Original Face in Mortgage-Backed Securities: Definition, Evaluation, and Impact
AN
Summary:
Original face, or original face value, is the principal amount of a mortgage-backed security (MBS) when initially issued, representing the total value of underlying mortgage loans. While it offers insight into the initial value of the MBS, it does not predict its future worth. Over time, as borrowers repay their loans, the current face value of the MBS decreases. Understanding original face is crucial for investors in assessing MBS performance and managing factors like prepayment risk. Mortgage refinancing and interest rate fluctuations also impact the original and current face values of MBSs.
What is original face?
Origins of mortgage-backed securities
Mortgage-backed securities (MBSs) are created when banks sell home loans to entities like government-sponsored enterprises (GSEs) or financial institutions. These loans are then combined into a single security for investment purposes, with investors receiving both principal and interest payments.
Original face value
The original face value indicates the total outstanding balance of the mortgage loans within the MBS at its inception. As borrowers make payments, reducing the outstanding balance, the actual value of the MBS decreases relative to its original face value.
Variance in original face
The original face may vary slightly from the targeted face value due to factors such as borrower profiles and loan amounts. While typically minimal, this variance can impact the actual value of the MBS.
Original face vs. current face
Changing values over time
While the original face value remains constant, reflecting the initial total loan amount within the MBS, the current face value evolves as borrowers make payments or repay their loans early. This dynamic nature of the current face value contrasts with the fixed nature of the original face.
Pool factor calculation
The pool factor, determined by dividing the current face by the original face value, indicates the proportion of the original loan principal remaining. A pool factor of one at issuance implies that the original face equals the current face. Changes in the pool factor reflect shifts in the MBS’s current face value over time.
Mortgage refinancing and interest rate risk
Impact on prepayments
During periods of low interest rates, homeowners are incentivized to refinance their mortgages, leading to increased prepayments on the original loans within the MBS. This surge in prepayments accelerates the decrease in the MBS’s current face value.
Risk for investors
Faster prepayments pose risks for MBS investors, as they may experience lower returns due to reduced interest payments on prepaid principal. Additionally, declining interest rates can result in reinvestment challenges, with investors facing lower yields on new investments compared to the initial MBS.
Benefits of understanding original face
Performance evaluation
Original face facilitates performance evaluation for investors, offering insights into the MBS’s current value compared to its inception. By comparing original and current face values, investors can assess the accuracy of their valuation assumptions and evaluate factors such as prepayment rates.
Valuation modeling
Traders and investors utilize original face values in modeling and valuing MBSs throughout their lifecycle. Analyzing changes between original and current face values helps refine valuation assumptions and adjust investment strategies based on actual market dynamics.
Frequently asked questions
How does original face differ from current face?
Original face represents the total principal amount of a mortgage-backed security (MBS) at issuance, while current face value changes over time as borrowers make payments or repay their loans early.
Why is understanding original face important for investors?
Original face assists investors in evaluating the performance of an MBS and refining valuation models. It provides a reference point for comparing the MBS’s initial value with its current value and assessing factors such as prepayment risk.
What factors can cause variance in original face values?
Variance in original face values can occur due to differences in borrower profiles, loan amounts, and targeted face values. These factors may lead to slight discrepancies between the targeted and actual original face values of an MBS.
Key takeaways
- Original face represents the total principal amount of a mortgage-backed security (MBS) at issuance.
- Current face value evolves over time as borrowers make payments or repay their loans early.
- Understanding original face aids in performance evaluation and valuation modeling for MBS investors.
Share this post: