FIXED INCOME AND SECURITY ANALYSIS PROJECT REPORT ON STRIPPED MORTGAGE BACKED SECURITIES

SUBMITTED BY DISHA GANATRA 113712 Msc. FINANCE

MORTGAGE-BACKED SECURITY (MBS)

A type of asset-backed security that is secured by a mortgage or collection of mortgages. These securities must also be grouped in one of the top two ratings as determined by a accredited credit rating agency, and usually pay periodic payments that are similar to coupon payments. Furthermore, the mortgage must have originated from a regulated and authorized financial institution. When you invest in a mortgage-backed security you are essentially lending money to a home buyer or business. An MBS is a way for a smaller regional bank to lend mortgages to its customers without having to worry about whether the customers have the assets to cover the loan. Instead, the bank acts as a middleman between the home buyer and the investment markets. This type of security is also commonly used to redirect the interest and principal payments from the pool of mortgages to shareholders. These payments can be further broken down into different classes of securities, depending on the riskiness of different mortgages as they are classified under the MBS. In addition to the standard type of MBS, there are several offshoot investments derived from mortgagebacked securities, including:
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CMOs. Collateralized mortgage obligations (CMOs) break up mortgage pools into separate maturity categories called "tranches." Each CMO is a set of two or more tranches, each with average lives and cash-flow patterns designed to meet specific investment objectives. One CMO might have four tranches with average life expectancies of two, five, seven, and 20 years. That gives investors a wider array of options. Some CMOs have several dozen tranches. The system helps cut back on the early prepayment of mortgages, which is one of the biggest drawbacks of the MBS market. With CMOs, all prepayments from underlying mortgages are applied to the first tranche until it is paid off. Then prepayments are applied to the next tranche until it is paid off, and the process continues until all the tranches are eventually retired. The concept gives investors the ability to choose a tranche that fits their maturity time frame. REMICs. Real estate mortgage investments conduits (REMICs) are similar to CMOs with a twist. While CMOs separate mortgage securities into maturity classes, REMICs also separate them into risk classes. A REMIC may have a pool of higher risk or even distressed mortgages, so the risk is higher, but the yield is higher as well. REMICs are the junk bonds of the mortgage-backed securities category. STRIPs. Mortgage-backed securities may be stripped of their interest coupons and sold as zero coupon bonds. Rather than make regular monthly interest and principal payments, STRIPs pay all the principal and compounded interest in one lump sum at maturity.

For investors looking for a steady stream of income at a higher interest rate than most government bonds pay, mortgage-backed securities provide an appealing option.

STRIPPED MORTGAGE-BACKED SECURITIES (SMBS)

Mortgage backed instrument consisting of two distinct classes: interest-only (IO) securities and principalonly (PO) securities . In its purest form, the mortgage-backed security is converted into an interest-only strip, where the investor receives 100% of the interest cash flow, and a principal- only strip, in which the investor receives 100% of the principal cash flows. Both are highly interest rate sensitive. Investors who expect rising interest rates (and declining mortgage prepayments) tend to buy interest-only strips. Those who anticipate lower rates (rising prepayments) should buy principal-only strips, because the principal is repaid faster when rates are declining. Mortgage backed securities can be stripped into principal only (PO) strips and interest only (IO) strips. The principal component of the MBS payment is used to pay down the PO strip MBS, while the interest component of the payment is used to pay the IO strip MBS. The bonds of stripped MBS therefore do not have a pro-rata principal and interest payment distribution to investors. Stripped MBSs consist of two classes: 1. 2. Principal-only (PO) class that receives only the principal from the underlying mortgages. Interest-only (IO) class that receives just the interest.

There is an IO and a PO class. These acronyms refer to interest-only and principal-only. As there are no interest payments in the PO class, PO securities are purchased at a substantial discount to par. Basically, the faster the prepayments occur, the faster they receive their principal back and the higher the yield on the investment. As you can see, PO tranches benefit from lower interest rate environments where prepayments are much faster. IO investors on the other hand would prefer higher interest rates which result in lower prepayments. The longer the principal remains unpaid, the more interest they will make.

Principal Only Strips (PO)

A type of fixed-income security where the holder is only entitled to receive regular cash flows that are derived from incoming principal repayments on an underlying loan pool. The loan is often a pool of mortgages in the form of a mortgage-backed security (MBS). This security is created by splitting a mortgage-backed security into its interest and principal payments. The principal payments create a string of cash flows which are sold at a discount to investors. These investors will receive the principal portions of the monthly mortgage payments from the underlying pool of loans. The yield on a PO strip depends on the prepayment speed of the underlying loan. The faster the principal is repaid, the higher the yield an investor will receive. Since the investor benefits from faster repayment speeds, he or she is protected from contraction risk. This means that, unlike a usual bond, the investor will benefit from decreases in the interest rate.

PO Strips PO strips receive the entire mortgage principal and only the mortgage principal.

PO strips have a known dollar amount but an unknown timing. The PO strip will be sold to investors at a significant discount to the gross principal balance; the discount amount will be based on the level of interest rates and the prepayment speed. Generally, PO strip bonds are more volatile than conventional MBS. Declining interest rates increase PO repayment speed, lowering the discount rate and increasing the PO price. Rising interest rates cause prepayments to decelerate and increases the discount rate applied to cash flows, thus lowering the PO price. The yield on PO strips varies based on the prepayment speed. The higher the prepayment, the faster the principal is repaid, and the higher is the yield for the investors. The investor is protect from the contraction risk.

Interest Only Strips (IO)

The interest portion of mortgage, Treasury or bond payments, which is separated and sold individually from the principal portion of those same payments. The periodic payments of several bonds can be "stripped" to form synthetic zero-coupon bonds. Also, an IO strip might be part of a larger collateralized mortgage obligation (CMO), asset-backed security (ABS) or collateralized debt obligation (CDO) structure. Financial engineers, such as Wall Street dealers, frequently strip and restructure bond payments in an effort to earn arbitrage profits. Zero-coupon Treasury strips are an important building block in many financial calculations and bond valuations. For example, the zero coupon or spot-rate Treasury yield curve is used in option-adjusted spread (OAS) calculations and for other valuations of bonds with embedded options. IO Strips IO strip investors receive only the interest component of the mortgages in the security pool.

Assuming that a mortgage is held to maturity, the IO payments would be very high in the early years and very low in the later years. High prepayments tend to reduce IO values. As interest rates decline and prepayments increase, less dollars of interest are paid to IO investors, so IO prices can drop when interest rates decline. As interest rates increase, prepayments decrease, so mortgages last longer and the total dollars paid to IO holders rises; therefore IO prices can rise when interest rates rise.

The Pricing of Stripped Mortgage-Backed Securities

Interest only (IO) and principal only (PO) stripped mortgage-backed securities (MBS) are derivative securities which pay out only the interest component (IO) or principal component (PO) of the cash ows from the underlying mortgages. Their often extreme and nonlinear response to interest rate movements

has led to many dramatic losses by traders in these securities, and makes it vital to specify correctly any model used to value or hedge them. A significant fraction of the enormous mortgage-backed security market consists of mortgage derivatives, whose payoffs are functions of the payoffs of an underlying mortgage-backed security (MBS) or pool of MBS. The main mortgage derivatives are Stripped Mortgage- Backed Securities (SMBS) and Collateralized Mortgage Obligations (CMO). As the market for MBS and mortgage derivatives has developed, there have been many well-publicized cases of large losses incurred by supposedly sophisticated investors in these securities. The complex payoff structures of these securities serve to magnify the problems inherent in pricing any MBS. The key factors underlying both mortgage and mortgage derivative prices are interest rates and mortgage holder prepayment behavior. The level of interest rates determines the present value of the future cash flows from the securities, and prepayment affects both their level and timing. High prepayment rates typically increase PO prices, all else being equal, since PO holders receive their payments earlier than they would otherwise. On the other hand, high prepayment rates decrease IO values, since IO holders receive none of the principal, and their interest payments stop immediately after prepayment. To price and hedge mortgages and MBS requires a model for interest rate dynamics, and for the prepayment behavior of mortgage holders in response to changes in interest rates (and possibly other factors). Mortgage holders possess an option to prepay their existing mortgage and renounce their property. They are more likely to do so as interest rates, and hence renouncing rates, decline further below the rate of their current mortgage. Thus a mortgage with an X% coupon is roughly equivalent to a default-free X% coupon-bearing bond and a short position in a call option on that bond, with an exercise price of par. This option component induces a concave relation between the value of a mortgage and the level of interest rates (the so called negative convexity of mortgages). Early academic research, such as Dunn and McConnell, treated mortgages exactly as a portfolio of bond plus option, setting up and solving a valuation equation for the value of the mortgage, and determining the optimal exercise strategy of frictionless mortgage holders as the solution to a free boundary problem. Though internally consistent, such models produced two rather unfortunate results. First, all mortgage holders find it optimal to refinance at the same time, so there will be no prepayment (or some background level of prepayment) until one instant when all remaining mortgages in a pool will suddenly prepay. Second, mortgage prices can never exceed par. In response to these shortcomings, a second strand of research emerged in which mortgage prepayment is modeled as a function of some set of (non-model based) explanatory variables, and the resulting prepayment function is inserted into a Monte Carlo simulation algorithm to perform the valuation. Most such models use either past prepayment rates or some other endogenous variable, such as burnout, to explain current prepayment. Their use of large numbers of explanatory variables, including lagged dependent variables, combined with a lack of any theoretical restrictions on the nature of the relationship, makes such models very good at predicting prepayment a short time into the future. However, these same characteristics make the models prone to finding spurious relationships between variables. In addition, since these models are really heuristic reduced form representations for some true underlying process, it is impossible to know how they would change in response to a shift in the underlying economy, such as a change in interest rate volatility, or a reduction in the costs of refinancing. All we know is that there would be some change.

