Calculating the Single Monthly Mortality Rate: Understanding SMM for Month 40 with 250 PSA

Introduction

Welcome to this educational blog post where we will dive deep into the world of mortgage-backed securities (MBS) and explore the concept of Single Monthly Mortality (SMM). In this article, we will discuss what SMM is, how it works, and most importantly, calculate the SMM rate for month 40 assuming a Public Securities Association (PSA) of 250. So, let's get started!

What Is Single Monthly Mortality?

Single Monthly Mortality (SMM) is a vital metric used in the world of mortgage-backed securities. It represents the amount of principal on MBS that is prepaid in a given month. When borrowers make additional principal payments or fully repay their mortgage loans, it reduces the outstanding principal balance of the MBS. SMM captures the rate at which this principal prepayment occurs.

Understanding Single Monthly Mortality (SMM)

SMM is a crucial concept to understand as it plays a significant role in assessing the prepayment risk associated with mortgage-backed securities. Higher SMM rates indicate higher prepayment risk, which can impact the cash flows and returns on MBS investments. It is essential for investors and analysts to calculate and monitor SMM to make informed decisions.

Single Monthly Mortality and Prepayment Risk

Prepayment risk is a significant concern for investors in mortgage-backed securities. Mortgage borrowers have the option to prepay their loans partially or fully, especially when interest rates drop. This prepayment risk affects the expected cash flows and duration of MBS investments. SMM helps investors assess and manage this risk.

SMM, Constant Prepayment Rate, and Prepayment Ramps

When analyzing SMM, it is important to understand its relationship with the Constant Prepayment Rate (CPR) and prepayment ramps. CPR represents the annualized prepayment rate, while SMM focuses on the monthly prepayment rate. Prepayment ramps refer to the gradual increase or decrease in prepayment rates over time. By analyzing these metrics, investors can gain insights into the prepayment behavior of MBS and make informed investment decisions.

Calculating the Single Monthly Mortality Rate

Now, let's dive into the calculation of the Single Monthly Mortality rate for month 40, assuming a PSA of 250. PSA is a benchmark used to model prepayment behavior. To calculate SMM, you can use the following formula:

SMM = (1 - (1 - CPR)^(1/12))^12

Where CPR is the annualized prepayment rate. In our case, we assume a PSA of 250, which translates to a CPR of 2.5%. Let's plug in the values:

SMM = (1 - (1 - 0.025)^(1/12))^12

After evaluating the equation, we find that the SMM for month 40 with a PSA of 250 is approximately 0.205, or 20.5%. This means that 20.5% of the principal on the mortgage-backed securities is prepaid in month 40.

Conclusion

Understanding Single Monthly Mortality (SMM) is crucial for investors and analysts in the mortgage-backed securities market. It helps assess the prepayment risk associated with MBS investments. In this blog post, we explored the concept of SMM, its relationship with prepayment risk, and how to calculate the SMM rate for month 40 assuming a PSA of 250. By monitoring SMM and other related metrics, investors can make informed decisions and manage their MBS portfolios effectively.