case of
floating-rate structures). In an MBS transaction, there may be various classes of investors
– this would depend on the structure of the transaction.
Hedging Counterparties and/or Liquidity Providers

In order to ensure that the SPV is not exposed to interest rate risk (often in the form of
basis risk), the SPV will enter into hedging contracts with hedging counterparties. Similarly,
in order to ensure that the SPV always has cash available to meet its obligations, the SPV
will have liquidity facilities provided by a liquidity facility provider. Hedging counterparties
and liquidity providers are selected to ensure that their credit rating is commensurate with
the credit rating on the MBS. In order to achieve an AAA rating on the senior paper, these
counterparties would have to have the highest short-term rating (i.e., F-1+).
Credit Enhancement
A variety of credit enhancement techniques are employed to enhance the credit of asset-
backed and mortgage-backed structures. These enhancements are intended to act as a
cushion to protect investors against any possible losses. There are generally a number of
different enhancement combinations used in a transaction. They are chosen based on the
specific characteristics of the assets in the underlying pool and the requirements of the
rating agency. The most common credit enhancement technique is the creation of a
senior/subordinated structure, with senior bonds generally rated AAA and layers of
subordinated bonds receiving lower investment – or non-investment grade ratings. Credit
enhancements are designed to address adverse eventualities that may affect the asset
pool, hence, assisting in the creation of bonds that are more robust and resilient than other
securities.
Individual mortgage loans are the underlying collateral and source of cashflows for MBS
and should be of similar size, age and underwriting quality and have similar rates. All
principal and interest cashflows generated by the underlying mortgages, including any
prepayments or other proceeds from the mortgage loans or underlying mortgage
properties, are channelled to investors net of a servicing spread (a small portion of each
month’s interest payment paid to the institution that services the mortgage loans). In order
to qualify for inclusion in the pool, the loans will need to adhere to certain standards such
as documentation required, loan-to-value ratios, and payment-to-income ratios. In
addition, rating agencies require significant levels of credit enhancement (such as
senior/subordinated structures) to obtain an AAA rating. The combination of collateral
quality and structural features make it highly unlikely that investors in senior classes of
MBS will sustain credit-related losses.
12
Through structural and credit enhancements, an issuer can issue mortgage-backed
securities that have a higher credit quality and, hence, higher credit rating than the quality
or rating of the underlying pool of mortgages. Furthermore, as stated earlier, the credit
quality of the mortgage-backed securities is entirely separated from the credit of the
originator/seller of the mortgage loans. These features distinguish mortgage-backed and
asset-backed securities from other types of debt instruments.
Rating Agency Considerations

Unlike corporate issuers of corporate bonds, the special purpose vehicle issuing MBS
does not have a history of financial performance that can be evaluated by an investor. In
the case of MBS, investors rely on the rating assigned to the MBS by a rating agency in
order to assess the credit quality of the investment. Rating agencies consider the following
primary factors when assigning a rating:
• the type of property (single-family residences, sectional title),
• the type of loan (fixed-rate loans, floating-rate loans),
• the maturity of the loans,
• the geographical diversification of the pool of loans,
• the size of the loans,
• the level of seasoning of the loans,
• the purpose of the loans (purchase or refinancing), and
• the underwriting criteria of the originator and the credit quality of the borrowers.
Rating agencies will also consider the robustness of the legal structure, the credit quality
of any hedging of liquidity counterparties and the historic performance of the assets and
servicer before assigning a rating.
Credit enhancement is generally required in order to achieve an AA or AAA rating for the
most senior tranche and is dependent on the rating agency requirements. There are two
types of credit enhancements which can be applied: internal (provided by the originator or
via the deal structure) and external (provided by an external party).
External Credit Enhancements

External credit enhancements come in the form of third-party guarantees that provide for
first loss protection against losses up to a specified level. These enhancements may take
the form of a corporate guarantee, a letter of credit, mortgage pool insurance and note
(i.e., MBS) insurance.
One of the main disadvantages of third-party guarantees is that MBS protected by

external credit support are still subject to the credit risk of the third-party guarantor. Any
rating downgrade, negative news or volatility in the performance of the credit enhancer will
have a direct link to the performance of the insured bond. It is, therefore, essential that
investors perform credit analysis on both the underlying collateral as well as the third-party
guarantor when evaluating the issue.
External credit enhancements do not materially alter the cashflow characteristics of a

MBS structure. If the net losses exceed the guarantee level, investors will have a shortfall
in the cashflow.
13
Back-Up Servicer
The servicer is responsible for collecting cashflows on the assets throughout the term of
a transaction. In order to protect the investor against any deterioration in servicer viability,
a back-up servicer is usually appointed and will step in if there is any event that leads to
the termination and removal of the servicer. The back up servicer will ensure that the
collection of cashflows and subsequent distribution to the security holders remains
uninterrupted.
The appointment of a back-up servicer is a form of insurance against interruptions in the

collection and distribution of funds, regardless of any economic distress encountered by
the servicer. The rating agency will review the provisions for transferring servicing to a
back-up servicer when assigning a rating to the transaction.
Internal Credit Enhancements

Internal credit enhancements are slightly more complicated forms of protection than
external credit enhancements as there is the possibility that the cashflow characteristics
of the loans may be altered, even in the absence of default. This type of support is
provided within the structure, either by the originator or through the structure of the deal
itself. The forms of internal credit enhancements generally used are reserve funds (cash
reserve funds or excess servicing spread accounts), overcollateralisation and
senior/subordinated structures.
Reserve Funds
Reserve funds come in two forms, namely cash reserve funds and excess servicing
spread accounts. Cash reserve funds are straight deposits of cash that have been
generated from the proceeds of the issue, and are deposited into a fund that typically
invests in money market instruments. Excess servicing spread accounts involve the
deposit of excess cash into a separate account after the payment of the net coupon,
servicing fee, and all other MBS transaction expenses on a monthly basis. This will result
in the balance in the reserve account gradually increasing, which can be used to pay for
possible future losses. This form of credit enhancement is a form of self-insurance, similar
to the payment of a guarantee fee to an agency. The underlying assumption in this form
of enhancement is that infrequent defaults occur in the initial stages of the loans, and
gradually increase in the following years.
Overcollateralisation
Overcollateralisation exists when the principal balance of mortgage loans exceeds the
outstanding principal balance of mortgage-backed securities in a transaction, thus,
providing more assets to collateralise the outstanding MBS debt. The use of excess
spread (i.e., the excess interest margin on the mortgage loans) is often used to rapidly
amortise certain senior classes of MBS, thus, creating overcollateralisation.
To illustrate how overcollateralisation enhances the credit quality of notes issued by a SPV,
we consider a simple example. If an SPV issues MBS with a value of R1 billion but owns
a pool of mortgages with a value of R1.1 billion, then R100 million losses on the mortgage
pool could occur without this affecting the ability of the SPV to repay the MBS.
14
Senior/Subordinated Structure
Subordination is the allocation of cashflows generated by the underlying assets to the
different classes or tranches of MBS that have different payment priorities, in order of their
seniority. This is the most frequently used form of credit support. The priority of the
distribution of cashflows comes from the top, as in a waterfall manner, while the distribution
of losses comes from the bottom. In senior/subordinated structures, “subordinated” MBS
classes provide enhancement for “senior” MBS classes by allowing such senior classes to
be repaid first (prior to the subordinated classes) and/or by allowing those senior classes
to bear credit losses last (after the subordinated classes have been extinguished). The
subordinated class holder obviously requires a yield premium as compensation for the
greater default risk exposure relative to the senior class.
Again, we consider a simple example to demonstrate how the subordination of certain

tranches protects the senior MBS investors.
We consider a structure that has three tranches. Tranche A is senior and consists of MBS
to the value of R900 million, Tranche B is a R75 million mezzanine tranche (senior to the
junior tranche, but subordinated to the senior tranche) and Tranche C is a R25 million
junior tranche (subordinated to both other tranches).
The priority of payments states that any principal collected from the R1 billion mortgage
pool should be paid in the following order:
• First, to Tranche A until amortised;
• Second, to Tranche B until amortised; and then
• Last, to Tranche C until amortised.
If the mortgage pool suffers defaults resulting in losses of R20 million, the remaining
principal will still be sufficient to repay the Tranche A and Tranche B investors, but the
Tranche C investor will only receive R5 million in principal.
Similarly, if defaults resulted in losses of R50 million, the Tranche C would not receive any
principal, Tranche B would only receive R50 million while Tranche A investors would
receive their full principal.
Total losses in the mortgage loan pool would have to exceed R100 million, before the
Tranche A investors would suffer any loss.
Certain Other Structural Features

Clean-Up Call Provisions
A “clean-up call” provides the servicer of a mortgage pool the right, but not the obligation,
to liquidate the outstanding mortgage pool (thus, calling back any outstanding tranches of
the structure) when the outstanding mortgage pool balance has declined below a certain
percentage of the original pool principal balance. This right benefits the servicer, as it may
be uneconomic to service the structure when the mortgage pool balance has been paid
down to a small amount. The exercise of the call provision shortens the principal payment
window and the average life of the residual tranches.
15
Step-up and Call Provisions
A step-up and call feature is a feature that is often used to give investors increased
certainty regarding the timing of principal repayment. The SPV is given the right to call the
MBS at a certain point in time in the future. For example, the MBS might be callable after
5 years. The MBS are also structured to give the SPV an incentive to call the securities by
stepping up the coupon on the MBS at the same time. In this way, investors can view the
securities as having an effective maturity of 5 years.
The reason for making it callable in 5 years (and not maturing in 5 years) is that the SPV
might not be able to refinance. A credit event may have occurred, or market conditions may
simply be unfavourable.
16
Special Considerations
Mortgage-backed securities have certain unique characteristics. In this section, an
overview is presented regarding the causes and measurement of prepayment, the pricing
of MBS and the respective tax and accounting treatment of MBS. A more detailed
presentation of these topics is presented in Part II.
Prepayment Risk
A common feature of mortgage loans is that they allow the borrower to prepay some or
the entire principal loan amount without penalty, at any time before the stated maturity of
the loan. Any amounts paid in excess of the scheduled principal repayments are called
prepayments. Because of the right granted to the homeowner to prepay, called the
prepayment option, an investor in a mortgage cannot be certain of the timing of cashflows
as a 20 year old mortgage could turn out to have maturity of one year or a maturity of 20
years. This uncertainty regarding the amount and timing of the cashflows is known as
prepayment risk. One of the results of prepayment for the investor is that the timing of the
receipt of principal cannot be determined precisely.
Determinants of Prepayment Rates

Prepayments occur for many reasons such as:
• Relocation – a sale of the home could result from a change of employment

necessitating a move, the purchase of a more expensive house, or financial difficulties
of the borrower resulting in a need to sell the home. Mobility is also linked to prevailing
interest rate levels, as higher interest rates may deter borrowers from purchasing a new
home and lower interest rates would favour housing turnover.
• Refinancing – competitor mortgage lenders may be offering more attractive financing

at better rates, terms, etc.
• Partial prepayment – borrowers may make one-off prepayments or pay more than
their regularly scheduled repayments when they have surplus cash (e.g., when they
receive annual bonuses).
• Default – in the case of homeowners who cannot meet their mortgage obligations, the
property may be repossessed and sold, with the proceeds from the sale being used to
pay off the mortgage.
• Other factors – such as death, divorce and property destruction.
The factors affecting the rate or speed of prepayment on a pool of floating-rate mortgages
are:
• Seasonality – in markets such as the US, mortgage prepayments display a tendency

towards a seasonal pattern, with prepayments rising in the spring and summer and
declining in the autumn and winter. This pattern derives from the timing of homeowner
mobility in the primary market – i.e., homeowners prefer to move in the spring and
summer months, due to the better weather and end of the school year. Data available
in South Africa does not allow us to determine with certainty whether this seasonality
pattern is also present in the local market.
17
• Seasoning (ageing) – prepayment rates on mortgage loans generally are low shortly
after the loans are originated and gradually increase over time, levelling off sometime
after 12 to 60 months. Mortgage loans tend not to prepay soon after origination because
in the early months it is unlikely that the family or employment circumstances of a
borrower have changed significantly enough to make refinancing attractive.
Furthermore, there are costs involved in switching a mortgage loan, and homeowners
generally would not want to pay another set of administration and bond fees so soon
after taking out a mortgage. As a result, MBS collateralised by newly originated
mortgage loans will demonstrate low prepayment rates, but prepayment rates may
increase from month to month. Likewise, the prepayment rates of fully seasoned
mortgage loans, and the related MBS, will be relatively stable. (“Seasoned” means that
the mortgage loans have been outstanding long enough for this process to have
occurred and for prepayments to have reached a steady state appropriate for the
interest-rate environment.)
• Interest Rates – when interest rates fall, borrowers may have additional disposable
income with which to repay their mortgage loan and, conversely, if interest rates rise,
borrowers may not be in a position to pay higher than expected instalments. As a result,
prepayment rates are likely to increase when interest rates fall.
• Borrower Profile – higher income earners have more absolute disposable income and,
hence, are in a position to prepay their loans faster than borrowers with lower incomes.
As a result, larger loans are likely to prepay faster than smaller loans.
Measuring Prepayment Rates