Recently, the old rational approach to mortgage valuation has been resurrected. To allow mortgage prices to exceed par, add transaction costs that must be paid by mortgage holders on refinancing. Its been further extends these models, producing mortgage prepayment behavior that can exhibit most of the features noted in the data, such as 1. Burnout: Burnout refers to the dependence of expected prepayment rates on cumulative historical prepayment levels. The higher the fraction of the pool that has already prepaid, the less likely are those remaining in the pool to prepay at any interest rate level. 2. Some mortgages are prepaid even when their coupon rate is below current mortgage rates. 3. Some mortgages are not prepaid even when their coupon rate is above current mortgage rates. Since this model describes the prepayment process of mortgage holders, rather than the outcome of this process (as do the empirical models), it is robust to changes in the underlying economy. This has recently been used to price CMOs, but its pricing implications have not yet been thoroughly investigated, owing at least in part to a lack of reliable data. Stripped Mortgage-Backed Securities Stripped MBS were first introduced in 1986 by the Federal National Mortgage Association (FNMA), which remains the dominant issuer. Just as with regular MBS, stripped mortgage- backed security (SMBS) holders receive a fraction of the interest and principal payments made by some underlying pool of mortgages. The difference is that the interest and principal fractions differ. The first SMBS were synthetic coupon pass-through securities. For example, given a pool of 11% mortgages, synthetic 14% and 8% stripped mortgage-backed securities can be created by forming two new securities, each of which receives 1/2 of the principal payments from the 11% security, but where the interest payments are split in the ratio 7:4. These are not equivalent to standard 14% and 8% MBS, since their value depends on the prepayment behavior of the underlying holders of the 11% mortgages, which will differ from that of 14% or 8% mortgage holders. The most common type of SMBS is the interest only (IO) and principal only (PO) stripped MBS, first issued in 1987. As their name suggests, holders of these securities receive a share of only the interest component (IO) or principal component (PO) of the cash flows from the underlying mortgages. Holders of regular FNMA mortgage-backed securities submit these securities to FNMA, which consolidates them into one Megapool Trust. As with the loans underlying regular MBS, the securities in a given trust must be reasonably homogeneous. They must all be of the same loan type, and within a certain range of WAC (Weighted Average Coupon) and WAM (Weighted Average Maturity) values. FNMA returns to the original security holder two SMBS Trust certificates, giving the holder rights to a specific proportion of the principal and interest payments from the FNMA Megapool Trust. Agency Stripped mortgage-backed securities Stripped mortgage-backed securities are little bit different from Collateral mortage Obligations. Stripped MBS split the principal and interest portions between tranches. There is an IO or interest-only and a PO principal-only class. Since there are no interest payments in the PO class, PO securities are bought at a substantial discount to par. In a nut shell, the faster the prepayments take place, the faster they receive

their principal and the higher investment. PO tranches are benefited from lower interest rate, where prepayments are much faster. On the other hand IO investor prefers higher interest rates which yield lower prepayments. If the principal remains unpaid for longer the, the more interest they will make a mortgage-backed instrument encompass of two parts and they are interest and principal. An asset of a stripped MBS is interest or principal paid on debt securities, rather than both together. Stripped mortgagebacked securities are extremely perceptive to changes in interest rates, which allow investors to choose either an interest strip or a principal strip, but it depends upon the interest rates. In stripped mortgage-backed security (SMBS) each mortgage payment is used for both the loan of the principal amount as well as interest rate. These two components can be separated to create SMBS's, of which there are two types: Benefit from Stripped mortgage-backed securities an interest-only stripped mortgage-backed security (IO): It is a bond with cash flows with the interest rate of property owner's mortgage payments. A net interest margin security (NIMS): It is resecuritized remaining interest of a mortgage-payment.

