Current Face: Definition, Examples, and Risks
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Summary:
Current face refers to the remaining principal balance of a mortgage-backed security (MBS). It represents the snapshot of the outstanding principal on a group of home mortgages at any given time. Understanding current face is crucial for investors as it indicates the performance of the MBS compared to its original value. This article explores the concept of current face in detail, including its calculation, significance, and associated risks.
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Understanding current face
Mortgage-backed securities (MBSs) are financial instruments backed by a pool of home mortgages. These securities are created when banks or lenders sell the mortgages they originate to government-sponsored enterprises (GSEs) or financial institutions. The buyer then pools these mortgages together and sells them as a single investable security.
When an MBS is initially structured, it is assigned a par value known as the original face. This original face represents the total outstanding principal balance of the underlying mortgages at the time of issuance. As homeowners make monthly mortgage payments, the principal of the underlying mortgages is gradually paid down. The remaining principal balance of the mortgages in the pool at any point after issuance is referred to as the current face.
It’s important to note that the current face of an MBS will decrease over time as mortgage payments are made, leading to a decline in the outstanding principal balance. However, the rate at which the current face decreases can vary based on factors such as the prepayment speed of the underlying mortgages and changes in interest rates.
Calculating current face
The current face of an MBS is calculated by multiplying the current pool factor, which represents the remaining principal balance as a proportion of the original face, by the original face value of the MBS. Initially, when the MBS is issued, the pool factor is equal to one. However, as mortgage payments are made, the pool factor decreases, reflecting the reduction in the outstanding principal balance of the underlying mortgages.
Significance of current face
For investors in MBSs, understanding the concept of current face is essential as it provides insights into the performance and valuation of the security. By monitoring the current face, investors can assess whether the MBS is meeting expectations in terms of principal repayment and interest income.
Additionally, analyzing changes in the current face over time can help investors evaluate the accuracy of the assumptions made during the valuation of the MBS. For example, if the actual prepayment rate differs from the assumed rate, it can impact the valuation of the MBS and its attractiveness to investors.
Risks associated with current face
While MBSs offer investors the potential for steady income streams from mortgage payments, they also carry certain risks related to changes in the current face. One of the primary risks is prepayment risk, which refers to the risk that homeowners will refinance or pay off their mortgages earlier than expected, leading to a faster decline in the current face of the MBS.
High levels of prepayment can negatively impact investors by reducing the overall returns on their investment. This is because investors may receive their principal back sooner than anticipated, often at a time when reinvesting the funds at comparable yields is challenging.
Benefits of understanding current face
By closely monitoring the current face of an MBS, investors can gain valuable insights into the performance and risks associated with their investment. Some of the key benefits of understanding current face include:
- Evaluating the performance of the MBS compared to its original valuation.
- Assessing the impact of prepayment risk on investment returns.
- Identifying discrepancies between assumed and actual prepayment rates.
- Adjusting investment strategies based on changes in the current face of the MBS.
Comprehensive examples
Let’s consider a hypothetical example to illustrate the concept of current face:
Suppose an investor purchases an MBS with an original face value of $10 million. At the time of purchase, the pool factor is equal to one, indicating that the entire $10 million principal balance is outstanding. Over time, as homeowners make their monthly mortgage payments, the principal balance of the underlying mortgages begins to decrease. After one year, the current face of the MBS may be $9.5 million, reflecting the reduction in the outstanding principal balance due to mortgage payments.
Another example involves comparing two MBSs with identical issue dates, coupons, and original face values:
MBS A and MBS B both have an original face value of $20 million and were issued on the same date. However, MBS A has a current face of $18 million after one year, while MBS B has a current face of $17 million. Despite their similarities in terms of issuance, MBS A has experienced a slower rate of principal repayment compared to MBS B, resulting in a higher current face value.
Associated risks
While current face provides valuable information to investors, it also exposes them to certain risks:
Interest rate risk: Changes in interest rates can impact the prepayment behavior of homeowners, affecting the rate at which the current face of an MBS decreases. Rising interest rates may discourage homeowners from refinancing, leading to slower prepayment speeds and potentially higher current faces. Conversely, falling interest rates may incentivize homeowners to refinance, resulting in accelerated prepayment and lower current faces.
Credit risk: The creditworthiness of the underlying borrowerscan also influence the prepayment behavior and, consequently, the current face of an MBS. Borrowers with higher credit scores may be more likely to refinance when interest rates drop, leading to faster prepayment speeds and lower current faces. Conversely, borrowers with lower credit scores may be less inclined to refinance, resulting in slower prepayment speeds and higher current faces.
Credit risk: The creditworthiness of the underlying borrowerscan also influence the prepayment behavior and, consequently, the current face of an MBS. Borrowers with higher credit scores may be more likely to refinance when interest rates drop, leading to faster prepayment speeds and lower current faces. Conversely, borrowers with lower credit scores may be less inclined to refinance, resulting in slower prepayment speeds and higher current faces.
Conclusion
Understanding current face is essential for investors in the mortgage-backed securities market. It provides valuable insights into the performance and risks associated with MBS investments. By closely monitoring the current face, investors can evaluate the performance of their investments compared to their original valuation and make informed decisions regarding their investment strategies.
Additionally, analyzing changes in the current face over time allows investors to identify discrepancies between assumed and actual prepayment rates, helping them adjust their valuation assumptions accordingly. While current face offers valuable information, it also exposes investors to risks such as prepayment risk and interest rate risk.
Frequently asked questions
What factors influence the prepayment speed of underlying mortgages?
The prepayment speed of underlying mortgages can be influenced by various factors, including changes in interest rates, borrower credit profiles, and economic conditions. Generally, lower interest rates tend to incentivize homeowners to refinance their mortgages, leading to faster prepayment speeds. Similarly, borrowers with higher credit scores may be more likely to refinance or pay off their mortgages early.
How does prepayment risk affect the current face of an MBS?
Prepayment risk refers to the risk that homeowners will refinance or pay off their mortgages earlier than expected. High levels of prepayment can lead to a faster decline in the current face of an MBS, as the outstanding principal balance of the underlying mortgages decreases more rapidly. This can impact the returns on the MBS and may require investors to adjust their investment strategies accordingly.
What strategies can investors use to mitigate prepayment risk?
Investors can employ various strategies to mitigate prepayment risk in their MBS portfolios. One approach is to diversify across MBSs with different prepayment characteristics, including varying prepayment speeds and geographic locations. Additionally, investors can use hedging instruments such as interest rate swaps or options to manage their exposure to changes in interest rates and prepayment behavior.
How often should investors monitor the current face of their MBS investments?
Investors should regularly monitor the current face of their MBS investments to stay informed about changes in the outstanding principal balance of the underlying mortgages. While there is no set frequency for monitoring, investors may choose to review their investments on a quarterly or semi-annual basis, or more frequently if significant market events occur.
What role do credit ratings play in assessing the risk of MBS investments?
Credit ratings provide investors with an indication of the creditworthiness of MBS investments and the likelihood of timely repayment of principal and interest. Higher-rated MBSs are typically associated with lower credit risk, while lower-rated MBSs may carry higher credit risk and, consequently, higher potential returns. However, investors should conduct thorough due diligence and consider other factors, such as prepayment risk, when assessing the overall risk profile of MBS investments.
How do changes in interest rates impact the valuation of MBS investments?
Changes in interest rates can affect the valuation of MBS investments in several ways. Rising interest rates may reduce the attractiveness of MBSs, leading to lower prices and potential capital losses for investors. Conversely, falling interest rates may increase the demand for MBSs, resulting in higher prices and potential capital gains. Additionally, changes in interest rates can influence prepayment behavior, further impacting the valuation of MBS investments.
What are some potential drawbacks of investing in MBSs?
While MBSs offer investors the potential for steady income streams and diversification benefits, they also carry certain drawbacks. These may include prepayment risk, interest rate risk, and credit risk. Additionally, MBSs may be subject to liquidity risk, particularly in times of market stress when buyers may be less willing to purchase MBS securities. Investors should carefully consider these factors before investing in MBSs and ensure they align with their investment objectives and risk tolerance.
Key takeaways
- Current face refers to the remaining principal balance of a mortgage-backed security (MBS) and is calculated based on the total outstanding principal of the underlying mortgages.
- Understanding current face is essential for investors as it provides insights into the performance and risks associated with their investment.
- Changes in the current face of an MBS can impact investment returns and valuation assumptions, particularly in relation to prepayment risk.
- Monitoring changes in the current face allows investors to adjust their investment strategies and evaluate the accuracy of their valuation assumptions.
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