Prepayments are fundamental to mortgage-backed securities. Were it not for the right of
mortgagors to prepay their mortgages without penalty, a mortgage-backed security would
be more similar to an ordinary, non-callable corporate or Treasury bond.
With prepayments playing such an important role in the performance of mortgage-backed

securities, it is imperative that market participants have a common means of measuring
the rate at which prepayments occur. Two such measures are the Single Month Mortality
(“SMM”) and the Constant Prepayment Rate (“CPR”). The SMM is simply the
percentage of the pool that prepays on a monthly basis, while the CPR is the annualised
version of the SMM. Thus, a CPR rate of 10% indicates that the rate of prepayment is
such that on an annualised basis, the outstanding principal on the underlying loan pool will
be 10% less than what it would have been had no prepayment occurred.
Due to the uncertainty regarding the timing of receipts of principal on MBS, unlike
corporate or government bonds, MBS have no predetermined maturity. Instead the
expected cashflows on the MBS are modelled based on the expected prepayment rates
for the pool. The concept of the Weighted Average Life (WAL) of the MBS is used. The
WAL is a concept similar to duration and is defined as the weighted average time to the
receipt of future principal payments, using as weights the amounts of the principal
payments. When the prepayment speed increases, the WAL will decrease because the
principal on the MBS is redeemed earlier.
Pricing of Floating-Rate Mortgage-Backed Securities

In this section, we evaluate the level of risk associated with prepayments on MBS by
considering the effect that changes in the WAL of the MBS have on the price of MBS.
18
A MBS can be priced using a modified formula for pricing amortising floating-rate notes.
(The notation is described in detail in the pricing section of Part II.)
(IM – TM)
Z(b + IM)d/365 + anWAL + 1
k
PMBSFRN = x NMBSFRN
(r + TM)f
1+
365
Assuming that we are valuing the instrument on a coupon date, this formula can be
simplified. In principle, we are valuing a floating-rate note and an annuity for the difference
between the interest margin (IM) on the notes and the trading margin (TM) on the notes
where the maturity of the annuity is the WAL of the MBS. This simplified formula is given
below:
PV = 100% + (IM – TM) x PVBPWAL
Effect of Prepayment on Price of Floating-Rate MBS

The table below shows the change in the value of a R1 million floating-rate MBS for a 1-
year change in the WAL given various WAL and interest margin less trading margin
assumptions.
Delta for 1 year change in WAL

(IM-TM as given)
WAL PVBP 10 20 30 40 50
5 398 607 1215 1822 2430 3037
6 455 545 1091 1636 2182 2727
7 507 489 977 1466 1955 2443
8 553 437 874 1310 1747 2184
9 594 391 782 1173 1565 1956
10 631 352 704 1056 1407 1759
11 664 317 634 951 1268 1586
12 694 286 572 858 1143 1429
The table clearly demonstrates that the level of prepayment risk inherent in floating-rate
MBS is related to the WAL of the MBS and the difference between the margin/spread at
which the MBS was launched and the margin/spread at which the MBS is trading. Given
that the WAL is unlikely to be volatile, even at reasonably large differences between IM
and TM, the risks of prepayment are reasonably low.
On the other hand, the effect of differences in price for movements in TM can be seen by
looking at the PVBP column. The table shows that for small differences between IM and
TM, the effect of changes in credit spreads will dominate prepayment risk.
19
Tax Treatment in Respect of Floating-Rate Mortgage-Backed
Securities
In terms of MBS, investors would hold an instrument that will pay interest linked to a
floating-rate (the SAFEX three-month JIBAR) at regular intervals and may, in addition, pay
capital in redemption of all or part of the securities held. In respect of the South African
Income Tax Act of 1962, the following three tax issues will arise in respect of the majority
of investors:
1. Tax consequences of the amounts received from the security in respect of any partial
or total redemption of capital;
2. Tax consequences of interest received or accrued in terms of the security; and
3. The tax treatment of any adjusted gain or loss on the acquisition or disposal of the
security.
Redemption of Capital
In terms of general tax principles under the South African Income Tax Law any amounts
received in terms of the security that go to redeem part or all of the outstanding principal
will not form part of gross income as defined in Section 1 of the Act and will thus not be
subject to Income Tax.
Interest
Interest received or accrued on the securities will generally form part of the investor’s
gross income. The amount to be included in each year of assessment is determined in
terms of Section 24J of the Act on a yield to maturity basis. As a result of the nature of
these MBS instruments the amount of interest accrued on the security should always be
equal to the amount that needs to be included in the gross income of the investor.
Adjusted Gains and Losses on Disposal

Whenever the securities are traded on dates other than the interest payment date, an
adjusted gain or loss may be derived by the investor. The adjusted gain or loss is
determined as the difference between the proceeds received under the sale and the
adjusted initial amount of the instrument. The adjusted initial amount is determined as the
aggregate of the original purchase price of the instrument plus all interest accrued to date
of disposal in terms of section 24J less all interest actually received to date of disposal.
As the rate resets every three months the scope of the adjusted gains or losses is
relatively limited.
The tax treatment of any amounts received from the MBS instrument is, to some extent,
dependent on the nature of the business that the investor is conducting. Set out below are
some specific examples in respect of certain investors.
Retirement and Pension Funds

The treatment set out above will generally apply to pension funds, and any interest income
determined by applying section 24J would form part of income of the fund for purposes of
the definition of income contained in the Tax on Retirement Funds Act. Adjusted gains or
losses will fall outside the scope of interest for purposes of the tax on retirement funds.
20
Insurers
Interest income accrued will form part of an insurer’s taxable income. In respect of any
adjusted gains or losses on the disposal of the MBS instruments, the treatment is guided
by general income tax principles in determining if the gain or loss is for revenue or capital
account.
Unit Trusts
Unit trusts generally distribute the majority of the interest receipts to their unit holders (who
will generally be taxed on these proceeds) and will not be taxed on these receipts or
accruals in their own right.
Non-Residents
Non-residents, who do not have branches in South Africa, are exempt from paying South
African Income Tax in terms of Section 10(1)(hA) of the Act.
The issues regarding the tax treatment of the MBS instruments set out above are very
general and may differ for different taxpayers. Investors are advised to obtain their own tax
opinions.
21
PART II
Measuring Prepayment
Introduction
We will cover the basics of modelling mortgage pool prepayments in this section.
Underlying Mortgages
For our purposes, the primary requirement of the pool of mortgages is that they need to
be relatively homogenous – in other words, there should be no major discrepancies
between the features of the individual mortgages. In particular:
• The mortgages should be of broadly similar term (e.g., 20 years);
• The mortgages should carry a similar rate of interest (e.g., JIBAR + 2.00%);
• If the mortgages are floating, then the reset dates should be similar; and
• The credit characteristics of the mortgages should be broadly similar (e.g., LTV,
payment-to-income ratio, etc).
If the mortgages are homogenous, then we can use some simplifying assumptions to
model the cashflows of the pool as a whole. This is as opposed to modelling the individual
cashflows of potentially thousands of loans, and aggregating the cashflows to get the pool
cashflows.
The simplifying assumptions we make are as follows:

• We assume the pool behaves like a single large loan;
• The maturity of the pool is the Weighted Average Maturity (“WAM”) of the individual
loans; and
• The coupon of the pool is the Weighted Average Coupon (“WAC”) of the individual
coupons.
Prepayments
In order to make a start with the basics, we make the following assumptions:
• We have a pool of home loans, originated today, with a total nominal outstanding of R1
000 000;
• The pool has a WAM of 10 years;
• The home loans have a WAC of 10.75%;
• Instalments on the loans are paid monthly.
22
Then a selection of the scheduled repayments looks as follows:
YEARS SCHED POOL SCHED INT SCHED CAP SCHED

BAL PAY PAY TOTAL
0.0 1,000,000
0.1 995,285 8,836 4,715 13,551
0.2 990,527 8,794 4,757 13,551
0.2 985,728 8,752 4,799 13,551
0.3 980,887 8,710 4,842 13,551
0.4 976,002 8,667 4,884 13,551
0.5 971,075 8,624 4,928 13,551
0.6 966,104 8,580 4,971 13,551
0.7 961,089 8,536 5,015 13,551
0.7 956,029 8,492 5,059 13,551
0.8 950,925 8,447 5,104 13,551
0.9 945,776 8,402 5,149 13,551
1.0 940,582 8,357 5,195 13,551
1.1 935,341 8,311 5,240 13,551
… … … … …
9.0 141,453 1,358 12,194 13,551
9.0 129,152 1,250 12,301 13,551
9.1 116,742 1,141 12,410 13,551
9.2 104,222 1,031 12,520 13,551
9.3 91,592 921 12,630 13,551
9.4 78,850 809 12,742 13,551
9.5 65,996 697 12,854 13,551
9.5 53,028 583 12,968 13,551
9.6 39,945 469 13,083 13,551
9.7 26,747 353 13,198 13,551
9.8 13,432 236 13,315 13,551
9.9 (0) 119 13,432 13,551
23
Weighted Average Life
A useful concept is that of Weighted Average Life (“WAL”). It is similar a concept to
duration, and is defined as the weighted average time to the receipt of future principal
payments, using as weights the amounts of the principal payments. In other words:
WAL =
∑tiPi
∑Pi
where ti are the times to receipt of the principal payments, and Pi are the principal
payments.
Duration, by contrast, is the weighted average time to receipt of all cashflows (i.e., principal
and interest)
As a very simple example, consider the following schedule of principal payments Pi

occurring at the times ti:
TIME TI PRINCIPAL PI PI * TI
1 10000 10000
2 9000 18000
3 8000 24000
4 7000 28000
5 6000 30000
∑
ti Pi 110000
Then WAL = ––––– = –––––– = 2.75.
Pi ∑ 40000
In the previous example, the WAL = 5.83.
Prepayment
In the South African market, as with most other markets, home loan borrowers pay off their
loan far more quickly than the original term of the loan would suggest.
At the pool level, this suggests that every month, there are more capital repayments than
are reflected in the above schedule.
We need to incorporate this notion of prepayment into our schedule of payments in the
previous section. How do we do this?
Measurement of Prepayment
In order to start examining the various prepayment measurement conventions, we need to
establish some convenient definitions. These are:
• Bi This is the scheduled pool balance at the end of month i, expressed as a
percentage of the initial pool balance.
24
• Ci This is the actual pool balance at the end of month i, expressed as a percentage
of the initial pool balance. If Bi and Ci are different, then this is due typically to
prepayment. Ci is sometimes called the pool factor.
• Qi = Ci
• Qi = –– This is the ratio between Bi and Ci. Obviously, if Qi <1, then prepayment has
• Qi = Bi
occurred.
Let us say that no prepayment has occurred. Then the first few rows of the previous table
look as follows:
YEARS SCHED SCHED BI SMMI QI CI

POOL BAL CAP PAY
0.00 1,000,000 100.00% 100.00% 100.0000%
0.08 995,285 4,715 99.53% 0.00% 100.00% 99.5285%
0.17 990,527 4,757 99.05% 0.00% 100.00% 99.0527%
0.25 985,728 4,799 98.57% 0.00% 100.00% 98.5728%
0.33 980,887 4,842 98.09% 0.00% 100.00% 98.0887%
0.41 976,002 4,884 97.60% 0.00% 100.00% 97.6002%
0.50 971,075 4,928 97.11% 0.00% 100.00% 97.1075%
0.58 966,104 4,971 96.61% 0.00% 100.00% 96.6104%
0.66 961,089 5,015 96.11% 0.00% 100.00% 96.1089%
0.74 956,029 5,059 95.60% 0.00% 100.00% 95.6029%
0.82 950,925 5,104 95.09% 0.00% 100.00% 95.0925%
0.91 945,776 5,149 94.58% 0.00% 100.00% 94.5776%
0.99 940,582 5,195 94.06% 0.00% 100.00% 94.0582%
We explain the SMM later. Note that Bi and Ci are identical, and that, hence, all the Qi are
equal to 100%.
Next, let us say that some prepayment has occurred. For illustrative purposes, let us
assume the prepayment only occurs in the first month, and not thereafter. Let us also
assume that the prepayment occurs to such an extent that, at the end of the first month,
Ci is equal to 98.53%, and not 99.53% as before.
What is the effect of this? We see that Qi decreases (from 100% to 99%) and stays
constant thereafter at 99%. This is behaviour that we should expect – the pool size has (in
the first month) decreased more quickly than scheduled. However, thereafter, there are no
further payments ahead of schedule. In other words, in month 1, the pool has gone from
being a pool with 99.53% outstanding to a pool with 98.53% outstanding – but in all other
characteristics remains the same. Hence, all the payments and speed of reduction in the
pool size remain the same, bar the fact that everything should now be scaled down by a
factor of 99%. We now have the following schedule:
25
POOL BAL CAP PAY
0.00 1,000,000 100.00% 100.00% 100.00%
0.08 995,285 4,715 99.53% 1.00% 99.00% 98.53%
0.17 990,527 4,757 99.05% 0.00% 99.00% 98.06%
0.25 985,728 4,799 98.57% 0.00% 99.00% 97.59%
0.33 980,887 4,842 98.09% 0.00% 99.00% 97.11%
0.41 976,002 4,884 97.60% 0.00% 99.00% 96.62%
0.50 971,075 4,928 97.11% 0.00% 99.00% 96.14%
0.58 966,104 4,971 96.61% 0.00% 99.00% 95.64%
0.66 961,089 5,015 96.11% 0.00% 99.00% 95.15%
0.74 956,029 5,059 95.60% 0.00% 99.00% 94.65%
0.82 950,925 5,104 95.09% 0.00% 99.00% 94.14%
0.91 945,776 5,149 94.58% 0.00% 99.00% 93.63%
0.99 940,582 5,195 94.06% 0.00% 99.00% 93.12%
We note that, after the prepayment, the ratio Qi between the original scheduled pool
balance and the actual pool balance stays constant at 99%.
Say now that prepayment occurs in second and third months only. What does that look
like?