A principal-only stripped mortgage-backed security (PO): It is a bond with cash flows backed by the principal repayment amount of property owner's mortgage payments. In its real form, the mortgage-backed security is converted into an interest-only strip, where the investor gets 100% of the interest cash flow, and in a principal- only strip, the investor obtains 100% of the principal cash flows. Both are highly interest rate sensitive. Investors who expect increased interest rates and low mortgage prepayment always tends to buy interest-only strips. The investors who anticipate lower rates that are raising prepayments should buy principal-only strips, because the principal is repaid faster when rates are declining. The investors who anticipate higher rates that is decreasing prepayments should buy interest-only strips, because the principal is repaid faster when rates are declining. Stripped security obtains a percentage of the security principal or interest payments. For example, the cash flow of a 6% pass-through can be utilized for making two fresh stripped securities, one with 4% coupon and another with 8% coupon, by directing more of the interest to the security with higher coupon. For Stripped securities each investor obtains combination of principal and interest payments. Strips can also be designed to be an Interest-Only (IO), which gets only interest from the underlying securities, and Principal-Only (PO), which receives only the principal payments without any interest. Both IOs and POs show price unpredictability in an market environment of changing mortgage rates.

STRIPPED MORTGAGE-BACKED SECURITIES AND RISK MANAGEMENT

Derivative mortgage securities were financially engineered to meet growing fixed-income investor demands for mortgage-related products that provide a better estimate of the duration associated with mortgage pass-through securities. With these securities, the total prepayment risk associated with mortgages is redistributed among different classes of bondholders. Collateralized mortgage obligations (CMOs) and stripped mortgage-backed securities, such as interest only securities (IOs) and principal-only securities (POs), are attractive, alternative mortgage-related investments for financial institutions. With these securities, investors are better able to control their prepayment risk exposure. This occurs because investors can choose the desired type and amount of prepayment risk. More specifically, these financial instruments grant investors the ability to more effectively control their

exposure to contraction and extension risk. Contraction risk refers to that part of prepayment risk that stems from the decrease in the duration of mortgage pass through securities and the reinvestment risk associated with the speedup of prepayments resulting from a decline in interest rates within the negatively convex region of the price-yield curve. On the other hand, extension risk refers to that part of prepayment risk that derives from the increase in the duration of mortgage pass-through securities and the reinvestment risk associated with a rise in interest rates. The mortgage pass through strip is a unique CMO with only two classes of securities: an interest-only and a principal-only security. These two securities are created by dividing the typical fully amortizing monthly mortgage payment into its interest and principal components and then selling these cash flows separately to investors. For the most part, IOs and POs are characterized by high yields and returns that are extremely sensitive to changes in interest rates and mortgage prepayment speeds. As a result of their extreme sensitivity to interest rate movements, these derivative mortgage securities have riskreturn profiles that make them extremely useful to financial institutions for portfolio hedging purposes. For example, IOs have attractive bearish return features, because greater interest cash flows occur when prepayments of principal fall due to increases in market interest rates. In contrast, POs have attractive bullish return features, because the speedup in prepayments when market interest rates fall causes principal to be returned sooner than expected. Due to the asymmetry in their return profiles to changes in interest rates and prepayment speeds, IO and PO mortgage strips have very different cash flow characteristics. As a result, their interest rate risk exposures differ sharply. Indeed, it is the duration and convexity characteristics of their price yield curves that make interest-only and principal-only mortgage strips particularly attractive for hedging the prepayment risk and interest rate risk associated with mortgage portfolios and mortgage servicing rights, respectively.

PREPAYMENT RISK AND MORTGAGE-BACKED SECURITIES

An inverse relationship exists between the prices of fixed-income financial instruments, such as mortgage-backed securities, and interest rate changes. This inverse relationship is largely determined by what is known as the discount effect. According to the discount effect, the present value of any cash flows received on a security rises as interest rates fall, and vice versa. Interest rate changes also affect the prices of mortgage-backed securities by causing the expected prepayments of principal to either speedup or slowdown. This is known as the prepayment effect. Prepayment risk is the risk associated with the prepayment effect. It arises because mortgagors have a call option on the mortgage loans that serve as the collateral for mortgage-backed securities. Mortgagors will choose to exercise this option and prepay their mortgages as interest rates fall sufficiently below contract mortgage coupon rates. The price of a residential mortgage passthrough security is given by the present value of the expected cash flows associated with the pool of underlying mortgages. These cash flows consist of interest payments, scheduled repayments of principal, and any prepayments. It is important to observe that both the direction and size of the change in the price of a mortgage-backed security due to a change in interest rates will be determined by the interaction between the discount effect and the prepayment effect.

For example, when interest rates fall, prepayments rise due to increased mortgage refinancings, and the present value of expected mortgage cash flows also rises as long as the discount effect is larger than the prepayment effect. On the other hand, when interest rates rise, prepayments fall due to decreased mortgage refinancings, and the present value of expected mortgage cash flows also falls as long as the discount effect is larger than the prepayment effect. We will see below that the interaction between the discount effect and the prepayment effect is particularly important when analyzing the duration and convexity of IO and PO mortgage strip securities. Stripped Mortgage backed Securities Stripped mortgage backed securities are mortgage-related securities that are created from the stripping or separation of the interest and principal cash flows associated with the underlying mortgage collateral. The typical mortgage pass through security involves the distribution of interest and principal payments to investors on a pro-rata basis. In contrast, stripped mortgage-backed securities involve the unequal distribution of interest and principal cash flows to investors. The process of stripping produces mortgage securities with interest and/or principal cash flows that are dramatically different from those of the underlying pool of mortgages. As a result, fixed-income investors are allowed to take strong portfolio positions on expected changes in prepayment speeds and interest rates. There are three general types of stripped mortgage-backed securities: synthetic-coupon mortgage passthrough securities, IOs and POs, and CMO strips. Each of these security types uses a different distribution scheme for allocating interest and principal cash flows to investors. Synthetic-coupon mortgage pass-through securities were first created by Fannie Mae in July 1986. With these securities, any coupon rate can be created with the appropriate proportions of the interest and principal cash flows on the underlying mortgage collateral. For example, a synthetic 15% coupon rate would be created for a mortgage strip that is allocated 75% interest and 50% principal of the cash flows from an underlying mortgage pool with a 10% coupon rate. This occurs because the 7.50% coupon (calculated as 75% of the 10% underlying coupon) is expressed as 100% of principal; i.e., 7.50% coupon/50% principal = 15.00% coupon/100% principal. This example shows the creation of a premium mortgage strip security because the synthetic coupon rate is greater than the contract coupon rate on the underlying mortgage collateral. With the appropriate proportions of interest and principal cash flows, it would be straightforward to create a discount mortgage strip security with a synthetic coupon rate below the contract coupon rate on the underlying mortgage collateral. Interest-only and principal-only mortgage strips are extreme examples of the unequal distribution of interest and principal cash flows characteristic of stripped mortgage-backed securities. More specifically, IOs receive only the interest cash flows, while POs receive only the principal cash flows from the underling mortgage collateral. Fannie Mae created this type of stripped mortgage-backed security product in early 1987. Finally, CMO strips are tranches in a CMO structure. Typically, these strips are divided into two types: those that receive only principal cash flows, and those that receive a large proportion of interest cash flows relative to principal cash flows.

INTEREST-ONLY MBS AND THEIR PRICE-YIELD CURVE

An IO mortgagebacked security is a special type of CMO bond that receives only the interest cash flows on the underlying mortgage collateral. This type of derivative mortgage security can be issued against either whole mortgage loans or mortgage passthrough securities. Typically, however, they are issued against mortgage pass-through securities. The price or value of an IO mortgage strip is given by the present value of the expected mortgage interest cash flows to be received. Because there is no face value or principal amount attached to an IO strip, it is customary to express its price as a percentage of the notional principal of the underlying mortgage collateral. The price of an IO mortgage strip is determined by the amount and timing of the mortgage interest payment stream, which are both uncertain. Changes in both prepayment speeds and market interest rates will affect the mortgage strips value. As such, the value of an IO is particularly sensitive to prepayments because the size of the interest cash flow is based on the amount of remaining principal in the underlying mortgage pool. For example, expected interest cash flows for an IO will fall, as prepayments rise, because interest payments are based on a smaller outstanding principal amount, and there are fewer interest payments actually received by investors. As a result, both the discount effect and the prepayment effect are important determinants of the duration and convexity characteristics of an IOs price-yield curve. In fact, an IO mortgage strip is a rare example of what is known as a negative duration asset. As market interest rates fall below the coupon rate on the underlying mortgage pool, the IO mortgage strips price actually falls. This means that the slope of its priceyield curve is positive over some range of market interest rates. Unlike other fixed-income securities, the price of an IO strip moves in the same direction as interest rates. In addition, the price-yield curve of an IO mortgage strip over this same range of interest rates also displays negative convexity. The negative duration arises for an IO mortgage strip because the discount effect and prepayment effect move in opposite directions as interest rate fall, and the prepayment effect dominates. For interest rate increases above the coupon rate on the underlying mortgage pool, however, the price yield curve of an IO strip looks like that of a typical bond with positive duration and convexity. Over the positively convex region of the IOs price-yield curve, the prepayment effect and discount effect still move in opposite directions, but the discount effect dominates. From a price performance perspective, the yield actually received by investors on an IO strip will be related to how quickly prepayments are made by mortgagors. While IO strips are attractive investments because of their potentially high yields, they are also very risky due to their extreme sensitivity to prepayments and movements in interest rates.

PRINCIPAL-ONLY MBS AND THEIR PRICE-YIELD CURVE

A PO mortgage-backed security is a special type of CMO bond that receives only the principal cash flows on the underlying mortgage collateral. This type of derivative mortgage security can be issued against either whole mortgage loans or mortgage pass-through securities. Similar to IO mortgage strips, however, they are typically issued against mortgage passthrough securities. The price or value of a PO mortgage strip is given by the present value of the expected mortgage principal cash flows to be received. Because the principal amount, or face value, of a PO is always received, the uncertainty is eliminated because Pos are typically issued against AAA-rated MBS. As a result, a PO mortgage strip is issued to investors at a discount to its par value, because it is a zero-coupon bond. While the total amount of principal to be received is known, the timing of these cash flows is uncertain and will be determined by changes in interest rates and prepayments. For example, an increase in prepayments will produce an unexpected rise in principal repayments. Clearly, the yield actually received by investors on PO mortgage strips will be related to how quickly prepayments are made by mortgagors. In contrast to IO mortgage strips, the discount effect and prepayment effect move in the same direction for both interest rate increases and decreases. As a result, the duration of a PO mortgage strip is always positive, and its priceyield displays positive convexity. However, due to the substantial increase in a POs price with a decline in interest rates and concomitant acceleration in prepayments, the priceyield curve for a PO is much steeper than that of a non-callable bond. As a result, PO mortgage strips typically have very long durations that are attractive for hedging purposes.

PORTFOLIO HEDGING WITH IOS AND POS

The extreme sensitivity of IOs and POs to prepayments and the asymmetry of their returns to changing interest rates make them attractive as potential hedging instruments. For example, IOs can be used by thrift institutions to hedge their fixedrate mortgage portfolios against interest rate increases. As interest rates increase, the value of mortgages falls, but this decline is offset by the rise in the value of IO strips. This assumes that the increases in interest rates occur over the negatively convex region of the IOs price-yield curve. In addition, thrifts with positive effective duration gaps can combine negative duration IO strips with long duration assets to reduce the duration of their asset portfolio, and thereby reduce the duration gap between assets and liabilities. This would decrease interest rate risk. On the other hand, POs can be used to hedge an institutions portfolio of mortgage servicing rights. Mortgage servicing rights behave like IO strips in response to changes in prepayments and interest rates. As interest rates fall, the decrease in the value of mortgage servicing rights is offset by the increase in the value of the PO mortgage strips. Although IOs and POs are potentially attractive hedging instruments with high yields, they are also very risky due to their extreme sensitivity to changes in prepayments and interest rates. For this reason, care and diligence should be exercised when considering adding these instruments to a portfolio. An institution

should fully understand how the addition of these instruments facilitates the management of interest rate risk of the overall portfolio.