Alright... here's my question...

Let's say you buy 1MM of spec pool 30 year Fnma 3.5 outright @ 99-21 ( for example)

The original face is 1MM
Current face is 630,000

What happens to the price of the bond when the loan holder lowers the loan face value 300,000 .... does the bond become more valuable?

meaning.... If the next time you buy 1MM 30Yr Fnma 3.5 (with current face of 300,000) ... would the price be closer to par or lower than 99-21???

Just to be clear, the face value of a pool falls due to prepayment... And you can't buy \$1mm of a pool if there is only a current face of \$300k. When its a TBA (in your example, a FNMA 3.5 TBA), and you buy say \$5mm of that, you are delivered \$5mm face worth of MBS on settlement of that contract. However, as time goes on and people prepay their mortgages within the pool you received, thus lowering the face value.

Correct... that i am aware of... my question is... what happens to the price of the bond as the face lowers? As a person payd off the mortgage, the face lowers and the bond gets closer to the maturity.... Does the price decrease from ( Let's say purchased: 1MM FN3.5 @ 99-21) and once value of face decreases to 330k.... it gets closer to maturity.... does the price increase from 99-21 or decrease??

I don't actually know what I'm talking about, but I'm assuming the price shouldn't change much. It's my understanding that prepayments are already factoring into the original price and the lowering of the face value is just a function of the expected prepayments. I'd assume that unless the prepayments happen more or less quickly than originally predicted, the price shouldn't move drastically.

But, again, this is just my intuition and I don't really know what I'm saying. I would, however, like to hear from someone with better understanding!

Bonds, price/yeild, the only two things that change. For the price to change the yeild has to change, just because the pool size is shrinking doesnt mean the projected yeild has changed. While in reality prepayment will affect the actual yeid, the stated yeild on the pool does not change. Since its illegal for a lender to go in and change the rate on a mortage because of prepayment to a MBS pool the rate stays the same therefore the price stays the same. Also its kind of stupid to pay 1MM for a 300k share of a MBS.

Life is hard, it's even harder when you're stupid - John Wayne

heister:

Bonds, price/yeild, the only two things that change. For the price to change the yeild has to change, just because the pool size is shrinking doesnt mean the projected yeild has changed. While in reality prepayment will affect the actual yeid, the stated yeild on the pool does not change. Since its illegal for a lender to go in and change the rate on a mortage because of prepayment to a MBS pool the rate stays the same therefore the price stays the same. Also its kind of stupid to pay 1MM for a 300k share of a MBS.

That's simply not true... the coupon is what remains constant, the yield (and price) does not. And, again, its impossible to buy 1mm of a pool that has a current face of 300k...

Prepayment assumptions are factored into the price, but that doesn't mean actual prepayment speeds fail to alter the price (couldn't be further from the truth). Even though the MBS in that pool are similar, they are NOT identical. I won't even get into the characteristics that affect prepayment expectations, as there are books written on them. The key is, if prepayents are faster than what was otherwise priced in, the duration of that bond shortens. Does the price go up or down? Actually, it could go both ways, as the price converges to par in that case. So if you bought the pool above par, you would lose money... whereas if you bought it at a discount, you would make money.

Another way to look at MBS pools is to consider there are really two main parts to them, that move very differently (and by differently, I mean the opposite). Theres the discounted value of the principal, and the discounted value of the interest payments. So when prepayment speeds are faster, the PV of the principal increases (you expect to get the principal back quicker, duration shortens). However, with faster prepayments shortening the duration of the interest leg, you will collect coupon payments over a shorter period of time (as once the mortgage is paid off, obviously there won't be anymore checks coming for you).

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I don't understand what is so complicated about this. If you have 630k current face, 50% pays off (315k) at 99-21, you take a paydown hit (which is positive). The bond price for the next cycle will then be determined by the FN 3.5 roll.

bearflatten:

I don't understand what is so complicated about this. If you have 630k current face, 50% pays off (315k) at 99-21, you take a paydown hit (which is positive). The bond price for the next cycle will then be determined by the FN 3.5 roll.

If 315k pays off, you are returned par (100) on that amount.... the roll has nothing to do with this. You own a spec pool, not a TBA.