POOL BAL CAP PAY
0.00 1,000,000 100.00% 100.00% 100.00%
0.08 995,285 4,715 99.53% 0.00% 100.00% 99.53%
0.17 990,527 4,757 99.05% 1.00% 99.00% 98.06%
0.25 985,728 4,799 98.57% 4.00% 95.04% 93.68%
0.33 980,887 4,842 98.09% 0.00% 95.04% 93.22%
0.41 976,002 4,884 97.60% 0.00% 95.04% 92.76%
0.50 971,075 4,928 97.11% 0.00% 95.04% 92.29%
0.58 966,104 4,971 96.61% 0.00% 95.04% 91.82%
0.66 961,089 5,015 96.11% 0.00% 95.04% 91.34%
0.74 956,029 5,059 95.60% 0.00% 95.04% 90.86%
0.82 950,925 5,104 95.09% 0.00% 95.04% 90.38%
0.91 945,776 5,149 94.58% 0.00% 95.04% 89.89%
0.99 940,582 5,195 94.06% 0.00% 95.04% 89.39%
26
We see that the ratio between the actual pool balance and the original scheduled balance
declines first to 99%, and, thereafter, declines to 95.04%. After the decline to 95.04%,
there are no more prepayments and, hence, the ratio stays constant at 95.04%.
How do we measure this prepayment? One way to do it is to look at the changes in Qi. We
see that, after the first prepayment, Qi declines from 100% to 99%, a decline of 1%. After
the second prepayment, Qi declines by 4%, i.e.
4% = 99.00% – 95.04%
4% = –––––––––––––––
99.00%
In other words, 4% is the percentage of the pool that has prepaid. If the pool has prepaid
by 4%, then the new Qi is equal to the previous Qi less 4% of the previous Qi.
We generalise these notions, and define the following:

The Single Month Mortality (“SMM”) is the percentage of the pool that prepays every
month, and is defined by
Qi
SMMi = 1 – ––––
Qi–1
In our examples above, the SMM is shown in the appropriate column.

We might also be interested in the total prepayment that has occurred. This can be
expressed as a percentage of the scheduled pool balance, or as:
Bi – Ci
–––––– .
Bi
With a bit of manipulation, we see that:
Bi – Ci
–––––– = 1 – Qi
Bi
Hence, the total percentage of the pool that has prepaid each month is given by 1 – Q1.
Qi
Now, recall that: SMMi = 1 – ––– :
Qi–1
We can derive the following from this formula:
Qi = (1 – SMMi)Qi–1
and, hence,
Qi = (1 – SMMi)(1 – SMMi–1)(1 – SMMi–2)....(1 – SMM1)
In the previous paragraphs, we have looked at the SMM as a possible measure of
prepayment. Another possible measure is the CPR, defined below.
The Constant Prepayment Ratio (“CPR”) is the annualised version of the SMM, defined
as:
CPRi = 1 – (1 – SMMi)12
We will use the CPR later on during our prepayment modelling.
With a little simple manipulation, we see also that:
1
SMMi = 1 – (1 – CPRi) 12
27
We end off this section with an example where the SMM is slowly increasing:

POOL BAL CAP PAY
0.00 1,000,000 100.00% 100.00% 100.00%
0.08 995,285 4,715 99.53% 0.02% 99.98% 99.51%
0.17 990,527 4,757 99.05% 0.03% 99.95% 99.00%
0.25 985,728 4,799 98.57% 0.05% 99.90% 98.47%
0.33 980,887 4,842 98.09% 0.07% 99.83% 97.92%
0.41 976,002 4,884 97.60% 0.08% 99.75% 97.36%
0.50 971,075 4,928 97.11% 0.10% 99.65% 96.77%
0.58 966,104 4,971 96.61% 0.12% 99.53% 96.16%
0.66 961,089 5,015 96.11% 0.13% 99.40% 95.53%
0.74 956,029 5,059 95.60% 0.15% 99.25% 94.88%
0.82 950,925 5,104 95.09% 0.17% 99.08% 94.22%
0.91 945,776 5,149 94.58% 0.19% 98.90% 93.54%
0.99 940,582 5,195 94.06% 0.20% 98.70% 92.83%
Scheduled Interest Payment and Scheduled Capital Payment

It is obvious that, if there has been prepayment, there will be adjustments to the original
scheduled capital and interest payments. In other words, if the pool size has reduced, then
the scheduled capital payments and scheduled interest payments should also reduce.
Hence, if prepayment has occurred once, and assuming no further prepayments, then all
capital and interest payments should be scaled down (as the pool size is now smaller) but
should still change over time in line with the original schedule, albeit scaled down.
For example, say that our first prepayment occurs during a period i. Say also that the initial
pool balance is denoted by IPB. Then our original scheduled interest payment Ii was:
Ii = IPB(ti – ti–1)Bi–1y
where ti denotes time expressed in years, and y is the interest rate, expressed as a simple
yield, that the pool carries. If there has been prepayment, then our new adjusted
scheduled interest payment Îi becomes
Îi = IPB(ti – ti–1)Ci–1y
In other words, the relationship between Îi and Ii is simply
Îi = Qi–1Ii
A similar relationship holds between the original scheduled capital payments Pi , and the
adjusted (after prepayment) scheduled capital prepayment P̂i is
P̂i = Qi–1Pi
28
We now use the last example that we had in the previous section, and show what the
scheduled and adjusted scheduled capital and interest payments look like:
SCHED SCHED SCHED ADJ ADJ QI

POOL CAP PAY INT SCHED SCHED
BAL CAP PAY INT
1,000,000 100.00%
995,285 4,715 8,836 4,715 8,834 99.98%
990,527 4,757 8,794 4,755 8,790 99.95%
985,728 4,799 8,752 4,794 8,743 99.90%
980,887 4,842 8,710 4,833 8,695 99.83%
976,002 4,884 8,667 4,872 8,645 99.75%
971,075 4,928 8,624 4,910 8,593 99.65%
966,104 4,971 8,580 4,948 8,540 99.53%
961,089 5,015 8,536 4,985 8,485 99.40%
956,029 5,059 8,492 5,021 8,428 99.25%
950,925 5,104 8,447 5,057 8,369 99.08%
945,776 5,149 8,402 5,092 8,309 98.90%
940,582 5,195 8,357 5,127 8,248 98.70%
29
Modelling Prepayment
Introduction
We will cover the basics of modelling mortgage pool prepayments in this section. In
particular, we will look at:
• Constant prepayment model;
• PSA model; and
• Other factors.
The variables that we will focus on are:

• SMM;
• CPR; and
• WAL.
In the previous section, we examined how prepayment could be measured, once it had
occurred, and what the effects of prepayment were on some other related variables.
In this section, we start from a different premise. Say we have a pool of mortgages, and
we wish to model the pool’s prepayment behaviour going forward in time. How do we do
this? What assumptions do we need to make?
Constant Prepayment Model

Perhaps the simplest assumption that we can make is that prepayment will be constant
over the life of the pool. Let us, for example, assume that CPR=6% throughout the life of
the pool. What do we obtain?
BN CPR SMM QN CN TOTAL CAP

PAY
100.00% 100.00% 100.00%
99.53% 6% 0.51% 99.49% 99.02% 0.98%
99.05% 6% 0.51% 98.97% 98.04% 0.98%
98.57% 6% 0.51% 98.47% 97.06% 0.98%
98.09% 6% 0.51% 97.96% 96.09% 0.97%
97.60% 6% 0.51% 97.45% 95.12% 0.97%
What do these columns mean?

• B is calculated from the previous example;
• CPR is assumed to be 6%;
• SMM is calculated from CPR;
• Q is calculated from the SMM and previous values of Q, as per the equation
Qi = (1 – SMMi)Qi–1;
30
• C is calculated from Q and B;
• The “Total Cap Pay” is the total amount of capital repayment made during the period,
expressed as a percentage of the initial pool balance; and
We note that WAL is 4.72 with CPR=6% constant prepayment. With no prepayment, and
all other assumptions the same, WAL is 5.83. As another example, if we change CPR to
10%, then the WAL changes to 4.13.
PSA Model
“PSA” stands for Public Securities Association, and the PSA model is a model developed
by this organisation for prepayment behaviour. It is also a very simple model that assumes
that CPR increases up towards a plateau and, thereafter, levels off. In its original form,
CPR is assumed to grow from 0% to 6% over the first 30 months, and thereafter remain
level at 6%. In other words,
n
6% ––, for n ≤30
CPR =
{ 6% 30
6%, for n ≥30
The PSA model is often used as a descriptive standard, in the sense that people might say
that a pool is prepaying at 100% PSA, or 150% PSA. If the pool is at 100% then the
prepayment is as we described above. If it is at 150% PSA, then the prepayment
behaviour is described by
n
6% ––, for n ≤30
CPR = 150% x
{ 6% 30
6%, for n ≥30
where n describes the number of months.
We now show the first 4 years of our previous example, with a 120% PSA prepayment
assumption.

PAY
100.00% 100.00% 100.00%
99.53% 0.24% 0.02% 99.98% 99.51% 0.49%
99.05% 0.48% 0.04% 99.94% 98.99% 0.52%
98.57% 0.72% 0.06% 99.88% 98.45% 0.54%
98.09% 0.96% 0.08% 99.80% 97.89% 0.56%
97.60% 1.20% 0.10% 99.70% 97.31% 0.59%
97.11% 1.44% 0.12% 99.58% 96.70% 0.61%
96.61% 1.68% 0.14% 99.44% 96.07% 0.63%
96.11% 1.92% 0.16% 99.28% 95.41% 0.65%
95.60% 2.16% 0.18% 99.10% 94.74% 0.67%
95.09% 2.40% 0.20% 98.90% 94.04% 0.70%
94.58% 2.64% 0.22% 98.68% 93.33% 0.72%
94.06% 2.88% 0.24% 98.44% 92.59% 0.74%
31
PAY
93.53% 3.12% 0.26% 98.18% 91.83% 0.76%
93.01% 3.36% 0.28% 97.90% 91.05% 0.78%
92.47% 3.60% 0.31% 97.60% 90.25% 0.80%
91.93% 3.84% 0.33% 97.28% 89.43% 0.82%
91.39% 4.08% 0.35% 96.94% 88.60% 0.84%
90.84% 4.32% 0.37% 96.59% 87.74% 0.85%
90.29% 4.56% 0.39% 96.21% 86.87% 0.87%
89.73% 4.80% 0.41% 95.82% 85.98% 0.89%
89.17% 5.04% 0.43% 95.41% 85.08% 0.91%
88.60% 5.28% 0.45% 94.98% 84.15% 0.92%
88.03% 5.52% 0.47% 94.53% 83.22% 0.94%
87.45% 5.76% 0.49% 94.06% 82.26% 0.95%
86.87% 6.00% 0.51% 93.58% 81.29% 0.97%
86.28% 6.24% 0.54% 93.08% 80.31% 0.98%
85.69% 6.48% 0.56% 92.56% 79.32% 1.00%
85.09% 6.72% 0.58% 92.02% 78.31% 1.01%
84.49% 6.96% 0.60% 91.47% 77.29% 1.02%
83.88% 7.20% 0.62% 90.90% 76.25% 1.03%
83.27% 7.20% 0.62% 90.34% 75.23% 1.03%
82.65% 7.20% 0.62% 89.78% 74.20% 1.02%
82.02% 7.20% 0.62% 89.22% 73.18% 1.02%
81.39% 7.20% 0.62% 88.67% 72.17% 1.01%
80.76% 7.20% 0.62% 88.12% 71.16% 1.01%
80.12% 7.20% 0.62% 87.57% 70.16% 1.00%
79.47% 7.20% 0.62% 87.03% 69.16% 1.00%
78.82% 7.20% 0.62% 86.49% 68.17% 0.99%
78.16% 7.20% 0.62% 85.95% 67.18% 0.99%
77.49% 7.20% 0.62% 85.42% 66.19% 0.98%
76.82% 7.20% 0.62% 84.89% 65.21% 0.98%
76.15% 7.20% 0.62% 84.36% 64.24% 0.98%
75.46% 7.20% 0.62% 83.84% 63.27% 0.97%
74.78% 7.20% 0.62% 83.32% 62.30% 0.97%
74.08% 7.20% 0.62% 82.80% 61.34% 0.96%
73.38% 7.20% 0.62% 82.28% 60.38% 0.96%
72.67% 7.20% 0.62% 81.77% 59.43% 0.95%
71.96% 7.20% 0.62% 81.27% 58.48% 0.95%
71.24% 7.20% 0.62% 80.76% 57.54% 0.94%
32
The WAL with a 120% PSA assumption is 4.89. By comparison, a 100% PSA prepayment
behaviour gives a WAL of 5.03, which is slightly longer than the WAL of 4.72 for a constant
CPR of 6%. This is due to the ramp period of the PSA, which extends the capital
payments somewhat.
We can graph the various assumptions as follows:
We also look at the capital payments that arise under the different assumptions. In
particular, we look at the pool balances:
33
We use a 200% PSA (as opposed to a 100% PSA) assumption to highlight the differences
in pool balances. We note, as expected, the pool balance declines fastest for the 200%
PSA assumption. Also note, however, that the pool balance declines to zero at 10 years
for all of the pools.
The total capital payments are graphed below. Note that, as expected, the faster the
prepayment scenario, the more capital is paid in the early years. To the extent that capital
is paid in the early years, there will be less capital paid in the later years. In all cases,
however, the total capital payments should obviously add up to 100%.
34
We can also look at the total payments (combined prepayment, scheduled capital and
interest) which are graphed below. The shape of the graph (Total Payment) is similar to
the shape of the Total Capital Payment graph, as the capital payments are the major
effect.
The WAL of the various prepayment scenarios looks as follows:
PREPAYMENT WAL
5% CPR 4.89
50% PSA 5.41
100% PSA 5.03
150% PSA 4.69
200% PSA 4.39
Other Factors
There are many other factors that people often regard as important. These include:
• Seasonality;
• Burnout;
• Seasoning (ageing);
• Interest rates; and
• Other variables (e.g., divorce).
35
Seasonality
This refers to the way that prepayment varies according to the time of year. People may
be more inclined to move in summer, for example, or (in Gauteng) to do renovations or
building in winter, when the rainfall is less. This will affect prepayment rates.
Burnout
In some markets, there is a relationship between the percentage of the pool that has
prepaid, and the speed of the prepayment of the remainder of the pool. The more that a
pool has prepaid, the slower (all other things being equal) the remainder of the pool will
prepay.
Seasoning (ageing)
There is a relationship between the age of the pool and prepayment. This is referred to as
“seasoning”. For example, a pool may prepay at a low rate in early years, which increases
over time and eventually levels off at a fairly constant level.
Interest Rates
There is a clear relationship between interest rates and prepayment. In South Africa,
where most loans are floating, default (and indirectly, prepayment) rates rise dramatically
if interest rates go very high, as they did, for example, in 1998 during the emerging
markets crisis. In the USA, where many mortgage loans are fixed, prepayment rates rise
if interest rates fall.
Other Variables
Some other factors are also important, e.g., sales of existing homes and other macro-
economic variables. Divorce rates are also an important underlying variable in causing
prepayment. However, many of these variables depend on your ability to make macro-
economic or social forecasts and to model accurately the relationship between the variable
and the prepayment. These factors are, hence, excluded from our consideration here.
Calibrating the Model

The only way that these models can be calibrated (or validated, for that matter) is by
examining the historical data, and fitting the model as appropriate to the data.
More detail on prepayments is typically included at the time of deal.
36
Structural Features Affecting Cashflows
Introduction
We will cover some basic elements of the design of mortgage-backed securities. We will
focus predominantly on some of the more simple features.
In particular, we will focus on:

• Step-up and call structures;
• Substitution Periods; and
• Tranching.
We will look at the effect of each of these design features on the cashflow to investors.
Once again, we will focus predominantly on the cashflows. The pricing of the security will
be discussed in a later chapter.
The Base Case – A Simple Pass-Through

One of the simplest types of mortgage security is arguably a simple pass through, where
the pass-through is the only security issued by the SPV. In a pass-through of this sort, all
cashflows that are received by the SPV are passed through to the investor (less a servicing
and/or administration charge). Hence, the cashflows that are received by the SPV are
virtually identical to the cashflows received by the investor. For the purposes of this
chapter, we need to do no further work to model the cashflows of this particular mortgage-
backed security.
Step-Up and Call

A step-up and call feature is a feature that is often used when the pool behaviour (and
especially prepayment behaviour) is relatively uncertain. In this case, the SPV has a call
on the bond at a certain point in time. For example, the bond might be callable at 5 years.
The reason for this is that if there is uncertainty regarding a pool statistic (e.g.,
prepayment), then getting the statistic wrong has a less detrimental effect if the statistic
applies only over 5 years, as opposed to over 20 years. If the bond is called then the SPV
can potentially refinance.
We said that the bond was callable – yet the argument above sounds valid for a bond that
automatically terminates at the 5-year point. Why is the bond callable? The reason for
making it callable in 5 years (and not maturing in 5 years) is that the SPV might not be able
to refinance. A credit event may have occurred, or market conditions may simply be
unfavourable. However, barring significant market events, we nonetheless wish the SPV to
call the bonds. We do this by resetting the interest that is payable on the bonds to a much
higher level, if the SPV does not call the bonds. In other words, if the SPV does not call
the bonds after 5 years, then the interest rate that is payable on the bonds might change
from, for example, JIBAR+0.50% to JIBAR+1.50%. So barring a very significant event, the
SPV will call the bonds. To all intents and purposes, we can, thus, assume the bond has
a maturity of 5 years.
37
Example
We start by looking at graphs of the cashflows that occur for the pool itself. In the first
graph, we examine the cashflows that occur for the pool if there is no prepayment at all.
In other words, the only cashflows are the scheduled interest and capital cashflows. These
are graphed below.
Note that:
• The sum of the interest and capital payments is constant; and
• The capital payments, as a percentage of the total, increases steadily.
Payment
38
Next, we look at the cashflows that arise according to a 100% PSA model. These
cashflows look as follows:
We now look at the case in which there is a step-up on the notes and a call option for the
SPV on the notes after 3 years. The cashflows then terminate in 3 years, and the
remaining capital payments that are still outstanding are paid out on the three-year date.
39
The last cashflow is not to scale, and is much larger than can be seen on the graph. If we
plot the same graph with a different y-axis, we get the following:
We can see that the payments are dominated by the principal payment at the end of the
six years. We will see later that this ensures that the security behaves very similarly to a
plain-vanilla floating-rate note.
The effect of the call on the WALs is as follows:
PREPAYMENT WAL
5%CPR 4.14
50%PSA 4.50
100%PSA 4.28
150%PSA 4.08
200%PSA 3.89
The range of the WALs here is 0.25. The range of the WALs in the previous pass-through
example (without a call) is 0.50.
Substitution Period
A substitution period is a period during which the SPV may add new loans to its pool, or
substitute existing ones. As an example, an SPV may replace any capital payments that
arise during the first two years with new loans (that satisfy the original loan criteria), thus
keeping the pool balance constant at the initial balance. In other words, if we have a two-
year substitution period, and a R1 billion pool, then the pool balance is likely to stay at
R1 billion for the first two years.
40
What is the effect of this? There are several effects:
• The pool WAL becomes longer (as principal repayments are pushed further out in time);
• The WAL of the security will also become longer, for the same reason; and
• If we combine a substitution period with a call and step-up in six years, then we should
expect the variability of the WAL to decrease even further (as we now know for sure
what is going to happen in the first two years – there is now only uncertainty over four
years as opposed to six years).
We start off by looking at the effect on the pool of having a substitution period. Firstly, we
assume no prepayment at all, and look at the graph of the scheduled capital and interest
payments:
As we can see, the total monthly payment to investors is constant for the first two years,
and comprises only interest. This is because all the capital that is coming into the pool is
being used to purchase new mortgages. At the end of two years, the total monthly
payment to investors increases to a new, higher constant level. This is because investors
are now receiving capital as well as interest. Note that the graph from 2 years to 10 years
looks very similar to the first graph of this section.
Next, in similar fashion to before, we look at effects of adding a prepayment model to the
cashflows. For simplicity, we assume that:
• The WAC stays at 10.75%, and the WAM stays at 10 years from today; and
• The CPR is 0% up to the end of the 2-year period, and starts increasing thereafter.
41
To clarify, we show the calculations up to three years:
YEARS BN CPR SMM QN CN

0.00 100.00% 100.00% 100.00%
0.08 100.00% 0.00% 0.00% 100.00% 100.00%
0.17 100.00% 0.00% 0.00% 100.00% 100.00%
0.25 100.00% 0.00% 0.00% 100.00% 100.00%
0.33 100.00% 0.00% 0.00% 100.00% 100.00%
0.41 100.00% 0.00% 0.00% 100.00% 100.00%
0.50 100.00% 0.00% 0.00% 100.00% 100.00%
0.58 100.00% 0.00% 0.00% 100.00% 100.00%
0.66 100.00% 0.00% 0.00% 100.00% 100.00%
0.74 100.00% 0.00% 0.00% 100.00% 100.00%
0.82 100.00% 0.00% 0.00% 100.00% 100.00%
0.91 100.00% 0.00% 0.00% 100.00% 100.00%
0.99 100.00% 0.00% 0.00% 100.00% 100.00%
1.07 100.00% 0.00% 0.00% 100.00% 100.00%
1.15 100.00% 0.00% 0.00% 100.00% 100.00%
1.24 100.00% 0.00% 0.00% 100.00% 100.00%
1.32 100.00% 0.00% 0.00% 100.00% 100.00%
1.40 100.00% 0.00% 0.00% 100.00% 100.00%
1.48 100.00% 0.00% 0.00% 100.00% 100.00%
1.56 100.00% 0.00% 0.00% 100.00% 100.00%
1.65 100.00% 0.00% 0.00% 100.00% 100.00%
1.73 100.00% 0.00% 0.00% 100.00% 100.00%
1.81 100.00% 0.00% 0.00% 100.00% 100.00%
1.89 100.00% 0.00% 0.00% 100.00% 100.00%
1.98 100.00% 0.00% 0.00% 100.00% 100.00%
2.06 100.00% 0.00% 0.00% 100.00% 100.00%
2.14 99.32% 0.20% 0.02% 99.98% 99.31%
2.22 98.64% 0.40% 0.03% 99.95% 98.59%
2.30 97.95% 0.60% 0.05% 99.90% 97.85%
2.39 97.26% 0.80% 0.07% 99.83% 97.10%
2.47 96.56% 1.00% 0.08% 99.75% 96.32%
2.55 95.85% 1.20% 0.10% 99.65% 95.52%
2.63 95.14% 1.40% 0.12% 99.53% 94.69%
2.72 94.42% 1.60% 0.13% 99.40% 93.85%
2.80 93.69% 1.80% 0.15% 99.25% 92.99%
2.88 92.96% 2.00% 0.17% 99.08% 92.11%
2.96 92.22% 2.20% 0.19% 98.90% 91.21%
42
We graph the cashflows, as follows below:
It remains now to look at the effect of a call on a pool with substitution.
Call Plus Step-Up for a Pool with Substitution

As mentioned earlier, the effect of a call is to shorten the WAL of the security. We now
show the effects of a call on a security backed by a pool with substitution. We note the
following:
• The substitution period is two years, as before;
• The prepayment starts after two years; and
• All the outstanding capital is repaid at the end of 6 years.
YEARS BN CPR SMM QN CN TOTAL CAP

PAY
0.00 100.00% 100.00% 100.00%
0.08 100.00% 0.00% 0.00% 100.00% 100.00% 0.00%
0.17 100.00% 0.00% 0.00% 100.00% 100.00% 0.00%
0.25 100.00% 0.00% 0.00% 100.00% 100.00% 0.00%
0.33 100.00% 0.00% 0.00% 100.00% 100.00% 0.00%
0.41 100.00% 0.00% 0.00% 100.00% 100.00% 0.00%
0.50 100.00% 0.00% 0.00% 100.00% 100.00% 0.00%
43
YEARS BN CPR SMM QN CN TOTAL CAP
PAY
0.58 100.00% 0.00% 0.00% 100.00% 100.00% 0.00%
0.66 100.00% 0.00% 0.00% 100.00% 100.00% 0.00%
0.74 100.00% 0.00% 0.00% 100.00% 100.00% 0.00%
0.82 100.00% 0.00% 0.00% 100.00% 100.00% 0.00%
0.91 100.00% 0.00% 0.00% 100.00% 100.00% 0.00%
0.99 100.00% 0.00% 0.00% 100.00% 100.00% 0.00%
1.07 100.00% 0.00% 0.00% 100.00% 100.00% 0.00%
1.15 100.00% 0.00% 0.00% 100.00% 100.00% 0.00%
1.24 100.00% 0.00% 0.00% 100.00% 100.00% 0.00%
1.32 100.00% 0.00% 0.00% 100.00% 100.00% 0.00%
1.40 100.00% 0.00% 0.00% 100.00% 100.00% 0.00%
1.48 100.00% 0.00% 0.00% 100.00% 100.00% 0.00%
1.56 100.00% 0.00% 0.00% 100.00% 100.00% 0.00%
1.65 100.00% 0.00% 0.00% 100.00% 100.00% 0.00%
1.73 100.00% 0.00% 0.00% 100.00% 100.00% 0.00%
1.81 100.00% 0.00% 0.00% 100.00% 100.00% 0.00%
1.89 100.00% 0.00% 0.00% 100.00% 100.00% 0.00%
1.98 100.00% 0.00% 0.00% 100.00% 100.00% 0.00%
2.06 100.00% 0.00% 0.00% 100.00% 100.00% 0.00%
2.14 99.32% 0.20% 0.02% 99.98% 99.31% 0.69%
2.22 98.64% 0.40% 0.03% 99.95% 98.59% 0.72%
2.30 97.95% 0.60% 0.05% 99.90% 97.85% 0.74%
2.39 97.26% 0.80% 0.07% 99.83% 97.10% 0.76%
… … … … … … …
5.43 66.76% 6.00% 0.51% 87.30% 58.28% 1.15%
5.51 65.79% 6.00% 0.51% 86.85% 57.14% 1.14%
5.59 64.81% 6.00% 0.51% 86.40% 56.00% 1.14%
5.67 63.82% 6.00% 0.51% 85.96% 54.86% 1.14%
5.76 62.83% 6.00% 0.51% 85.52% 53.73% 1.13%
5.84 61.82% 6.00% 0.51% 85.08% 52.59% 1.13%
5.92 60.81% 6.00% 0.51% 84.64% 51.47% 1.13%
6.00 59.78% 6.00% 0.51% 0.00% 0.00% 51.47%
6.08 58.75% 6.00% 0.51% 0.00% 0.00% 0.00%
44
We can graph the effects of the call as follows below:
If we show these payments to scale, we get the following:
45
As before, we can generate the various different WALs under the different scenarios:
PREPAYMENT WAL – CALL + WAL – CALL

SUBSTITUTION
5% CPR 5.00 4.14
50%PSA 5.20 4.50
100%PSA 5.11 4.28
150%PSA 5.03 4.08
200%PSA 4.96 3.89
We note the following:

• The WALs are longer, all other things being equal, for a pool with substitution; and
• The difference between the highest and lowest WAL for a pool with substitution is 0.24.
For the previous example, the difference is 0.25.
Tranching
One of the aims in structuring a mortgage-backed security is often to achieve a particular
rating for the notes that are used to fund the bulk of the pool.
In order to do this, it is often (perhaps usually) necessary to have several different

categories of notes. For example, it might be necessary to have a structure where the pool
funding comprises of 90% of notes that are AAA, and senior to all other notes (senior
tranche), 5% of notes that are subordinate to the senior notes (mezzanine tranche) and
5% of notes that are subordinate to all other notes (the junior tranche).
There are many ways to accomplish the subordination, and many different features of the
subordination (there may be, for example, different legal rights accruing under liquidation).
We will focus only on the possible effects of subordination on the cashflows of the security.
If we have several different securities, what should we do with incoming interest and
principal? How much of interest and principal should we pay out to each of the notes? For
example, we could:
• Allocate the interest and principal pro-rata;
• Allocate the principal to the most senior securities first, and the interest pro-rata; or
• Allocate the principal and interest to the most senior securities first.
Each of these can have their place in different circumstances. For now, we will focus on
the second option, which is often called a sequential pay structure.
Our analysis will focus primarily on the large senior tranches although the analysis
presented below can quite easily be extended to the mezzanine tranche. Some or all of
the junior tranche is often held by the originator.
In reality, although we say the interest will be “pro-rata”, the interest that the junior and
mezzanine noteholders receive will be higher due to the increased risk that they are taking.
For simplicity, we will (in this section) assume that the interest rate is the same.
46
As an example, say the pool is funded only by two securities:
• A senior security, which has an AAA rating. This security attracts all capital payments
until it is fully paid down, and pro-rata interest. This security comprises 90% of the
funding of the pool; and
• A junior security, which has a BB rating. This security attracts all capital payments that
remain after the senior security has been paid down, and pro-rata interest. This security
comprises 10% of the funding of the pool.
What are the likely effects of the tranching? These are:

• The senior security will have a lower WAL than the pool, as all the capital is allocated
to it first; and, similarly
• The junior security will have a higher WAL.
We start by looking at our pool with a 2-year substitution period, and prepayment at 100%
PSA.
Note the following:

• The outstanding balance on the senior tranche starts at 90%;
• The outstanding balance on the junior tranche starts at 10%; and
• The total capital payments from the pool are all capital repayments towards the senior
tranche, until (after 9.13 years) the senior tranche is paid down. At that point, all the
capital payments go towards reducing the junior tranche.
YEARS TOTAL TOT SENIOR SENIOR CN TOT JUNIOR JUNIOR CN

CAP PAY CAP PAY CAP PAY
0.00 0.00% 90.00% 10.00%
0.08 0.00% 0.00% 90.00% 0.00% 10.00%
0.17 0.00% 0.00% 90.00% 0.00% 10.00%
0.25 0.00% 0.00% 90.00% 0.00% 10.00%
0.33 0.00% 0.00% 90.00% 0.00% 10.00%
0.41 0.00% 0.00% 90.00% 0.00% 10.00%
0.50 0.00% 0.00% 90.00% 0.00% 10.00%
0.58 0.00% 0.00% 90.00% 0.00% 10.00%
0.66 0.00% 0.00% 90.00% 0.00% 10.00%
0.74 0.00% 0.00% 90.00% 0.00% 10.00%
0.82 0.00% 0.00% 90.00% 0.00% 10.00%
0.91 0.00% 0.00% 90.00% 0.00% 10.00%
0.99 0.00% 0.00% 90.00% 0.00% 10.00%
1.07 0.00% 0.00% 90.00% 0.00% 10.00%
1.15 0.00% 0.00% 90.00% 0.00% 10.00%
1.24 0.00% 0.00% 90.00% 0.00% 10.00%
47
YEARS TOTAL TOT SENIOR SENIOR CN TOT JUNIOR JUNIOR CN
CAP PAY CAP PAY CAP PAY
1.32 0.00% 0.00% 90.00% 0.00% 10.00%
1.40 0.00% 0.00% 90.00% 0.00% 10.00%
1.48 0.00% 0.00% 90.00% 0.00% 10.00%
1.56 0.00% 0.00% 90.00% 0.00% 10.00%
1.65 0.00% 0.00% 90.00% 0.00% 10.00%
1.73 0.00% 0.00% 90.00% 0.00% 10.00%
1.81 0.00% 0.00% 90.00% 0.00% 10.00%
1.89 0.00% 0.00% 90.00% 0.00% 10.00%
1.98 0.00% 0.00% 90.00% 0.00% 10.00%
2.06 0.00% 0.00% 90.00% 0.00% 10.00%
2.14 0.69% 0.69% 89.31% 0.00% 10.00%
2.22 0.72% 0.72% 88.59% 0.00% 10.00%
2.30 0.74% 0.74% 87.85% 0.00% 10.00%
2.39 0.76% 0.76% 87.10% 0.00% 10.00%
2.47 0.78% 0.78% 86.32% 0.00% 10.00%
… … … … … …
8.80 1.05% 1.05% 3.48% 0.00% 10.00%
8.88 1.05% 1.05% 2.43% 0.00% 10.00%
8.96 1.05% 1.05% 1.39% 0.00% 10.00%
9.04 1.04% 1.04% 0.34% 0.00% 10.00%
9.13 1.04% 0.34% 0.00% 0.70% 9.30%
9.21 1.04% 0.00% 0.00% 1.04% 8.26%
9.29 1.04% 0.00% 0.00% 1.04% 7.22%
9.37 1.04% 0.00% 0.00% 1.04% 6.19%
9.45 1.04% 0.00% 0.00% 1.04% 5.15%
9.54 1.03% 0.00% 0.00% 1.03% 4.12%
9.62 1.03% 0.00% 0.00% 1.03% 3.09%
9.70 1.03% 0.00% 0.00% 1.03% 2.06%
9.78 1.03% 0.00% 0.00% 1.03% 1.03%
9.87 1.03% 0.00% 0.00% 1.03% 0.00%
We can see also how this is useful for credit enhancement. Clearly, any losses that are
borne (up to 10%) will be borne only by the junior noteholders, and not by the senior
noteholders.
48
The size of the senior tranche relative to the size of the junior tranche has an effect on the
WAL of each tranche. The WAL of the pool is 6.09. Hence, if the size of the senior tranche
is, for example, 99%, we would expect a WAL very close to 6.09. The junior tranche is
always longer than the senior tranche, so we would expect a WAL higher than 6.09. In
summary:
• The WAL of the senior tranche is always lower than the WAL of the junior tranche, and
lower than the pool WAL;
• The WAL of the junior tranche is always higher than the WAL of the senior tranche, and
higher than the pool WAL; and
• The WAL of the junior tranche can never be higher than 10 years, the life of the pool.
If we vary the size of the senior tranche, we get the following:
SPLIT SENIOR WAL JUNIOR WAL

100% senior, 0% junior 6.09 N/A
99% senior, 1% junior 6.05 9.87
95% senior, 5% junior 5.90 9.71
90% senior, 10% junior 5.71 9.51
75% senior, 25% junior 5.15 8.92
50% senior, 50% junior 4.23 7.96
We can graph the payments for a 90% split as follows below. The capital repayments only
start after 2 years (due to the substitution period) and are initially all directed towards the
senior tranche.
49
We can graph the cashflows of the note as follows below:
To scale, the cashflows look as follows:
50
As before, we examine the WALs that we get under various prepayment assumptions:
PREPAYMENT WAL – CALL + WAL – CALL + WAL – CALL

SUBSTITUTION + SUBSTITUTION
TRANCHING
5% CPR 4.45 5.00 4.14
50%PSA 5.11 5.20 4.50
100%PSA 5.02 5.11 4.28
150%PSA 4.93 5.03 4.08
200%PSA 4.84 4.96 3.89
We note that the variability of the WALs is highest after the effects of tranching are taken
into account. The reason for this is that effects of prepayment are magnified due to the
tranching.
Summary
We have described the broad principle effects of three common features of security
design. The effects of the features on the WAL have also been described. We are now in
a position to do the following:
• Include more “real-world” details relating to the cashflows and design features; and
• Describe the pricing of the securities, and the effects of the assumptions that we need
to make on the pricing.
51
Some Real World Considerations
Introduction
Up until now, we have focussed mainly on some of the broad principle issues relating to
mortgages and mortgage-backed securities. In doing so, we have deliberately made some
simplifying assumptions. This section presents some of the real world considerations that
should be taken account of when modelling MBS. In particular:
• Almost all SA mortgages that we will consider are floating, and not fixed;
• The loans are typically 20 years in length, as opposed to the 10 years we used in our
previous examples;
• A servicing spread is payable by the SPV to its servicer. The cash from the pool is
received by the SPV, which then pays the servicing fee to the servicer, and the
remainder is then paid to the investors;
• The payment of interest is slightly more complex than previously described;
• Prepayment behaviour is not as uniform as portrayed in the examples;
• It is worth mentioning that relatively little prepayment history exists – although this is not
a problem; and
• A mortgage pool as a whole can carry an element of default risk.
Fixed versus Floating

Almost all SA mortgages that we will consider are floating and not fixed. How does this
affect our cashflows:
• The scheduled interest payments are not fixed;
• As JIBAR or Prime changes, so will the remaining schedule of principal payments; and
• Default behaviour may be affected in times of high interest rates.
We will discuss each possible factor in turn.
Scheduled Payments
As JIBAR or Prime changes, so will the scheduled payments change. In each month that
there is an interest rate change, a new instalment amount is calculated so that, if the new
interest rate were the interest rate for the entire period, the new instalment would correctly
amortise the existing principal over the remaining life of the loan. Hence, the scheduled
principal payments will change over the life of the deal.
Consider the following scenarios:
SCENARIO NAME WAL INTEREST RATE SCENARIO

Base Case 13.18 10.75% fixed
Pn2 12.76 I decreasing by 0.25% per year from 10.75%
Pn3 13.59 I increasing by 0.25% per year from 10.75%
Pn4 11.52 5% fixed
Pn5 14.21 15% fixed
52
We obtain the following principal schedules:
We see that the schedule can change noticeably; however, the effect on the WAL is still
fairly small.
As a consistency and integrity test, we can do the following:

• Create a set of monthly dates;
• Calculate the number of years corresponding to each date;
• Obtain a zero coupon yield curve, with rates for each of the above dates;
• Calculate the forward rates;
• For each period, recalculate the instalment size;
• Calculate the interest for each period;
• Calculate the principal repayment for each period; and
• PV all the values of the instalment size that we calculate.
The sum of all the PVs should equal the initial balance.
Why should the sum of the PVs equal the initial balance? Because, at each period, the
interest that the security is bearing is equal to the forward rate off the same curve that we
use to PV the cashflows.
We also see that the values of the instalment size will then change at each period, as
shown in the graph below. The forward rates used for each period are extracted from the
current yield curve.
53
Length of Loans
The length of the loans is usually around 20 years. The examples that we calculated in the
previous chapter are still valid.
Servicing Spread
In reality, the interest that comes into the SPV will first have a servicing spread subtracted
before making the payment to investors. This is called the servicing spread. As an order-
of-magnitude figure, it might be 0.50% or 50 basis points.
For example, let G be the interest rate that is owed to the pool. Of this interest, we note
that:
G=S+C
where S is the service fee (e.g., 0.50%), and C is the coupon that is paid to investors.
Hence, the amount that is paid for servicing is equal to:

S
{ }
Servicing Amount = ––––– Ii
C+S
and the total cashflow to investors is then
{ }
C
Pn + ––––– In
C+S
54
Interest Payments
Suppose, for example, that we have three tranches split as follows:
• The overall pool bears interest at JIBAR + 2.10%;
• AAA tranche bears interest at JIBAR + 0.50% and is 90% of the issue;
• BBB tranche bears interest at JIBAR + 1.50% and is 6% of the issue; and
• B tranche bears interest at JIBAR + 2.50% and is 4% of the issue.
The manner of paying interest might be as follows:

• Say the amount of interest that comes in is I;
• Then I is used to pay the interest of JIBAR + 0.50% on the AAA tranche, which is 90%
of the issue;
• To the extent that I is greater than zero, the remainder of I is then used to pay JIBAR +
1.50% on the BBB tranche, which is 6% of the issue; and
• To the extent that I is greater than zero, the remainder of I is then used to pay JIBAR +
2.50% on the BBB tranche, which is 4% of the issue.
Excess Spread and Reserve Fund

If we look at the spreads mentioned in the previous example, there is normally more
interest available than is paid out to noteholders. So what happens to this excess spread?
The excess spread is paid into the Reserve Fund. It is utilised mainly as follows:
• It covers any defaults that may have occurred; and
• After all other obligations are met, the remainder is paid out to the originator.
The calculations are usually done in such a way to try to ensure that there is not too much
excess spread.
Prepayment Behaviour and History

The prepayment behaviour is not as orderly as the PSA or other models might describe.
However, this is of relatively little consequence, for reasons that are described in the
chapter on pricing.
We also note that the pool size may increase as well as decrease.
There is little good prepayment history available. However, this is of relatively little
consequence, for reasons that are described in the chapter on pricing.
Defaults
Any pool of mortgages is subject to an element of default risk. However, the securities and
tranching are normally designed such that the AAA carries a negligible amount of default
risk.
55
Pricing Floating-Rate Mortgage-Backed Securities
Introduction
In this chapter, we describe the pricing of floating-rate mortgage-backed securities. Up
until now, we have focussed mainly on the cashflows and some characteristics of the
cashflows.
Principles of Pricing any FRN

Any FRN, including a MBS FRN, bears interest (by definition) at a floating-rate of interest.
This floating-rate of interest is usually related to some benchmark interest rate, which is
very often a short-term interest rate. For example, we might have the following security:
• A R1 million FRN, bearing interest quarterly at JIBAR + 50 basis points, repaying the
full principle in six years time.
Let us now consider the position of an investor in this paper. The investor has the following
options:
• Strategy A: She can invest R1 million in our FRN; or
• Strategy B: She can invest R1 million in a three-month NCD bearing JIBAR. At the end
of the first three months, she can re-invest the principal in another three month NCD
bearing JIBAR, and so forth until three years are up.
Are there any significant differences between these two strategies?

