Prepayment Model
Pools may be the simplest mortgage-back securities. A pool is a combination of many loans to individual home buyers. For convenience, pools are combined into generic mortgages. A generic mortgage is a dynamic pool having common characteristics, such as GNMA 8% Seasons.
The size of one pool may be too small for investment. Agencies can therefore issue a sequence of tranches using many pools as collateral. This is a CMO service. The pools may be split into two tranches, one paying only principal (PO, or Principal Only) and another one paying interest (IO, or Interest Only).
The cash flow of a mortgage-backed security can be divided into two parts: schedule payments and prepayments. The size of the prepayments depends on the home owners' collective behavior. A statistical model to describe the prepayment behavior is called a prepayment model.
Prepayments depend on the interest rate level, the group of the security, and the age of the pools. Therefore. a money manager needs to apply a contingent claim model to value a mortgage-backed security. Furthermore, the prepayment behavior is path-dependent. Therefore they may need Monte Carlo simulation to solve the problem.
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