Option Adjusted Spread Option adjusted spread (OAS) is a constant spread that when added to the interest rates used to discount the cash flows produces a theoretical value of the bond that is equal to the market price of the bond. It is an alternative
Defaults These are full involuntary prepayments which arise when the borrower is unable to make loan payments. The loan is foreclosed and liquidated to pay off the outstanding loan balance. The probability of default is impacted by the borrower’s level of equity in the house
Refinancing There are two types of refinancing, cash-out refinancing and rate refinancing. These constitute the largest source of prepayments. Cash out refinancing These types of refinancing are not sensitive to economic incentives to prepay such as lower mortgage rates. Regardless of the direction of rates
Prepayments In the model above we have assumed that prepayments are at 100% of PSA. Expressing prepayments in terms of the PSA model is an industry standard but what are the primary drivers for prepayments? The principal drivers for prepayments are housing turnover and refinancing.
Valuation of Mortgage Backed Securities Valuation of Mortgage Backed Securities is a complex process with multiple layers. We start with a simple high level review of pricing and valuation of Mortgage Backed Securities and then delve deeper into individual factors. The following is a high