• Interest rate exposure: in each case, she is exposed to three month JIBAR;
• Credit/liquidity exposure: in the case of Strategy A, she is exposed to six- year credit
risk of the issuer. In the case of Strategy B, she is exposed to three-month credit
exposure.
Our investor (or the market) might decide, for example, that this particular issuer should
pay no credit/liquidity spread relative to JIBAR for three-month paper. However, this
particular issuer should be charged 30 basis points for credit/liquidity risk for six year risk.
How do we assess the PV of each strategy?
Strategy B:
In the case of Strategy B, the PV of her strategy is the same as her investment. In other
words, she invests R1 million, and at the end of the three months, she receives her R1
million back plus JIBAR interest. She reinvests the R1 million, and in six months time,
receives her R1 million back plus interest at the then-ruling JIBAR interest rate. We see
that her PV is R1 million.
Strategy A:
In the case of Strategy A, at the end of every three months she receives exactly the same
as in Strategy B, plus she receives an extra 50 basis points. So:
• Firstly, we can say we start with a PV of R1 million;
• Next, we look at the extra 50 basis points. Of the extra 50 basis points, 30 basis points
is charged for the credit risk;
56
• In other words, for this particular credit risk, a 6-year FRN needs to bear JIBAR+30 in
order to be priced at par;
• Hence, we are left with an ‘extra’ 20 basis points. This is effectively a six year annuity;
• We calculate the PV of this annuity by using an appropriate swap rate. An easy way to
do it is to calculate the PV01 of the swap (a six year swap in our case) and multiply the
extra 20 basis points by the PV01 of the swap.
In summary, we can say that purchasing a MBS FRN is very similar to engaging in a
strategy of investing in NCDs, and rolling the investments. The primary interest rate risk
that investors thus face is simply to the short-term interest rate. The pricing principles will
follow from this.
We now describe how a MBS FRN can be regarded as the sum of several vanilla FRNs.
Decomposing a MBS FRN into a Series of Vanilla FRNs

In this section, we see that a MBS FRN can be regarded as a series of vanilla FRNs. We
assume that we have modelled the prepayment behaviour, and know how the principal is
going to be prepaid.
Example 1
Let us assume that we have the following schedule of capital payments:
YEARS CAPITAL PAYMENT

0.00
0.25 200,000.00
0.50 250,000.00
0.74 300,000.00
0.99 250,000.00
We make the additional assumption that the security pays JIBAR+50 basis points (as its
IM), and should price at JIBAR flat, (i.e., TM=0). We now calculate the applicable interest
rates to use, by interpolation from the swap curve attached as Appendix 1:
YEARS CC RATE DISCOUNT FWD SIMPLE FWD+IM

FACTOR FWD
0.00 9.24% 99.97%
0.25 9.53% 97.65% 9.53% 9.65% 10.15%
0.50 9.22% 95.53% 8.91% 9.00% 9.50%
0.74 9.11% 93.46% 8.90% 9.00% 9.50%
0.99 9.06% 91.43% 8.90% 9.00% 9.50%
The CC Rate is the appropriate zero coupon interest rate (expressed as a continuously
compounding rate). The discount factor is simply the factor by which we multiply a
cashflow in order to calculate its PV. It is calculated from the continuously compounded
rates. The Fwd is the appropriate forward rate, expressed as a continuously compounded
rate, and the Simple Fwd is the corresponding simple rate. Fwd + IM is the simple forward
rate plus IM.
57
Using these interest rates, we can now calculate the schedule of payments:
YEARS CAPITAL CAPITAL PAYMENT INTEREST

0.00 1,000,000.00
0.25 800,000.00 200,000.00 25,020.94
0.50 550,000.00 250,000.00 18,746.82
0.74 250,000.00 300,000.00 12,883.81
0.99 – 250,000.00 5,856.64
We now show that this is essentially the sum of four floating-rate notes. Each FRN bears
interest at the same rate (JIBAR+50) as the entire MBS FRN. We decompose the capital
as shown in the table below. This table shows the capital outstanding on each of the four
FRNs:
YEARS FRN 1 FRN 2 FRN 3 FRN 4 TOTAL

0.00 200,000.00 250,000.00 300,000.00 250,000.00 1,000,000.00
0.25 200,000.00 250,000.00 300,000.00 250,000.00 1,000,000.00
0.50 250,000.00 300,000.00 250,000.00 800,000.00
0.74 300,000.00 250,000.00 550,000.00
0.99 250,000.00 250,000.00
Note that the sum total of the FRNs is exactly the original capital balance of the MBS FRN.
We can also show the composition of the outstanding capital as a graph:
58
Next we show the interest payments below. We calculate the interest payments in the
same manner as before. We note also that the sum of the interest payments equals the
interest payments on the original amortising schedule shown above.
YEARS FRN 1 FRN 2 FRN 3 FRN 4 TOTAL

0.00
0.25 5,004.19 6,255.23 7,506.28 6,255.23 25,020.94
0.50 5,858.38 7,030.06 5,858.38 18,746.82
0.74 7,027.53 5,856.28 12,883.81
0.99 5,856.64 5,856.64
We use the discount factors calculated in a previous table to calculate the PV of the entire
set as follows:
YEARS CAPITAL CAPITAL INTEREST TOTAL DF PV

PAYMENT CASHFLOW
0.00 1,000,000.00 99.97%
0.25 800,000.00 200,000.00 25,020.94 225,020.94 97.65% 219,736.88
0.50 550,000.00 250,000.00 18,746.82 268,746.82 95.53% 256,736.25
0.74 250,000.00 300,000.00 12,883.81 312,883.81 93.46% 292,411.45
0.99 – 250,000.00 5,856.64 255,856.64 91.43% 233,924.00
The sum of the PVs is R1 002 808-58. In similar fashion, we can calculate the PV of each
of the four FRNs:
YEARS FRN 1 TOTAL CASHFLOW DF PV

0.00 99.97%
0.25 205,004.19 97.65% 200,190.17
0.50 95.53%
0.74 93.46%
0.99 91.43%
The PV is R200 190-17.

0.00 99.97%
0.25 6,255.23 97.65% 6,108.35
0.50 255,858.38 95.53% 244,423.81
0.74 93.46%
0.99 91.43%
59
The PV is R250 532-16.

0.00 99.97%
0.25 7,506.28 97.65% 7,330.01
0.50 7,030.06 95.53% 6,715.88
0.74 307,027.53 93.46% 286,938.36
0.99 91.43%
The PV is R300 984-25.

0.00 99.97%
0.25 6,255.23 97.65% 6,108.35
0.50 5,858.38 95.53% 5,596.57
0.74 5,856.28 93.46% 5,473.10
0.99 255,856.64 91.43% 233,924.00
The PV is R251 102-01.

In total, we get:
PV
FRN 1 200,190.17
FRN 2 250,532.16
FRN 3 300,984.25
FRN 4 251,102.01
TOTAL 1,002,808.58
Note that the total once again equals the original PV that we calculated earlier.
In summary, we see that we can regard a MBS FRN as a string of ‘vanilla’ FRNs. This will
assist us in developing one of our pricing methodologies.
Pricing Methodologies
Now that we have shown that the MBS FRN can be regarded the sum of vanilla FRNs,
and we have done some initial pricing, we can move to summarising our pricing
methodologies. Based on the above example, we have three possible ways of pricing:
Pricing Methodology 1
The first way of pricing is as follows:
• We assume that we have measured the prepayment behaviour that has already
occurred, and is available to us;
60
• We assume that we have modelled the prepayment, and fitted an appropriate model.
This could be, for example, an assumption that CPR is constant, or that CPR follows
the PSA model, or some other model;
• Using the model that we have, and available interest rate data, we project the cashflows
that will occur, using the forward rates and IM and TM; and
• We price these cashflows by using the zero-coupon yield curve to calculate the PV of
each cashflow, and summing the cashflows.
Our second way of pricing is the following:
occurred, and is available to us;
the PSA model, or some other model;
• We calculate the capital repayments;
• We use the capital repayments to calculate the string of vanilla FRNs that makes up our
amortising; and
• We price each vanilla FRN individually, as per using the FRN formula in Appendix 1.
Simplifying the Formulas

In the previous section, we showed how we could regard a MBS FRN as the sum of a
number of ‘vanilla’ FRNs. One way to price a MBS FRN is to decompose the MBS FRN
into its individual ‘vanilla’ FRNs, and use the formula for pricing a FRN to price each FRN
individually. However, it would be more convenient to be able to price MBS FRN using one
formula, and not the sum of many individual FRNs.
The aim of this section is to show that a simple approximation exists.
We recall the FRN pricing formula:

(IM – TM)
Z(b + IM)d/365 + an + 1
k
P= x Nominal of FRN
(r + TM)f
1+
365
61
where
SYMBOL MEANING
P All In Price of the FRN.
Z 1 if the FRN is cum, and 0 if it is ex
b Floating benchmark rate from last interest reset date to next interest rate
date
d Number of days in current interest period
IM Initial margin (as a percentage) that is added to the floating benchmark
TM Trading margin (as a percentage) that is added to the floating benchmark
r Floating benchmark interest rate to the next interest reset date
f Number of days from settlement to next interest payment date
1 – vn
an an = v + v2 + . . . + vn = –––––
i
1
v v = ––––
1+i
i i = (s + TM)/k
k Payment frequency of FRN, e.g., 4 for quarterly payments and 2 for semi-
annual payments
s Yield from settlement to the maturity of the FRN (with frequency k)
n Number of complete interest periods to maturity as at the next interest
date
From previous sections, we know that our MBS FRN is made of 4 individual ‘vanilla’ FRNs.
The cashflows of our MBS FRN are equal to the sum of the cashflows of the underlying
‘vanilla’ FRNs. Hence, the PV of our MBS FRN must be equal to the sum of the PVs of
each of the four vanilla FRNs. Expressed differently:
PMBSFRN = PFRN1 + PFRN2 + PFRN3 + PFRN4
62
Also, we let the nominal of each FRN be denoted by N1, N2, N3, N4, with the total nominal
being denoted by NMBSFRN. We can then expand the above equality to get:
(IM – TM)
Z(b + IM)d/365 + an1 + 1
k
PMBSFRN = x N1
(r + TM)f
1+
365
(IM – TM)
Z(b + IM)d/365 + an2 + 1
k
PMBSFRN + x N2
(r + TM)f
1+
365
(IM – TM)
Z(b + IM)d/365 + an3 + 1
k
PMBSFRN + x N3
(r + TM)f
1+
365
(IM – TM)
Z(b + IM)d/365 + an4 + 1
k
PMBSFRN + x N4
(r + TM)f
1+
365
We want to collapse this long formula into a single shorter formula. We notice that the only
variables that change from each term to the next (after the equality) are n and N. The
formula that we wish to achieve is
(IM – TM)
Z(b + IM)d/365 + anWAL + 1
k
PMBSFRN = x NMBSFRN
(r + TM)f
1+
365
We wish to compute a nWAL that we can use in the formula above. The approximation that
we use is that nWAL is the weighted average of the n that applies to each individual FRN.
The weights are the sizes of the nominal values of each FRN relative to the total size. In
other words:
[ ] [ ] [ ] [ ]
N1
nWAL = n1 ––––––
NMBSFRN
N2
+ n2 ––––––
NMBSFRN
N3
+ n3 ––––––
NMBSFRN
N4
+ n4 ––––––
NMBSFRN
To summarise the above section, our third way of pricing is the following:
occurred, and is available to us.
the PSA model, or some other model.
• We calculate the capital repayments.
• We use the capital repayments to calculate the string of vanilla FRNs that makes up our
amortising.
• We calculate the weighted average life of the MBS FRN, and calculate NWAL.
63
We calculate
(IM – TM)
Z(b + IM)d/365 + anWAL + 1
k
PMBSFRN = x NMBSFRN
(r + TM)f
1+
365
Further Examples
In this section, we look at some examples that are closer to the real world:
Example 1
We look at the following schedule:
YEARS SENIOR CN SENIOR SENIOR TOTAL

