About MBS Interest Only (IO) Processing

Stripped Mortgage Backed Securities are securities constructed from MBS pass through securities. Essentially, these securities strip the cash flow stream into separate Interest Only (IO) and Principal Only (PO) securities. All interest payments of the pass through flow to the holder of the IO. All principal payments flow to the holder of the PO.

Because the market value of IO and PO securities approximates cost, inasmuch as the market value should represent the present value of future cash flows based on current pre-payment speed assumptions, a fair test of current cost is a comparison of current cost to current market value.

Eagle Accounting takes an approach based on a level yield amortization method to recognize amortization and Interest income for MBS interest-only securities. Because Eagle Accounting takes a level yield amortization approach to processing income and amortization for MBS/ABS IO securities, Eagle Accounting treats each lot as an identified lot, regardless of whether the portfolio is set up with an Average Cost Basis where Cost Method (tag 22) is set to A in the entity and accounting basis.

Paydowns of a MBS Interest-only security do not produce a loss because Eagle Accounting brings down the proportional amount of cost and amortization to produce zero gain/loss. The amount of cost that a tax lot is being reduced by is equal to the amount of close amortization being brought down. The amount of close amortization is calculated based off the percentage of current face being reduced, with regard to the current face of the tax lot prior to processing the paydown.

Eagle Accounting uses this formula to recognize Interest Receivable:

IO Interest Receivable = (Original Face * Current Factor * Coupon / Day Count Basis)

Eagle Accounting uses this formula to recognize Interest Income:

Interest Income = (Cost of Investments * YTM) / Day Count Basis

Eagle Accounting uses this formula to calculate Total Daily Cost Adjustment (amortization):

(Cost Adjustment) = Interest Receivable - Interest Income

Eagle Accounting uses this formula to calculate Cost & Close Amortization as the result of Paydown:

% of Paydown = Current Amount of Paydown / Previous Current Face

Close Amortization = % of Paydown * Amortization Life to Date on the open Tax Lot

Close Amortization = Cost

Eagle Accounting uses this formula to recognize deferred IO:

Deferred IO = (Total Income PTD ) / Accr PTD) * Deferred Income

MBS IO Purchased Interest Example

Initial Purchase

Purchased Interest = Current Face (78,017,054.67) * Coupon Rate (5.05% * Days in Accrual Period (28/360) = 306,433.65

MBS IO Daily Recognition of Daily Income Accrual

Daily Income Accrual

Total Daily Income Accrual

(Original Face (83,617,800) * Current Factor (.9330197) * Coupon (5.05%)) / 360 = 10,944.05 (IO Interest Receivable)

Total Daily Interest Income

(Cost of Investments (4,876,066) * YTM (20%)) / 360 = 2,709.92 (Interest Income)

Total Daily Cost Adjustment

(Interest Receivable (10,944) - Interest Income (2,709)) = 8,235.13 (Cost Adjustment)

MBS IO Paydown Example

No general Ledger entries are created for the paydown of an IO as the principal is reduced by the close amortization amount.

Par Reduction = Original Face * (Current Month Factor - Previous Month Factor), or 2,761,034.67 = 83,617,800 * (.90 - 0.9330197)

% of Paydown = Current amount of Paydown / Previous Current Face .035390142 = 2,761,034.67 / 78,017,054.67

Cost Reduction & Close Amortization = (% of Paydown * Amortization Life to Date) 582.88 = (0.035390142 * -16,470.26)

The paydown for a MBS/ABS Interest Only security is posted against zero cash, but because equal amounts of cost and amortization are reduced as a result of the paydown, no gain loss occurs. The amount of cost and amortization offset each other and therefore there are no general ledger entries when a paydown is processed for an MBS Interest Only security.