Single Monthly Mortality (SMM): Definition, Calculation, and Implications
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Summary:
Single Monthly Mortality (SMM) measures the prepayment rate of a mortgage-backed security (MBS), indicating the percentage of mortgages paid off early in a given month. Investors use SMM to assess prepayment risk, crucial for managing MBS investments effectively.
What is single monthly mortality?
Single Monthly Mortality (SMM) serves as a vital metric for investors in mortgage-backed securities (MBS) to assess prepayment risk. This measure represents the percentage of mortgages within an MBS pool that will be paid off early in a given month.
Understanding single monthly mortality (SMM)
Single Monthly Mortality (SMM) is a critical concept in the realm of mortgage-backed securities (MBS) investing, providing valuable insights into prepayment risk. In essence, SMM goes beyond scheduled principal prepayments to capture additional principal prepayments made within an MBS pool during a specific month. By subtracting the scheduled principal payments from the total principal paid and dividing by the outstanding balance scheduled for the month, investors can calculate SMM as a percentage.
Single monthly mortality and prepayment risk
The dynamics of Single Monthly Mortality (SMM) are closely intertwined with prepayment risk, a significant concern for investors in mortgage-backed securities (MBS). Fluctuations in SMM reflect various borrower behaviors, including refinancing and accelerated payments, influenced by changes in interest rates and economic conditions. During periods of falling interest rates, prepayments tend to increase, potentially diminishing future interest income for MBS investors. As a result, investors meticulously monitor SMM trends to assess prepayment risk and its potential impact on investment returns.
SMM, constant prepayment rate, and prepayment ramps
Single Monthly Mortality (SMM) can be annualized into the Constant Prepayment Rate (CPR), providing investors with a broader perspective on prepayment rates over a longer timeframe. This transition between SMM and CPR analysis enables investors to align their strategies with prevailing market conditions and investment objectives. Additionally, prepayment ramps, typically observed during the initial 30 months of an MBS’s lifespan, illustrate increasing prepayment rates before stabilizing. While historically based on the Public Securities Association (PSA) model, modern prepayment ramps may exhibit shorter durations due to evolving market dynamics and borrower behaviors influenced by factors such as refinancing trends and interest rate movements.
The calculation of single monthly mortality (SMM)
The calculation of Single Monthly Mortality (SMM) involves several steps to determine the prepayment rate of a mortgage-backed security (MBS) for a given month. Here’s the breakdown of the calculation process:
- Total Principal Paid: Calculate the total principal paid for the MBS pool during the specified month. This includes all principal payments made by borrowers.
- Scheduled Principal Payments: Determine the scheduled principal payments for the MBS pool for the same month. These scheduled payments are typically based on the original terms of the underlying mortgages and may be available from servicer records.
- Outstanding Balance: Calculate the outstanding balance of the MBS pool for the month in question. This represents the remaining balance of the mortgages within the pool.
- Subtract Scheduled Principal Payments: Subtract the scheduled principal payments from the total principal paid to determine the additional principal prepayments made during the month.
- Calculate SMM: Divide the result from step 4 (additional principal prepayments) by the outstanding balance calculated in step 3. Multiply the quotient by 100 to express the result as a percentage.
Formula for Single Monthly Mortality (SMM):
Explanation of variables:
- Unscheduled Principal Payoff: The amount of principal repaid on mortgages in the pool during the month that exceeds the scheduled amount.
- Interest Payment: The total interest paid on mortgages in the pool during the month.
- Beginning Month Balance: The total outstanding principal balance of the mortgage pool at the beginning of the month.
Important notes:
- SMM is typically expressed as a percentage.
- SMM can be used to estimate the conditional prepayment rate (CPR) by annualizing it using the following formula:
Example:
If the unscheduled principal payoff for a mortgage pool in a month is $100,000, the interest payment is $50,000, and the beginning month balance is $1,000,000, then the SMM would be:
This calculation provides investors with a measure of the prepayment rate for the MBS pool during the specified month, helping them assess prepayment risk and make informed investment decisions.
The bottom line
Single Monthly Mortality (SMM) is a crucial metric for investors in mortgage-backed securities (MBS) to assess prepayment risk and make informed investment decisions. By understanding SMM’s calculation, significance, and relationship with other prepayment indicators, investors can effectively manage prepayment risk and optimize their MBS portfolios.
Frequently asked questions
What factors influence single monthly mortality?
Factors such as changes in interest rates, borrower refinancing behavior, and economic conditions can significantly impact Single Monthly Mortality.
How does single monthly mortality affect MBS investors?
Single Monthly Mortality serves as a key indicator of prepayment risk, helping investors assess the potential impact on investment returns and adjust their strategies accordingly.
Can single monthly mortality be used to predict prepayment trends?
While Single Monthly Mortality provides valuable insights into current prepayment rates, predicting future trends requires a comprehensive analysis of market conditions and borrower behavior.
What is the relationship between single monthly mortality and constant prepayment rate?
Single Monthly Mortality can be annualized into the Constant Prepayment Rate (CPR), offering investors a broader perspective on prepayment risk over a longer timeframe.
How can investors mitigate the impact of prepayment risk?
Investors can employ various risk management strategies, including diversification, hedging, and actively monitoring prepayment indicators like Single Monthly Mortality.
Key takeaways
- Single Monthly Mortality (SMM) measures prepayment rates in mortgage-backed securities (MBS).
- SMM helps investors assess prepayment risk and adjust investment strategies accordingly.
- Fluctuations in SMM reflect borrower behaviors and market conditions, impacting MBS returns.
- SMM can be annualized into the Constant Prepayment Rate (CPR) for broader analysis.
- Investors can mitigate prepayment risk through proactive risk management strategies.
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