INTEREST CAPITAL CASHFLOW
0.00 90.00% 0.00% 0.00% 0.00%
0.08 90.00% 0.70% 0.00% 0.70%
0.17 90.00% 0.75% 0.00% 0.75%
0.25 90.00% 0.72% 0.00% 0.72%
0.33 90.00% 0.67% 0.00% 0.67%
0.41 90.00% 0.68% 0.00% 0.68%
0.50 90.00% 0.68% 0.00% 0.68%
0.58 90.00% 0.66% 0.00% 0.66%
0.66 90.00% 0.68% 0.00% 0.68%
0.74 90.00% 0.68% 0.00% 0.68%
0.82 90.00% 0.68% 0.00% 0.68%
0.91 90.00% 0.68% 0.00% 0.68%
0.99 90.00% 0.67% 0.00% 0.67%
1.07 90.00% 0.68% 0.00% 0.68%
1.15 90.00% 0.69% 0.00% 0.69%
1.24 90.00% 0.69% 0.00% 0.69%
1.32 90.00% 0.71% 0.00% 0.71%
1.40 90.00% 0.72% 0.00% 0.72%
1.48 90.00% 0.72% 0.00% 0.72%
1.56 90.00% 0.73% 0.00% 0.73%
1.65 90.00% 0.73% 0.00% 0.73%
1.73 90.00% 0.74% 0.00% 0.74%
1.81 90.00% 0.74% 0.00% 0.74%
1.89 90.00% 0.74% 0.00% 0.74%
64
1.98 90.00% 0.75% 0.00% 0.75%
2.06 90.00% 0.76% 0.00% 0.76%
2.14 89.82% 0.76% 0.18% 0.94%
2.22 89.62% 0.77% 0.20% 0.96%
2.30 89.40% 0.77% 0.22% 0.98%
2.39 89.17% 0.77% 0.23% 1.00%
2.47 88.92% 0.77% 0.25% 1.02%
2.55 88.66% 0.78% 0.27% 1.04%
2.63 88.38% 0.78% 0.28% 1.06%
2.72 88.08% 0.78% 0.30% 1.08%
2.80 87.76% 0.78% 0.31% 1.10%
2.88 87.43% 0.78% 0.33% 1.11%
2.96 87.08% 0.78% 0.35% 1.13%
3.04 86.72% 0.78% 0.37% 1.14%
3.13 86.34% 0.77% 0.38% 1.15%
3.21 85.94% 0.77% 0.40% 1.17%
3.29 85.52% 0.77% 0.41% 1.18%
3.37 85.09% 0.77% 0.43% 1.20%
3.45 84.65% 0.77% 0.45% 1.21%
3.54 84.18% 0.77% 0.46% 1.23%
3.62 83.71% 0.77% 0.48% 1.24%
3.70 83.22% 0.76% 0.49% 1.26%
3.78 82.71% 0.76% 0.51% 1.27%
3.87 82.19% 0.76% 0.52% 1.28%
3.95 81.66% 0.76% 0.53% 1.29%
4.03 81.11% 0.75% 0.55% 1.30%
4.11 80.54% 0.74% 0.57% 1.30%
4.19 79.96% 0.73% 0.58% 1.31%
4.28 79.37% 0.73% 0.59% 1.32%
4.36 78.76% 0.73% 0.61% 1.33%
4.44 78.14% 0.72% 0.62% 1.34%
4.52 77.51% 0.72% 0.63% 1.35%
4.61 76.88% 0.72% 0.63% 1.35%
4.69 76.25% 0.71% 0.63% 1.34%
65
4.77 75.63% 0.71% 0.62% 1.33%
4.85 75.01% 0.71% 0.62% 1.33%
4.93 74.39% 0.70% 0.62% 1.32%
5.02 73.78% 0.70% 0.61% 1.31%
5.10 73.16% 0.68% 0.62% 1.29%
5.18 72.55% 0.67% 0.61% 1.29%
5.26 71.94% 0.67% 0.61% 1.28%
5.35 71.33% 0.67% 0.61% 1.27%
5.43 70.73% 0.66% 0.60% 1.27%
5.51 70.13% 0.66% 0.60% 1.26%
5.59 69.53% 0.65% 0.60% 1.25%
5.67 68.93% 0.65% 0.60% 1.25%
5.76 68.34% 0.65% 0.59% 1.24%
5.84 67.75% 0.64% 0.59% 1.23%
5.92 0.00% 0.64% 67.75% 68.39%
This has been calculated using the following:

• 90% tranching;
• 6-year call;
• Changing instalment; and
• Yield curve in Appendix 2.
The PV off the curve is R907 600-60.
66
The following applies:
Z 0 1=CUM, 0 EX
b 0 Rate from last reset to next reset
d 0 Days in current interest period
Im 0 Initial margin
TM –0.20% Trading margin
r 0 Benchmark to next reset
f 0 Days from settlement to next interest payment
an 50.79874135 Calculated
v 0.991782917 Calculated
I 0.008285163 Calculated
K 12 Payment freq
S 10.14% Swap
N 66.2024558 Num of coupon periods to mat from next interest date
WAL 5.52
The PV from the formula is R907 619-81, a difference of R19-18.
Risk
In this section, we briefly examine possible risks that may arise from getting the
prepayment model or assumptions wrong.
We look at what can happen if either:

• The trading margin changes; or
• The prepayment speed changes.
If the trading margin changes, this is reflected in a change in IM-TM. If the prepayment
speed changes, we can show it as a change (for example) in the multiple of PSA (i.e.,
100% PSA, 50% PSA, etc.)
We will do the following:

• Use the assumptions in the previous section regarding tranching, substitution, etc. to
generate our cashflows;
• Vary IM-TM over a wide range and regenerate the cashflows and calculate the PV for
each scenario;
• Vary the multiple of PSA over a wide range and regenerate the cashflows and PV;
• Calculate all WALs for each scenario.
67
IM-TM 25%PSA 50%PSA 100%PSA 150%PSA 200%PSA 300%PSA
–1.50% 935,403.59 935,922.69 936,939.33 937,927.65 938,888.17 940,727.86
–1.00% 956,874.99 957,222.30 957,902.47 958,563.69 959,206.30 960,437.05
–0.50% 978,408.28 978,582.53 978,923.78 979,255.52 979,577.91 980,195.36
0.00% 1,000,000.00 1,000,000.00 1,000,000.00 1,000,000.00 1,000,000.00 1,000,000.00
0.50% 1,021,646.77 1,021,471.39 1,021,127.94 1,020,794.07 1,020,469.63 1,019,848.28
1.00% 1,043,345.30 1,042,993.48 1,042,304.50 1,041,634.77 1,040,983.94 1,039,737.56
1.50% 1,065,092.41 1,064,563.15 1,063,526.69 1,062,519.21 1,061,540.17 1,059,665.30
The WAL that is generated for each scenario is as follows:
IM-TM 25%PSA 50%PSA 100%PSA 150%PSA 200%PSA 300%PSA

–1.50% 5.66 5.60 5.49 5.38 5.27 5.07
–1.00% 5.67 5.61 5.50 5.39 5.28 5.08
–0.50% 5.67 5.62 5.51 5.40 5.29 5.09
0.00% 5.68 5.63 5.51 5.40 5.30 5.10
0.50% 5.69 5.63 5.52 5.41 5.31 5.10
1.00% 5.70 5.64 5.53 5.42 5.31 5.11
1.50% 5.71 5.65 5.54 5.43 5.32 5.12
In order to make sense of the numbers, we do the following:

• For every given IM-TM, we look at the change in PV that occurs across a range of PSA
prepayment speeds
• We calculate the difference between maximum and minimum PVs
• We express this difference in terms of basis points of a 100%PSA scenario, trading at
IM-TM=0.
We obtain:
IM-TM MAX DIFFERENCE IN BASIS POINT TERMS:

–1.50% 11.36
–1.00% 7.60
–0.50% 3.81
0.00% –
0.50% 3.84
1.00% 7.70
1.50% 11.58
68
How do we interpret this?
We note the following:

• A change in prepayment (and, hence, in WAL) generates a change in the present value
of a basis point;
• Hence, if IM-TM is large, then changes in prepayment assumption can have a
comparatively large effect on the price (e.g., 11.58 basis points, or 0.1158%)
• If IM-TM is small, then changes in prepayment have an effect that is close to zero on
the price.
Hence, the penalties for getting prepayment wrong, even to a relatively large degree, are
quite small.
69
Appendix 1 – Pricing Floating-Rate Notes
Introduction
We will cover the following sections in this lesson:
• Pricing Summary;
• Example; and
• Pricing – Explanation.
The intention is to develop a pricing formula for Floating-Rate Notes (“FRNs” or “floaters”).
During the course of the development, the theory behind the pricing will become clear.
Pricing Summary
Overview
The following needs to be known in order to price a FRN:
• Initial Margin (“IM”) – this is the margin at which the FRN is issued. For example, a FRN
that bears interest at JIBAR + 10bp would have an IM of 10bp.
• The last interest reset rate – for example, if the coupons are paid three monthly, and we
are one month away from the next coupon date, then the last interest reset rate is the
rate that was the three month interest rate, two months ago (at the time of the last
coupon). This rate is the one that is used to determine the next coupon.
• The number of days in the current interest period, i.e., the number of days from the last
coupon date to the next one.
• The number of days from settlement until the next coupon date.
• The payment frequency of the FRN (e.g., semi-annual, quarterly, etc).
The following needs to be taken from the screens, or calculated (by interpolation):
• The interest rate that applies from the settlement date to the next coupon. For example,
if the next coupon occurs one month away, then we might use one-month JIBAR.
• The swap rate from settlement until the maturity of the FRN. For example, if the maturity
were 2.5 years, then the swap rate to be used would be interpolated between the 2 and
3-year swap rates.
The following needs to be negotiated between buyer and seller:

• Trading Margin (“TM”) – the Initial Margin at which the FRN would be issued, if it were
issued today.
The formulae described in the next section can then be used to calculate the All In Price.
In essence, the formula uses a combination of money market and bond market formulae
to give an All In Price.
70
Detailed Formulae
We will use the following symbols:
SYMBOL MEANING
P All In Price of the FRN. See the formula below.
Z 1 if the FRN is cum, and 0 if it is ex
b Floating benchmark rate from last interest reset date to next interest rate
date
d Number of days in current interest period
IM Initial margin (as a percentage) that is added to the floating benchmark
TM Trading margin (as a percentage) that is added to the floating benchmark
r Floating benchmark interest rate to the next interest reset date
f Number of days from settlement to next interest payment date
1 – vn
an an = v + v2 + . . . + vn = –––––
i
1
v v = ––––
1+i
i i = (s + TM)/k
k Payment frequency of FRN, e.g., 4 for quarterly payments and 2 for semi-
annual payments
s Yield from settlement to the maturity of the FRN (with frequency k)
n Number of complete interest periods to maturity as at the next interest
date
The following formula is used to calculate the All-In Price of the FRN. The symbols that
are used are defined in the table above.
(IM – TM)
Z(b + IM)d/365 + an + 1
k
P= x Nominal of FRN
(r + TM)f
1+
365
71
Source of Interest Rates in the Formula
The interest rates that we refer to in the above sections are obtained as follows:
RATE SOURCE
b Floating benchmark rate from last interest reset date to next interest rate date.
For example, if the FRN pays quarterly rates, this might be 3 month JIBAR
from the screen SAFEY.
r Floating benchmark interest rate to use between settlement and the next
interest reset date. This rate is obtained either by:
Interpolating between whichever are applicable of the overnight dep. Rate, 1
month JIBAR, 3 month JIBAR, 6 month JIBAR and 12 month JIBAR rates on
the screen SAFEY, rounded to 2 decimal places, or
Using the applicable short-term benchmark interest rate, for example 3 month
T-Bill or JIBAR
We will typically use the second route listed above. This is for reasons of
simplicity, as well as availability – for example, one month JIBAR is available,
but one month T-Bill is not always available.
s Yield from settlement to the maturity of the FRN (with frequency k). This is
typically a swap rate, and is obtained from a swap screen such as SMBX,
interpolated where necessary, rounded to 2 decimal places.
Example 1
Consider pricing the DV20, as follows:
DV20 Term Sheet
Maturity: 28 April 2004
Coupon dates: 28 April, 28 July, 28 October, 28 January
Coupon: JIBAR+50bp
We will price the DV20 with the following parameters:

Settlement Date: 10 November 1999
We use the following yield curve:
MATURITY DATE VALUE DESCRIPTION

10-Dec-99 11.10% 1 month JIBAR
10-Feb-00 11.50% 3 month JIBAR
10-May-00 11.75% 6 month JIBAR
10-Nov-00 12.20% 12 month JIBAR
10-Nov-03 13.51% 4 year swap (quarterly)
10-Nov-04 13.78% 5 year swap (quarterly)
We also need to know what the last coupon rate was, so that we can work out the size of
the next coupon:
72
Historical Rates
MATURITY DATE VALUE DESCRIPTION

28-Jan-00 11.28% 3 month JIBAR on 28 October
There are several important dates that we need for pricing. In particular, we need to know
what swap and swap dates we should use for pricing.
Relevant Dates for Pricing
RELEVANT DATES VALUE DESCRIPTION

Settlement Date 10-Nov-99 This is t + 3 bond settlement
Previous Coupon of Bond 28-Oct-99

Next Coupon of Bond 28-Jan-00
Bond Redemption 28-Apr-04
4 year swap date for settlement 10-Nov-03 This is the last swap before
redemption
5 year swap date for settlement 10-Nov-04 This is the first swap after
redemption
There are several date calculations that we need to do, in particular for the (linear)
interpolation. Our date calculations are as follows:
Date Calculations
DATE CALCULATIONS VALUE DESCRIPTION

Days from Settlement to next 79.00 Used to work out the discount from
coupon next coupon back to settlement
Years to bond redemption 4.47 Shows us that we need the 4 year
and 5 year swaps for interpolation
Days from 4 year swap date to 170.00 Needed to calculate interpolated
redemption swap rate
Days from redemption to 5 year 196.00 Needed to calculate interpolated
swap date swap rate
Days from 4 year swap to 5 year 366.00 Needed to calculate interpolated
swap swap rate
Days in current interest period 92.00 Used to calculate size of next
coupon
We need to do some interest rate calculations. In particular, we need to calculate the

interpolated swap rate to use in the formula.
73
Interest Rate Calculations
RATE CALCULATIONS VALUE DESCRIPTION

Interpolated Swap Rate 13.63% Weight for 4 year swap times 4 year
swap rate plus weight for 5 year
swap times 5 year swap rate (see
below)
Interpolation weight for 4 year 0.54 This is the number that we multiply
swap the 4 year swap by, equal to 196/366
Interpolation weight for 5 year 0.46 This is the number that we multiply
swap the 5 year swap by, equal to 170/366
Now we can work out all the different parameters:
Parameters
PARAMETER VALUE DESCRIPTION

Z 1 Bond is cum
b 11.28% Applicable JIBAR rate to use for working out next
coupon, i.e., 3 month JIBAR on last coupon date.
d 92.00 Days in current interest period
IM 0.50% Bond yields JIBAR+0.50%
TM 0.63% Above 3 month JIBAR
r 11.50% Short term (yield) rate until next interest payment. We
use 3 month JIBAR
f 79 Days from settlement to next interest payment
an 12.58581539 As per formula
v 0.965569977 As per formula
I 0.035657719 As per formula
K 4 Periodicity
s 13.63% 4.47 year swap rate
n 17 Number of full periods remaining
We plug the numbers into the formula as follows:

(IM – TM)
Z(b + IM)d/365 + an + 1
k
P= x Nominal of FRN
(r + TM)f
1+
365
74
We have
CALCULATIONS VALUE DESCRIPTION

d
First term on top 0.0297 Z(b + IM) –––
First term on top 0.0297 Z( b + IM) 365
an
Second term on top 0.00409039 (IM – TM) ––
k
f
Term on bottom 1.03 1 + (r + TM) –––
365
FINAL RESULT 0.9993595 (first term +second term + 1)/bottom term
Hence our price is R99.93595%.
Reality Check
For traders, we briefly present a “back-of the-matchbox” reality check on the above
numbers.
We start by assuming the PV of the bond is R1 000 000.00 on 28 January 2000, if the
Trading Margin is JIBAR + 50 basis points.
However, the Trading Margin is 63 basis points above JIBAR, and the PV of a basis point
of a 4.5 year swap is R327 per million. The difference between 50 and 63 basis points is
13. The PV of the extra margin is therefore 327 x 13 = R4251.00. As the margin is above
JIBAR plus the Initial margin, we subtract this from R1 million to get R995 749.00.
The coupon on 28 January 2000 is 11.28% x 92/365 x R1 000 000.00 = R28 431.78.
This gives us R1 000 000.00 – 4251.00 + 28 431.78=1 024 180.78.
We PV this from 28 January 2000 to 10 November 1999 at the current rate of 11.50% to
get R999 307.60.
The difference between this and the above price is R56.78 per million, which is less than
the PV of one basis point.
Hence we are in the correct ballpark.
Pricing and Trading Formulae

Introduction
In this section, we give a brief intuitive explanation of how the formulae in the previous
section are derived. We go through a number of different concepts, and tie them all up at
the end. Our roadmap is as follows:
• First, we show how buying a FRN is equivalent to buying a series of money market
instruments (ignoring, for now, spreads and credit risk). This gives us our first pass at a
price;
75
• Next, we show we change the price of the FRN to accommodate any margins. For
example, if the FRN is issued at 3 month JIBAR plus a margin of 10 basis points, then
we need to change the price to reflect the margin of 10 basis points; and
• Lastly, we show how to adjust the price of the FRN if the settlement date occurs on a
date that is not a coupon date.
At this point, we will have derived the pricing formula for FRNs.
FRN and Money Market Equivalence

In this section, we demonstrate how, in theory, buying a FRN is the same as investing in a
sequence of Money Market instruments.
Portfolios
Consider the following two possible portfolios:
• Portfolio A: Buy a FRN for R1 million, yielding 3m JIBAR every quarter, and repaying
R1 million in 2 year’s time.
• Portfolio B: Invest in a 3-month BA or NCD. In three months’ time, keep the interest and
re-invest the R1million in the new current 3-month BA or NCD. In six months time, keep
the interest from the second instrument, and re-invest the R1 million in another 3-month
BA or NCD. Carry on in this fashion until 2 years have elapsed.
In each case, we are investing R1 million. Also in each case, we are receiving JIBAR
related interest every three months, and receiving our R1 million back at the end. As the
cashflows are identical (ignoring spreads) we conclude that the two strategies are exactly
the same.
Also, the two strategies have the same present value. If we examine Portfolio B, we see
that on each coupon or payment date, we have R1 million to invest. We conclude that the
PV of each strategy, including the FRN, is the same on each coupon date, and is equal
to R1 million.
Conclusion
Ignoring bid/offer and credit spreads, the present value of our FRN is R1 million on each
coupon date. This present value of R1 million is our starting point for pricing.
As an example, consider a FRN that still has 2 years to run, with the settlement date on a
coupon date. This FRN may, for example, have been in issue for a year already.
We know that, without a margin, the PV (or All In Price) of the FRN is R1 million.
However, what happens if, for example, the FRN does not bear a coupon of JIBAR, but
rather a coupon of JIBAR plus a margin (i.e., JIBAR + IM)?
For example, let IM be 50 basis points. Then the coupon rate of the FRN is JIBAR + 50bp.
How do the 50 basis points affect the price of the FRN, which we currently have at R1
million? If we look at the coupons of the FRN, then we see that the margin forms an
annuity flow. We need to know the PV of this annuity flow.
76
Swaps
We also note that a swap is also a par bond rate for fixed rate bonds. In other words, if one
issues a fixed rate bond, and the PV of the bond is the same as the nominal, then the YTM
of the bond should be the same as the coupon of the bond. This coupon/YTM rate for our
par bond is precisely the same as the swap rate. Hence if we wish to discount the
cashflows of a par bond, then we should use the appropriate swap rate.
Similarly, we note that a FRN is also a par bond, or very close to a par bond. In fact, an
FRN bearing interest at JIBAR and a par bond are exactly the same if we do a swap to
convert from one to the other.
Hence, if we wish to find a YTM rate to use for discounting the margin flows on a FRN,
then the swap rate is the appropriate rate to use.
Formula
We can start building up the formula, for a FRN with a nominal of R1 000 000. Firstly, if
there is no margin, then we have (as discussed above), the following:
PV = 1000000
Next, we say that i is the swap rate. We wish to discount the margin IM at each date. Hence
we get
IM 1
[[ ] [ ]
IM 1
PV of Margin = –– –––– + ––– ––––
k 1+i k 1+i
2
IM 1
[ ]]
+ … + –– ––––
k 1+i
n
1000000
which simplifies to
IM
[ ]
PV of Margin = –– an 1000000
k
where
1 – vn
an = v + v2 + … + vn = –––––
i
and
1
v = ––––
1+i
and
s
i = ––
k
Hence, our total PV is currently
IM
[ ]
PV = –– an + 1 1000000
k
with the same definitions as before.
Initial Margin and Trading Margin

In the formulae in the Executive Summary, there are two margins mentioned. These are
the Initial Margin (IM) and Trading Margin (TM). We discuss these two different margins.
77
The most convenient way to price and discuss Floating-Rate Notes is in terms of the
margin above JIBAR at which the issuer can issue. For example, say that an Issuer can
issue a Floating-Rate Note at par, at JIBAR + 60bp. Then the note bears interest at JIBAR
+ 60bp, and (initially) trades at JIBAR + 60bp, with a price at par.
Say now that after 3 months, the Issuer’s credit rating has improved dramatically, and the
Issuer (if it wanted to do so) would be now able to issue Floating-Rate Notes at JIBAR +
35bp.
However, the note that is now in issue bears interest at a rate of JIBAR + 60bp. Hence a
potential investor should pay more for this note than before – in other words, the investor
should pay an extra amount that is the equivalent of the PV of 60-35 = 25 basis points.
Hence, the actual margin that we wish to PV is not the margin above JIBAR that the FRN
pays as interest – it is the difference between the margin above JIBAR at issue (Initial
Margin IM) and the margin above JIBAR at which the issuer would be able to issue
now (Trading margin TM). Hence our formula changes as follows:
[
IM – TM
PV = ––––––– an + 1 1000000
k ]
Lastly, we note that the swap rate that we use for discounting should reflect the par rate
for the Issuer. We have just seen that the par rate for the FRN is JIBAR + TM. Hence the
swap rate that we should use for discounting is swap rate + TM. Our formula now is as
follows:
[
IM – TM
PV = ––––––– an + 1 1000000
k ]
where
1 – vn
an = v + v2 + … + vn = –––––
i
and
1
v = ––––
1+i
and
s + TM
i = ––––––
k
Settlement Dates that are not Coupon Dates

In this section, we change the pricing to accommodate settlement dates that are not
coupon dates. We will first consider the situation where the FRN is ex, and then the
situation where it is cum.
Ex-dividend
As an example, let us consider the case where the FRN is ex-dividend. Now, we know that
on the coupon date, the price of the FRN is:
[
IM – TM
PV = ––––––– an + 1 1000000
k ]
78
However, we want to know the price as on our settlement. Hence we discount the price
back to today, using an appropriate short-term interest rate. The rate that we should use
is the rate at which the Issuer of the FRN is able to borrow. This is approximately the rate
r, as described in the previous section, but with the margin TM added, i.e., r + TM. So,
discounting the price, we get
[
IM – TM
PV = ––––––– an + 1
k ]
PV = –––––––––––––– 1000000
(r + TM)f
1 + ––––––––
365
Cum-Dividend
The cum dividend case is very similar to the case dividend case, in the sense that we:
• Calculate the PV as of the next payment date
• Calculate the next coupon that is due on the next payment date
• Add the PV and the coupon (which occur on the next coupon date)
• Discount the result back to the settlement date
The first step is as before. For the second step, we know that the coupon is calculated as
follows:
d
Coupon = (b + IM) –––
365
We add this to the PV as of the next coupon date to get:
d
365 [
IM – TM
Total PV = (b + IM) ––– + ––––––– an + 1 1000000
k ]
Next, we discount (as before) to get:
d
[
IM – TM
Total PV = (b + IM) ––– + ––––––– an + 1
365 k
Total PV = –––––––––––––––––––––––––– 1000000
]
(r + TM)f
1 + ––––––––
365
Combining the formulae

We can combine the two formulae into one formula, that caters for both the cum and ex
situation, as follows:
(IM – TM)
Z(b + IM)d/365 + an + 1
k
P= 1000000
(r + TM)f
1+
365
Z is an “indicator” variable, that is 1 if the bond is cum, and 0 if it is ex. If Z is 1, we see

that the formula is the same as the formula that we derived for the cum FRN, and if it is 0,
we see that it is the same as the formula for the price of the ex FRN.
79
Generalising slightly, this gives us our formula in the first section of this document of:
(IM – TM)
Z(b + IM)d/365 + an + 1
k
P= x Nominal of FRN
(r + TM)f
1+
365
80
Appendix 2 – Swap Curve as at 1 August 2001
YEARS CC RATE
0.00 9.24%
0.09 9.22%
0.17 9.58%
0.25 9.53%
0.34 9.32%
0.42 9.27%
0.50 9.21%
0.58 9.15%
0.67 9.13%
0.75 9.11%
1.00 9.06%
1.25 9.06%
2.00 9.29%
3.01 9.64%
4.00 9.93%
5.00 10.14%
6.00 10.29%
7.01 10.41%
8.01 10.48%
9.01 10.53%
10.01 10.53%
12.01 10.47%
15.01 10.32%
17.01 10.20%
20.02 10.00%
25.02 9.68%
30.02 9.37%
81
82
83
Director of Treasury Sales and Structuring
Wayne Laskey (011) 636 7109
Sales and Structuring Team

David Rajak (011) 636 2171
Ryan Tholet (011) 636 2171
Melanie Vermeulen (011) 636 2171
Head of Fixed Income Sales and Research

Robert J. van Eyden (011) 636 6694
Fixed Income Research

Samantha Springfield (011) 636 0971
Theunis De Wet (011) 636 4301
Director of Debt Origination

Paul Hewitt (011) 636 2487
Securitisation Team
Erinn Harley-Lewis (011) 636 2487
Aidan-John Rothman (011) 636 2487
Mike Brunke (011) 636 3489
PRINTED BY INCE (PTY) LTD

MBS South Africa

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

MBS South Africa

Uploaded by

Copyright:

Available Formats

E S E A R C H

• Mortgage-Backed Securities are a large potential

• This document summarises some of the possible

INTRODUCTION TO MORTGAGE-BACKED SECURITIES 7

STRUCTURAL FEATURES AFFECTING CASHFLOWS 37

SOME REAL WORLD CONSIDERATIONS 52

PRICING FLOATING-RATE MORTGAGE-BACKED SECURITIES 56

APPENDIX 2 – SWAP CURVE AS AT 1 AUGUST 2001 81

This document serves as an introduction to securitisation and, in particular, focuses on

A further important characteristic of mortgages is the default characteristics of mortgage

Mortgage Loan Pools

In many cases, a weighted average of a particular characteristic is considered. In order to

Some key loan pool characteristics are:

In order to create the MBS:

The Special Purpose Vehicle

Thus, investors in mortgage-backed securities will not be exposed to any credit

Hedging Counterparties and/or Liquidity Providers

Rating Agency Considerations

External Credit Enhancements

One of the main disadvantages of third-party guarantees is that MBS protected by

External credit enhancements do not materially alter the cashflow characteristics of a

The appointment of a back-up servicer is a form of insurance against interruptions in the

Internal Credit Enhancements

Again, we consider a simple example to demonstrate how the subordination of certain

Certain Other Structural Features

Determinants of Prepayment Rates

• Relocation – a sale of the home could result from a change of employment

• Refinancing – competitor mortgage lenders may be offering more attractive financing

• Other factors – such as death, divorce and property destruction.

• Seasonality – in markets such as the US, mortgage prepayments display a tendency

Measuring Prepayment Rates

With prepayments playing such an important role in the performance of mortgage-backed

Pricing of Floating-Rate Mortgage-Backed Securities

PV = 100% + (IM – TM) x PVBPWAL

Effect of Prepayment on Price of Floating-Rate MBS

Delta for 1 year change in WAL

2. Tax consequences of interest received or accrued in terms of the security; and

Adjusted Gains and Losses on Disposal

Retirement and Pension Funds

The simplifying assumptions we make are as follows:

YEARS SCHED POOL SCHED INT SCHED CAP SCHED

As a very simple example, consider the following schedule of principal payments Pi

In the previous example, the WAL = 5.83.

YEARS SCHED SCHED BI SMMI QI CI

YEARS SCHED SCHED BI SMMI QI CI

We generalise these notions, and define the following:

In our examples above, the SMM is shown in the appropriate column.

YEARS SCHED SCHED BI SMMI QI CI

Scheduled Interest Payment and Scheduled Capital Payment

In other words, the relationship between Îi and Ii is simply

SCHED SCHED SCHED ADJ ADJ QI

The variables that we will focus on are:

Constant Prepayment Model

BN CPR SMM QN CN TOTAL CAP

What do these columns mean?

BN CPR SMM QN CN TOTAL CAP

We can graph the various assumptions as follows:

The WAL of the various prepayment scenarios looks as follows:

Calibrating the Model

More detail on prepayments is typically included at the time of deal.

In particular, we will focus on:

The Base Case – A Simple Pass-Through

Step-Up and Call

The effect of the call on the WALs is as follows: