An FI originates a pool of real estate loans worth $20 million with maturities of 10 years and paying interest rates of 9 percent per year.
a. What is the average payment received by the FI, including both principal and interest, if no prepayment is expected over the life of the loan?
b. If the loans are converted into pass-through certificates and the FI charges a servicing of 50 basis points, including insurance, what is the payment amount expected by the holders of the pass-through securities if no prepayment is expected?
c. Assume that the payments are separated into interest only (IO) and principal only (PO) payments, that prepayments of 5 percent occur at the end of years 3 and 4, and that the payment of the remaining principal occurs at the end of year 5. What are the expected annual payments for each instrument? Assume discount rates of 9 percent.
d. What is the market value of IOs and POs if the market interest rates for instruments of similar risk decline to 8 percent?