What are the limitations of cash flow yield measures for a mortgage pass-through security?

Question

What will be an ideal response?

Answer 1

The yield corresponding to a price must be qualified by an assumption concerning prepayments. Although yields are frequently quoted, remember that the yield is based on some underlying prepayment assumption. Consequently, a yield of 9% based on 150% PSA means that it is assumed that the underlying mortgages will prepay at a rate equal to 150% PSA. A yield number without qualification as to the prepayment assumption is meaningless.

In fact, even with specification of the prepayment assumption, the yield number is meaningless in terms of the relative value of a pass-through. For an investor to realize the yield based on some PSA assumption, a number of conditions must be met: (1) the investor must reinvest all the cash flows at the calculated yield, (2) the investor must hold the pass-through security until all the mortgages have been paid off, and (3) the assumed prepayment rate must actually occur over the life of the pass-through. Moreover, in the case of private-label pass-throughs, the assumed default and delinquencies must actually occur. Now, if all this is likely, we can trust the yield numbers. Otherwise, investors must be cautious in using yield numbers to evaluate pass-through securities.