CHAPTER 11

AGENCY MORTGAGE PASS-THROUGH SECURITIES

CHAPTER SUMMARY
In this chapter and the two that follow, we discuss the different sectors in the residential
mortgage-backed security (RMBS) market. In the current chapter, we will focus on what agency
mortgage pass-through securities are and general information about RMBS. We begin this chapter
with a discussion of the different sectors of the RMBS market. That discussion will provide us
with a roadmap for this and the next two chapters.

SECTORS OF THE RESIDENTIAL MORTGAGE-BACKED SECURITY MARKET

The residential mortgage market can be divided into two subsectors based on the credit quality of
the borrower: prime mortgage market and subprime mortgage market. The prime sector includes
(1) loans that satisfy the underwriting standard of Ginnie Mae, Fannie Mae, and Freddie Mac (i.e.,
conforming loans); and (2) loans that fail to conform for a reason other than credit quality or
because the loan is not a first lien on the property (i.e., nonconforming loans). The subprime
mortgage sector is the market for loans provided to borrowers with an impaired credit rating or
where the loan is a second lien; these loans are nonconforming loans.

All of these loans can be securitized in different sectors of the RMBS market. Loans that satisfy the
underwriting standard of the agencies are typically used to create RMBS that are referred to as
agency mortgage-backed securities (MBS). All other loans are included in what is referred to
generically as nonagency MBS.

The agency MBS market includes three types of securities: agency mortgage pass-through
securities, agency collateralized mortgage obligations (CMOs), and agency stripped MBS.

GENERAL DESCRIPTION OF AN AGENCY MORTGAGE

PASS-THROUGH SECURITY

A mortgage pass-through security, or simply pass-through security, is a type of MBS created by

pooling mortgage loans and issuing certificates entitling the investor to receive a pro rata share in
the cash flows of the specific pool of mortgage loans that serves as the collateral for the security.
Because there is only one class of bondholders, these securities are sometimes referred to as
single-class MBS.

When a pass-through security is first issued, the principal is known. Over time, because of
regularly scheduled principal payments and prepayments, the amount of the pool’s outstanding
loan balance declines. The pool factor is the percentage of the original principal that is still
outstanding. At issuance, the pool factor is 1 and declines over time. Pool factor information is
published monthly.

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Payments are made to the security holders each month. However, neither the amount nor the
timing of the cash flow from the loan pool is identical to that of the cash flow passed through to
investors. The monthly cash flow for a pass-through security is less than the monthly cash flow of
the loan pool by an amount equal to servicing and other fees. Because of prepayments, the cash
flow of a pass-through is also not known with certainty.

Not all of the mortgages that are included in the loan pool that are securitized need to have the
same note rate and the same maturity. Consequently, when describing a pass-through security, the
weighted-average coupon rate and a weighted-average maturity are determined.

A weighted-average coupon rate (WAC) is found by weighting the note rate of each mortgage
loan in the pool by the amount of the mortgage outstanding. A weighted-average maturity
(WAM) is found by weighting the remaining number of months to maturity for each mortgage loan
in the pool by the amount of the mortgage outstanding.

After origination of the MBS, the WAM of a pool changes. Fannie Mae and Freddie Mac report
the remaining number of months to maturity for a loan pool, which they refer to as weighted
average remaining maturity (WARM). Both Fannie Mae and Freddie Mac also report the weighted
average of the number of months since the origination of the security for the loans in the pool. This
measure is called the weighted average loan age (WALA).

Other information about the loan pool is provided in the prospectus supplement to assist the
investor in assessing the value of the security or, more specifically, assessing the prepayments that
might be expected from the loan pool.

ISSUERS OF AGENCY PASS-THROUGH SECURITIES

Agency pass-through securities are issued by the Governmental National Mortgage Association
(Ginnie Mae), the Federal National Mortgage Association (Fannie Mae), and the Federal Home
Loan Mortgage Corporation (Freddie Mac). The pass-through securities that they issue are
referred to as: Ginnie Mae Mortgage-Backed Securities (MBS), Fannie Mae Guaranteed Mortgage
Pass-Through Certifications (MBS), and Freddie Mac Mortgage Participation Certificates (PC).
Do not be confused by the generic term “MBS” and the pass-through certificates that Ginnie Mae
and Fannie Mae have elected to refer to as MBS.

Ginnie Mae

Ginnie Mae is a federally related institution because it is part of the Department of Housing and
Urban Development. As a result, the pass-through securities that it guarantees carry the full faith
and credit of the U.S. government with respect to timely payment of both interest and principal.

It is not technically correct to say that Ginnie Mae is an issuer of pass-through securities. Ginnie
Mae provides the guarantee, but it is not the issuer. Pass-through securities that carry its guarantee
and bear its name are issued by lenders it approves, such as thrifts, commercial banks, and
mortgage bankers. Thus, these approved entities are referred to as the “issuers.”

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Fannie Mae and Freddie Mac

Although the MBS issued by Fannie Mae and Freddie Mac are commonly referred to as “agency
MBS,” both are in fact shareholder-owned corporations chartered by Congress to fulfill a public
mission. Their stocks trade on the New York Stock Exchange.

The mission of these two GSEs is to support the liquidity and stability of the mortgage market.
They accomplish this by buying and selling mortgages, creating pass-through securities and
guaranteeing them, and buying MBS. The mortgages purchased and held as investments by Fannie
Mae and Freddie Mac are held in a portfolio referred to as the retained portfolio. However, the
MBS that they issue are not guaranteed by the full faith and credit of the U.S. government. Rather,
the payments to investors in MBS are secured first by the cash flow from the underlying pool of
loans and then by a corporate guarantee.

PREPAYMENT CONVENTIONS AND CASH FLOW

To value a pass-through security, it is necessary to project its cash flow. The difficulty is that the
cash flow is unknown because of prepayments. The only way to project a cash flow is to make
some assumption about the prepayment rate over the life of the underlying mortgage pool. The
prepayment rate assumed is called the prepayment speed or, simply, speed. The yield calculated
based on the projected cash flow is called a cash flow yield.

Estimating the cash flow from a pass-through requires making an assumption about future
prepayments. Several conventions have been used as a benchmark for prepayment rates:
(1) Federal Housing Administration (FHA) experience, (2) the conditional prepayment rate, and (3)
the Public Securities Association (PSA) prepayment benchmark. The first convention is no longer
used.

Conditional Prepayment Rate

A benchmark for projecting prepayments and the cash flow of a pass-through requires assuming
that some fraction of the remaining principal in the pool is prepaid each month for the remaining
term of the mortgage.

The prepayment rate assumed for a pool, called the conditional prepayment rate (CPR), is based
on the characteristics of the pool and the current and expected future economic environment.

Single-Monthly Mortality Rate

The CPR is an annual prepayment rate. To estimate monthly prepayments, the CPR must be
converted into a monthly prepayment rate, commonly referred to as the single-monthly mortality
rate (SMM). A formula can be used to determine the SMM for a given CPR:

SMM = 1 – (1 – CPR)1/12.

Single-Monthly Mortality Rate and Monthly Prepayment

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An SMM of w% means that approximately w% of the remaining mortgage balance at the
beginning of the month, less the scheduled principal payment, will prepay that month.

That is, prepayment for month t =

SMM × (beginning mortgage balance for montht – scheduled principal payment for montht)

Public Securities Association Prepayment Benchmark

The Public Securities Association (PSA) prepayment benchmark is expressed as a monthly series
of annual prepayment rates. The PSA benchmark assumes that prepayment rates are low for newly
originated mortgages and then will speed up as the mortgages become seasoned.

The PSA benchmark assumes the following CPRs for 30-year mortgages: (1) a CPR of 0.2% for
the first month, increased by 0.2% per year per month for the next 30 months when it reaches 6%
per year, and (2) a 6% CPR for the remaining years. This benchmark is referred to as “100% PSA”
or simply “100 PSA.” Mathematically, 100 PSA can be expressed as follows:

If t … 30: CPR = 6% (t > 30)

If t 7 30: CPR = 6%

Slower or faster speeds are then referred to as some percentage of PSA. For example, 150 PSA
means 1.5 times the CPR of the PSA benchmark prepayment rate. A prepayment rate of 0 PSA
means that no prepayments are assumed. The CPR is converted to an SMM using

SMM = 1 – (1 – CPR)1/12.

Monthly Cash Flow Construction

The text constructs a monthly cash flow for a hypothetical pass-through given a PSA assumption.
This construction assumes that the underlying mortgages for the hypothetical
pass-through are fixed-rate level-payment mortgages with a WAC of 8.125%. It is further assumed
that the pass-through rate is 7.5%, with a WAM of 357 months, while the cash flow for selected
months assumes 100 PSA. The cash flow is broken down into three components:
(1) interest (based on the pass-through rate), flow is broken down into three components:
(1) interest (based on the pass-through rate), (2) the regularly scheduled principal repayment, and
(3) prepayments based on 100 PSA.

Beware of Conventions

The PSA prepayment benchmark is simply a market convention. It is the product of a study by the
PSA based on FHA prepayment experience. Data that the PSA committee examined seemed to
suggest that mortgages became seasoned (i.e., prepayment rates tended to level off) after
30 months and the CPR tended to be 6%. Astute money managers recognize that the CPR is a
shorthand enabling market participants to quote yield and/or price, but as a convention in deciding

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value it has many limitations.

FACTORS AFFECTING PREPAYMENTS AND PREPAYMENT MODELING

A prepayment model is a statistical model that is used to forecast prepayments. Modelers have
developed different prepayment models for agency and nonagency mortgage-backed securities.

Much less borrower and loan data are provided for agency MBS than for nonagency MBS. As
a result, prepayment modeling has been done at the pool level rather than the loan level.

An agency prepayment model typically consists of three components: housing turnover, cash-out
refinancing and rate/term refinancing. Although the factors driving prepayments in a prepayment
model typically do not change over time (except when more detailed data become available), the
relative importance of the values of the factors does change.

Housing Turnover Component

Housing turnover means existing home sales. The two factors that impact existing home sales
include: family relocation due to changes in employment and family status (e.g., change in family
size, divorce), and trade-up and trade-down activity attributable to changes in interest rates,
income, and home prices.

In general, housing turnover is insensitive to the level of mortgage rates. The factors typically used
to forecast prepayments due to housing turnover are (1) seasoning effect, (2) housing price
appreciation effect, and (3) seasonality effect.

With respect to housing appreciation, over time the LTV of a loan changes. This is due to both the
amortization of the loan and the change in the value of the home. There is an incentive for cash-out
refinancing if the value of a home appreciates. Thus, in prepayment modeling, to estimate
prepayments attributable to housing appreciation, a proxy is needed to capture the change in the
value of the LTV for a pool. Modelers do so in building agency prepayment models by
constructing a composite home appreciation index (HPI).

There is a well-documented seasonal pattern in prepayments. This pattern, referred to as the

seasonality effect, is related to activity in the primary housing market, with home buying
increasing in the spring and gradually reaching a peak in late summer.

Cash-Out Refinancing Component

Cash-out refinancing means refinancing by a borrower in order to monetize the price

appreciation of the property. Adding to the incentive for borrowers to monetize price appreciation
is the favorable tax law regarding the taxation of capital gains. Cash-out refinancing is more like
housing turnover refinancing because of its tie to housing prices and its insensitivity to mortgage
rates. The proxy measure used for price appreciation in prepayment models is the HPI.
Rate/Term Refinancing Component

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Rate/term refinancing means that the borrower has obtained a new mortgage on the existing
property to save either on interest cost or by shortening the life of the mortgage with no increase in
the monthly payment. The homeowner’s incentive to refinance is based on the projected present
value of the dollar interest savings from the lower mortgage rate after deducting the estimated
transaction costs to refinance.

Prepayment modelers have found that a proxy for capturing the incentive to refinance is the ratio
of the borrower’s note rate to the current mortgage rate. This ratio is called the refinancing ratio.
When the refinancing ratio exceeds unity, there is an incentive to refinance.

The refinancing decision is not based solely on the mortgage rate relative to the prevailing market
rate but also on a host of other borrower circumstances. This is reflected in the S-curve for
prepayments. The reason for the observed S-curve for prepayments is that as the rate ratio
increases, the CPR (i.e., prepayment rate) increases.

The S-curve is not sufficient for modeling the rate / term refinancing. This is because the S-curve
fails to adequately account for two dynamics of borrower attributes that impact refinancing
decisions: (1) the burnout effect, and (2) the threshold media effect. The burnout effect occurs
because the composition of borrowers in a mortgage pool changes over time due to seasoning and
refinancing patterns.

CASH FLOW YIELD

Given the projected cash flow and the price of a pass-through, its yield can be calculated. The yield
is the interest rate that will make the present value of the expected cash flow equal to the price. A
yield computed in this manner is known as a cash flow yield.

Bond-Equivalent Yield

For a pass-through, the yield that makes the present value of the cash flow equal to the price is
a monthly interest rate. The next step is to annualize the monthly yield. According to market
convention, to compare the yield for a pass-through to that of a Treasury or corporate bond, the
monthly yield should not be annualized just by multiplying the monthly yield by 12.

The yield on a pass-through must be calculated so as to make it comparable to the yield to maturity
for a bond. This is accomplished by computing the bond-equivalent yield. The
bond-equivalent yield is found by doubling a semiannual yield. For a pass-through security, the
semiannual yield is

semiannual cash flow yield = (1 + yM)6 – 1

where yM is the monthly interest rate that will equate the present value of the projected monthly
cash flow to the price of the pass-through. The bond-equivalent yield is found by doubling the
semiannual cash flow yield; that is,
bond-equivalent yield = 2[(1 + yM)6 – 1].

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Limitations of Cash Flow Yield Measure

The yield corresponding to a price must be qualified by an assumption concerning prepayments. A

yield number without qualification as to the prepayment assumption is meaningless. Even with
specification of the prepayment assumption, the yield number is meaningless in terms of the
relative value of a pass-through.

Yield Spread to Treasuries

Although it is not possible to calculate a yield with certainty, it has been stated that pass-through
securities offer a higher yield than Treasury securities. Typically, the comparison is between
Ginnie Mac pass-through securities and Treasuries, for both are free of default risk.

The yield spread between private-label pass-through securities and agency pass-through securities
reflects both credit risk and prepayment risk. Borrowers who obtain government guarantees have
different prepayment traits than those of holders of non-government-insured mortgages.
Borrowers who get government-guaranteed mortgages typically do not have the ability to take on
refinancing costs as interest rates decline.

When we compare the yield of a mortgage pass-through security to a comparable Treasury, the
stated maturity of a mortgage pass-through security is an inappropriate measure because of
prepayments. Instead, market participants use the Macaulay duration and average life. The more
commonly used measure is the average life.

Average Life

The average life of a mortgage-backed security is the average time to receipt of principal
payments (scheduled principal payments and projected prepayments), weighted by the amount of
principal expected. Mathematically, the average life is expressed as follows:

T
t (principal received at time t)
average life =  where T is the number of months.
t 1 12(total principal)

PREPAYMENT RISK AND ASSET/ LIABILITY MANAGEMENT

An investor who owns pass-through securities does not know what the cash flow will be because
that depends on prepayments. The risk associated with prepayments is called prepayment risk.

If mortgage rates decline there will be two adverse consequences. First, we know from the basic
property of fixed-income securities that the price of an option-free bond will rise. But in the case of a
pass-through security, the rise in price will not be as large as that of an option-free bond because
a fall in interest rates increases the borrower’s incentive to prepay the loan and refinance the debt at a
lower rate. The second adverse consequence is that the cash flow must be reinvested at a lower rate.
These two adverse consequences when mortgage rates decline are referred to as contraction risk.
If mortgage rates rise, the price of the pass-through, like the price of any bond, will decline. But it
will decline more because the higher rates will tend to slow down the rate of prepayment. This is

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just the time when investors want prepayments to speed up so that they can reinvest the
prepayments at the higher market interest rate. This adverse consequence of rising mortgage rates
is called extension risk.

SECONDARY MARKET TRADING

Pass-throughs are quoted in the same manner as U.S. Treasury coupon securities. A quote of
94-05 means 94 and 5/32nds of par value, or 94.15625% of par value. Many trades occur while a
pool is still unspecified, and therefore no pool information is known at the time of the trade. This
kind of trade is known as a “TBA” (to be announced) trade. The seller has the right in this case to
deliver pass-throughs backed by pools that satisfy the PSA requirements for good delivery.

KEY POINTS

 The residential mortgage-backed securities market is divided into two sectors: agency MBS and
nonagency MBS.
 A residential mortgage-backed security is created when residential loans are pooled and one or
more securities are issued whose obligations are to be repaid from the cash flow from the loan
pool.
 A mortgage pass-through security is one type of RMBS created when one or more mortgage
holders of loans pool them and sell a single debt obligation that is to be repaid from the cash
flow of the specific loan pool with each investor entitled to a pro rata share of the cash flow.
 Agency MBS include agency mortgage pass-through securities, agency collateralized mortgage
obligations, and agency stripped mortgage-backed securities. The cash flow of the latter two
types of MBS is derived from the first type, and hence, they are referred to as derivative MBS.
 The monthly cash flow of a mortgage pass-through security depends on the cash flow of the
underlying mortgages and therefore consists of monthly mortgage payments representing
interest, the scheduled repayment of principal, and any prepayments. The cash flow is less than
that of the underlying mortgages by an amount equal to servicing and any guarantor fees.
 As with individual mortgage loans, because of prepayments, the cash flow of a pass-through is
not known with certainty. Agency MBS are issued by Ginnie Mae, Fannie Mae, and Freddie
Mac. Ginnie Mae pass-through securities are guaranteed by the full faith and credit of the U.S.
government and consequently are viewed as risk-free in terms of default risk. Freddie Mac and
Fannie Mae are government-sponsored enterprises, and therefore, their guarantee does not
carry the full faith and credit of the U.S. government.
 Estimating the cash flow from a mortgage pass-through security requires forecasting
prepayments. The current convention is to use the PSA prepayment benchmark, which is a
series of conditional prepayment rates, to obtain the cash flow.
 A prepayment model begins by modeling the statistical relationships among the factors that are
expected to affect prepayments. The key components of an agency prepayment models are
housing turnover, cash-out refinancing, and rate/term refinancing.

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 Given the projected cash flow and the market price of a pass-through, a cash flow yield can be
calculated. Because the PSA prepayment benchmark is only a convention enabling market
participants to quote yield and/or price but that it has many limitations for determining the value
of a pass-through. The yield spread is quoted as the difference between the cash flow yield and
the yield to maturity of a comparable Treasury.
 A measure commonly used to estimate the life of a pass-through is its average life.
 The prepayment risk associated with investing in mortgage pass-through securities can
be decomposed into contraction risk and extension risk. Prepayment risk makes mortgage
pass-through securities unattractive for certain financial institutions to hold from an
asset–liability perspective.

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 ANSWERS TO QUESTIONS FOR CHAPTER 11
(Questions are in bold print followed by answers.)
1. Answer the below questions.

a. Explain what is meant by a residential mortgage-backed security.

By a residential mortgage-backed security (RMBS), we mean a security that is created when

residential mortgages are packaged together to form a pool of mortgage loans and then one or more
debt obligations are issued backed by the cash flow generated from the pool of mortgage loans.
“Backed” means that the principal and interest due to the investors in an RMBS come from the
principal and interest payments made by the borrowers whose loans are part of the pool of
mortgages. A mortgage loan that is included in an RMBS is said to be securitized, and the process
of creating an RMBS is referred to as securitization.

b. Describe the sectors of the residential mortgage-backed securities market.

The residential mortgage market can be divided into two subsectors based on the credit quality of
the borrower: prime mortgage market and subprime mortgage market. The prime sector includes
(1) loans that satisfy the underwriting standard of Ginnie Mae, Fannie Mae, and Freddie Mac (i.e.,
conforming loans); and (2) loans that fail to conform for a reason other than credit quality or
because the loan is not a first lien on the property (i.e., nonconforming loans). The subprime
mortgage sector is the market for loans provided to borrowers with an impaired credit rating or
where the loan is a second lien; these loans are nonconforming loans.

The above loans can be securitized in different sectors of the RMBS market. Loans that satisfy the
underwriting standard of the agencies are typically used to create RMBS that are referred to as
agency mortgage-backed securities (MBS). All other loans are included in what is referred to
generically as nonagency MBS. In turn, this subsector is classified into private-label MBS, where
prime loans are the collateral, and Subprime MBS, where subprime loans are the collateral. The
names given to the nonagency MBS are arbitrarily assigned. Some market participants refer to
private-label MBS as “residential deals” or “prime deals.” Subprime MBS are also referred to as
“mortgage-related asset-backed securities.” In fact, market participants often classify agency MBS
and private-label MBS as part of the RMBS market and subprime MBS as part of the market for
asset-backed securities.

2. What is a mortgage pass-through security?

A mortgage pass-through security, or simply a pass-through, is a security that results when one or
more mortgage holders form a collection (pool) of mortgages and sell shares or participation
certificates in the pool. From the pass-through, two further derivative mortgage-backed securities
are created: collateralized mortgage obligations and stripped mortgage-backed securities.

3. What are the two types of private–label MBS?

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First, let us address the MBS types. The agency MBS market includes three types of securities:
agency mortgage pass-through securities, agency collateralized mortgage obligations or CMOs,
and agency stripped MBS. Agency CMOs and stripped CMOs are created from mortgage
pass-through securities. Hence, agency CMOs and agency stripped MBS are routinely referred to
as derivative MBS products. Now let us address private-label MBS. Private-label mortgage
backed securities are securitized mortgages that do not conform to the criteria set by the
Government Sponsored Enterprises Freddie Mac, Fannie Mae and Ginnie Mae. The mortgages
that make up these securities do not have the backing of the government and as a result carry a
significantly greater risk. Some market participants refer to private label MBS as either
“residential deals” or “prime deals.”

Private label MBS are nonagency loans. Some private institutions, such as subsidiaries of
investment banks, financial institutions, and home builders, also issue mortgage securities. When
issuing mortgage securities, they may issue either agency or non-agency mortgage pass-through
securities; however, their underlying collateral will more often include different or specialized
types of mortgage loans or mortgage loan pools that do not qualify for agency securities. The
transactions may use alternative credit enhancements such as letters of credit. These non-agency or
so-called private-label mortgage securities are the sole obligation of their issuer and are not
guaranteed by one of the GSEs or the U.S. Government. Private-label mortgage securities are
assigned credit ratings by independent credit agencies based on their structure, issuer, collateral,
and any guarantees or other factors.

4. What are subprime mortgage-backed securities?

First, let us look at what a mortgage-backed security. A mortgage-backed security (MBS) is an

asset-backed asset whose cash flows are backed by the principal and interest payments of a set of
mortgage loans. A mortgage pass-through security, or simply pass-through security, is a type of
MBS created by pooling mortgage loans and issuing certificates entitling the investor to receive a
pro rata share in the cash flows of the specific pool of mortgage loans that serves as the collateral
for the security. All principal and interest payments (less a servicing fee) from the pool of
mortgages are “passed through” directly to investors each month. Because there is only one class
of bondholders, these securities are sometimes referred to as single-class MBS.

Now let us incorporate “subprime.” The subprime mortgage sector is the market for loans provided
to borrowers with an impaired credit rating or where the loan is a second lien; these loans are
nonconforming loans. All of these loans can be securitized in different sectors of the RMBS
market. Loans that satisfy the underwriting standard of the agencies are typically used to create
RMBS that are referred to as agency mortgage-backed securities (MBS). All other loans are
included in what is referred to generically as nonagency MBS. In turn, this subsector is classified
into private label MBS, where prime loans are the collateral, and subprime MBS, where
subprime loans are the collateral. The names given to the nonagency MBS are arbitrarily assigned.
Some market participants refer to private label MBS as “residential deals” or “prime deals.”
Subprime MBS are also referred to as “mortgage-related asset-backed securities.” In fact, market
participants often classify agency MBS and private label MBS as part of the RMBS market and
subprime MBS as part of the market for asset-backed securities. This classification is somewhat
arbitrary.

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5. What is meant by a derivative mortgage-backed security?

A derivative is a financial contract or instrument that derives its value from an underlying asset.
Thus, by a derivative mortgage-backed security we mean a security that is created and that derives
its value from an underlying mortgage asset. In terms of the agency MBS market, an agency
collateralized mortgage obligation (CMO) and an agency stripped MBS are derivatives because
they derive their value from agency mortgage pass-through securities.

6. Describe the cash flow of a mortgage pass-through security.

The cash flow of a mortgage pass-through security depends on the cash flow of the underlying
mortgages. The cash flow consists of monthly mortgage payments representing interest, the
scheduled repayment of principal, and any prepayments. Payments are made to security holders
each month. Neither the amount nor the timing, however, of the cash flow from the pool of
mortgages is identical to that of the cash flow passed through to investors.

The monthly cash flow for a pass-through is less than the monthly cash flow of the underlying
mortgages by an amount equal to servicing and other fees. The other fees are those charged by the
issuer or guarantor of the pass-through for guaranteeing the issue. The coupon rate on a
pass-through, called the pass-through coupon rate, is less than the mortgage rate on the underlying
pool of mortgage loans by an amount equal to the servicing and guaranteeing fees.

The timing of the cash flow, like the amount of the cash flow, is also different. The monthly
mortgage payment is due from each mortgagor on the first day of each month, but there is
a delay in passing through the corresponding monthly cash flow to the security holders. The length
of the delay varies by the type of pass-through security. Because of prepayments, the cash flow of
a pass-through is also not known with certainty.

7. Answer the below questions.

(a) What are the WAC and WAM of a pass-through security?

Not all of the mortgages that are included in a pool of mortgages that are securitized have the same
mortgage rate and the same maturity. Consequently, when describing a pass through security, a
weighted average coupon rate and a weighted-average maturity are determined.

A weighted-average coupon rate (WAC) is found by weighting the mortgage rate of each
mortgage loan in the pool by the amount of the mortgage outstanding. A weighted average
maturity (WAM) is found by weighting the remaining number of months to maturity for each
mortgage loan in the pool by the amount of the mortgage outstanding.

(b) After origination of a mortgage-backed security, the WAM changes. What measures are
used by Fannie Mae and Freddie Mac to describe the remaining term to maturity of the
loans remaining in the loan pool?

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After origination of the MBS, the WAM of a pool changes. Fannie Mae and Freddie Mac report
the remaining number of months to maturity for a loan pool, which they refer to as weighted
average remaining maturity (WARM). Both Fannie Mae and Freddie Mac also report the weighted
average of the number of months since the origination of the security for the loans in the pool. This
measure is called the weighted average loan age (WALA).

8. Although it is often stated that Ginnie Mae issues mortgage-backed securities, why is that
technically incorrect?

Ginnie Mae is a federally related institution because it is part of the Department of Housing and
Urban Development. As a result, the pass-through securities that it guarantees carry the full faith
and credit of the U.S. government with respect to timely payment of both interest and principal.
However, it is not technically correct to say that Ginnie Mae is an issuer of pass-through securities.
Ginnie Mae provides the guarantee, but it is not the issuer. Pass-through securities that carry its
guarantee and bear its name are issued by lenders it approves, such as thrifts, commercial banks,
and mortgage bankers. Thus, these approved entities are referred to as the “issuers.”

There are two MBS programs through which securities are issued: Ginnie Mae I program and
Ginnie Mae II program. In the Ginnie Mae I program, pass-through securities are issued that are
backed by single-family or multifamily loans; in the Ginnie Mae II program, single-family loans
are included in the loan pool. While the programs are similar, there are differences in addition to
the obvious one that the Ginnie Mae I program may include loans for multifamily houses, whereas
the Ginnie Mae II program only has single-family housing loans.

9. What are the different types of agency pass-through securities?

There are three major types of pass-throughs, guaranteed by three organizations: Government
National Mortgage Association (Ginnie Mae), Federal Home Loan Mortgage Corporation
(Freddie Mae), and Federal National Mortgage Association (Fannie Mae). These are called
agency pass-throughs.

10. How does the guarantee for a Ginnie Mae mortgage-backed security differ from that of a
mortgage-backed security issued by Fannie Mae and Freddie Mac?

Ginnie Mae, unlike Fannie Mae and Freddie Mac, are guaranteed by the full faith and credit of the
U.S. government. More details are given below. Ginnie Mae is a federally related institution
because it is part of the Department of Housing and Urban Development. As a result, the
pass-through securities that it guarantees carry the full faith and credit of the U.S. government with
respect to timely payment of both interest and principal. That is, the interest and principal are paid
when due even if mortgagors fail to make their monthly mortgage payment. While Ginnie Mae
provides the guarantee, it is not technically the issuer. Pass-through securities that carry its
guarantee and bear its name are issued by lenders it approves, such as thrifts, commercial banks,
and mortgage bankers. Thus, these approved entities are referred to as the “issuers.” These lenders
receive approval only if the underlying loans satisfy the underwriting standards established by
Ginnie Mae. When it guarantees securities issued by approved lenders, Ginnie Mae permits these
lenders to convert illiquid individual loans into liquid securities backed by the U.S. government. In

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the process, Ginnie Mae accomplishes its goal to supply funds to the residential mortgage market
and provide an active secondary market. For the guarantee, Ginnie Mae receives a fee, called the
guaranty fee.

Although the MBS issued by Fannie Mae and Freddie Mac are commonly referred to as “agency
MBS,” both are in fact shareholder-owned corporations chartered by Congress to fulfill a public
mission. They do not receive a government subsidy or appropriation and are taxed like any other
corporation. Fannie Mae and Freddie Mac are government-sponsored enterprises (GSEs). The
mission of these two GSEs is to support the liquidity and stability of the mortgage market. They
accomplish this by (1) buying and selling mortgages, (2) creating pass-through securities and
guaranteeing them, and (3) buying MBS. The mortgages purchased and held as investments by
Fannie Mae and Freddie Mac are held in a portfolio referred to as the retained portfolio. However,
the MBS that they issue are not guaranteed by the full faith and credit of the U.S. government.
Rather, the payments to investors in MBS are secured first by the cash flow from the underlying
pool of loans and then by a corporate guarantee. That corporate guarantee, however, is the same as
the corporate guarantee to the other creditors of the two GSEs. As with Ginnie Mae, the two GSEs
receive a guaranty fee for taking on the credit risk associated with borrowers failing to satisfy their
loan obligations.

11. On October 1, 2005, Fannie Mae issued a mortgage pass-through security and the
prospectus supplement stated the following:

FANNIE MAE
MORTGAGE-BACKED SECURITIES PROGRAM
SUPPLEMENT TO PROSPECTUS DATED JULY 01, 2004
$464,927,576.00
ISSUE DATE OCTOBER 01, 2005
SECURITY DESCRIPTION FNMS 05.0000 CL-844801
5.0000 PERCENT PASS-THROUGH RATE
FANNIE MAE POOL NUMBER CL-844801
CUSIP 31407YRW1
PRINCIPAL AND INTEREST PAYABLE ON THE 25TH OF EACH MONTH
BEGINNING NOVEMBER 25, 2005
POOL STATISTICS
SELLER WELLS FARGO BANK, N.A
SERVICER WELLS FARGO BANK, N.A
NUMBER OF MORTGAGE LOANS 1986
AVERAGE LOAN SIZE $234,312.06
MATURITY DATE 10/01/2035
WEIGHTED AVERAGE COUPON RATE 5.7500%
WEIGHTED AVERAGE LOAN AGE 1 mo
WEIGHTED AVERAGE LOAN TERM 360 mo
WEIGHTED AVERAGE REMAINING MATURITY 359 mo
WEIGHTED AVERAGE LTV 73%
WEIGHTED AVERAGE CREDIT SCORE 729

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Answer the below questions.

(a) What does the “pass-through rate” of 5% for this security mean?

It means that the coupon rate for the security is 5.00%.

(b) What is the average note rate being paid by the borrowers in the loan pool for this
security?

The average note rate (or weighted average coupon rate) is 5.75% and is a weighted-average of the
note rates for all mortgage loans in the loan pool.

(c) Why does the pass-through rate differ from the average note rate paid by the borrowers
in the loan pool for this security?

Not all of the mortgages that are included in the loan pool that are securitized need to have the
same note rate and the same maturity. Consequently, when describing a pass-through security, the
weighted-average coupon is determined. A weighted-average coupon rate (WAC) is found by
weighting the note rate of each mortgage loan in the pool by the amount of the mortgage
outstanding.

(d) What is the pool number for this security, and why is the pool number important?

The loan pool that is the collateral for this security is Fannie Mae pool number CL-844801. The
pool number is important because it indicates the specific mortgages underlying the pass-through
and the issuer of the pass-through.

(e) What is the prefix for this security, and what does a prefix indicate?

The “CL” appearing before the pool number is called the pool prefix. All agency issuers have their
own pool prefix, and it indicates the type of collateral. In the case of Fannie Mae, there is
a two-character prefix indicating (1) whether the loans are conventional, government insured, or
guaranteed by some entity; (2) whether the note rates for the loans are fixed or adjustable and
features about adjustment in the latter case; and (3) the general term to maturity of the loans at
issuance. In our Fannie Mae example, “CL” means “Conventional Long-Term, Level-Payment
Mortgages; Single-Family; maturing or due in 30 years or less.” Other examples of pool
prefixes used by Fannie Mae are “CL,” which means that the collateral is “Conventional
Intermediate-Term, Level-Payment Mortgages; Single-Family; maturing or due in 15 years or
less,” and “A1,” which means that the collateral is “Adjustable-Rate Mortgages; Single-Family;
indexed to the one-year Treasury Constant Maturity; 1 percent per interest rate adjustment;
lifetime caps are pool-specific.”

(f) The “maturity date” for this security is shown as “10/01/2035.” An investor in this
security might be concerned about its very long maturity (30 years). Why is the maturity
date a misleading measure of the security’s maturity?

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The maturity is misleading because of prepayments that, in essence, make the maturity less.

Not all of the mortgages that are included in the loan pool that are securitized need to have the
same maturity. Consequently, when describing a pass-through security, the weighted-average
maturity is determined. A weighted-average maturity (WAM) is found by weighting the remaining
number of months to maturity for each mortgage loan in the pool by the amount of the mortgage
outstanding. This measure is also referred to as the weighted average loan term (WALT). In
conclusion, the stated maturity of a mortgage pass-through security is an inappropriate measure
because of prepayments and for this reason market participants use two other measures: Macaulay
duration and average life.

(g) If an investor purchased $15 million principal of this security and, in some month, the
cash flow available to be paid to the security holders (after all fees are paid) is $12 million,
how much is the investor entitled to receive?

The investor owns $15 million principal of the total principal of $464,927,576. This represents
$15,000,000 / $464,927,576 = 0.0322630895 or about 3.2263% of ownership. This ownership
entitles the investor to 0.0322630895 × $12,000,000 = $387,157.07.

(h) Every month a pool factor would be reported for this security. If the pool factor for some
month is 0.92, what is the outstanding mortgage balance for the loan pool for that month?

When a pass-through security is first issued, the principal is known. Over time, because of
regularly scheduled principal payments and prepayments, the amount of the pool’s outstanding
loan balance declines. The pool factor is the percentage of the original principal that is still
outstanding. At issuance, the pool factor is 1 and declines over time. Pool factor information is
published monthly. If the pool factor is 0.92 it means the outstanding mortgage balance is
0.92 × $464,927,576 = $427,733,369.92.

(i) Why does the weighted average loan term differ from the weighted average remaining
maturity?

A weighted-average maturity (WAM) is found by weighting the remaining number of months to

maturity for each mortgage loan in the pool by the amount of the mortgage outstanding. This
measure is also referred to as the weighted average loan term (WALT). A WAM of 360 months
means that the mortgages were newly originated. After origination of the MBS, the WAM of a
pool changes. Fannie Mae and Freddie Mac report the remaining number of months to maturity for
a loan pool, which they refer to as weighted average remaining maturity (WARM). Both Fannie
Mae and Freddie Mac also report the weighted average of the number of months since the
origination of the security for the loans in the pool. This measure is called the weighted average
loan age (WALA).

(j) Wells Fargo Bank, N.A. is identified as the seller and the servicer. What does that mean?

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Ginnie Mae provides the guarantee, but Wells Fargo Bank, N.A., is the issuer or seller of the
security. It also services the payments and in this capacity is said to be the servicer. More details
are given below.

Pass-through securities that carry its guarantee and bear its name are issued by lenders it approves,
such as thrifts, commercial banks, and mortgage bankers. Thus, these approved entities are
referred to as the “issuers.” These lenders receive approval only if the underlying loans satisfy the
underwriting standards established by Ginnie Mae. When it guarantees securities issued by
approved lenders, Ginnie Mae permits these lenders to convert illiquid individual loans into liquid
securities backed by the U.S. government. In the process, Ginnie Mae accomplishes its goal to
supply funds to the residential mortgage market and provide an active secondary market. For the
guarantee, Ginnie Mae receives a fee, called the guaranty fee.

(k) What does the following mean: “MORTGAGE-BACKED SECURITIES PROGRAM

SUPPLEMENT TO PROSPECTUS DATED JULY 01, 2004”?

When issuing MBS, the GSEs provide a prospectus for the offering. What is issued first is what is
termed a “prospectus.” However, the prospectus contains general information about the securities
issued by each GSE and the risks associated with investing in MBS securities in general. The
prospectus is amended periodically. It does not provide specific information about the loan pool
for a security. That information is provided in a supplement to the prospectus, called the
prospectus supplement. This information is provided to assist the investor in assessing the value of
the security or, more specifically, assessing the prepayments that might be expected from the loan
pool. Thus, “MORTGAGE-BACKED SECURITIES PROGRAM SUPPLEMENT TO
PROSPECTUS DATED JULY 01, 2004” refers to the information needed to assist the investor in
understanding the offering.

12. Why is an assumed prepayment speed necessary to project the cash flow of a pass-through?

To value a pass-through security, it is necessary to project its cash flow. The difficulty is that the
cash flow is unknown because of prepayments. The only way to project a cash flow is to make
some assumption about the prepayment rate over the life of the underlying mortgage pool. The
prepayment rate assumed is called the prepayment speed or, simply, speed. If the assumed
prepayment rate is inaccurate or misleading, the resulting cash flow is not meaningful for valuing
pass-throughs.

13. What does a conditional prepayment rate of 8% mean?

One benchmark for projecting prepayments and the cash flow of a pass-through requires that one
assumes some fraction of the remaining principal in the pool is prepaid each month for the
remaining term of the mortgage.

The prepayment rate assumed for a pool, called the conditional prepayment rate (CPR), is based
on the characteristics of the pool (including its historical prepayment experience) and the current
and expected future economic environment. It is referred to as a conditional rate because it is
conditional on the remaining mortgage balance.

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The CPR is an annual prepayment rate. To estimate monthly prepayments, the CPR must be
converted into a monthly prepayment rate, commonly referred to as the single-monthly mortality
rate (SMM).

A formula can be used to determine the SMM for a given CPR:

SMM = 1 – (1 – CPR)1/12.

For our problem we want to know what a conditional prepayment rate of 8% means. Assuming the
CPR used to estimate prepayments is 8%, the corresponding SMM is

SMM = 1 – (1 – 0.08)1/12 = 1 – (0.92)0.08333 = 1 – 0.9930756 = 0.0069244 or 0.69244%.

An SMM of 0.69244% means that approximately 0.69244% of the remaining mortgage balance at
the beginning of the month, less the scheduled principal payment, will prepay that month. That is,
prepayment for month t is equal to

SMM = (beginning mortgage balance for month t – scheduled principal payment for month t).

For example, suppose that an investor owns a pass-through in which the remaining mortgage
balance at the beginning of some month is $90 million. Assuming that the SMM is 0.69244% and
the scheduled principal payment is $1 million, the estimated prepayment for the month is:

0.0069244($90,000,000 – $1,000,000) = 0.0069244($89,000,000) = $616,270.05.

14. Indicate whether you agree or disagree with the following statement: “The PSA
prepayment benchmark is a model for forecasting prepayments for a pass-through security.”

The Public Securities Association (PSA) prepayment benchmark is expressed as a monthly series
of annual prepayment rates. This benchmark is commonly referred to as a prepayment model,
suggesting that it can be used to estimate prepayments. Characterization of this benchmark as a
prepayment model is inappropriate. It is simply a market convention of prepayment behavior. The
PSA benchmark assumes that prepayment rates are low for newly originated mortgages and then
will speed up as the mortgages become seasoned.

The PSA benchmark assumes the following CPRs for 30-year mortgages: (i) a CPR of 0.2% for
the first month, increased by 0.2% per year per month for the next 30 months when it reaches 6%
per year, and (ii) a 6% CPR for the remaining years. This benchmark, referred to as “100% PSA”
or simply “100 PSA,” can be depicted graphically. Mathematically, 100 PSA can be expressed as
follows:

If t ≤ 30: CPR = 6% (t / 30)

If t > 30: CPR = 6%

where t is the number of months since the mortgage originated.

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15. Answer the below questions.

(a) Complete the following table:

CPR Assuming:
Month 100% PSA 70% PSA 320% PSA
1
4
9
27
40
120
340

The PSA benchmark assumes the following CPRs for 30-year mortgages: (i) a CPR of 0.2% for
the first month, increased by 0.2% per year per month for the next 30 months when it reaches 6%
per year, and (ii) a 6% CPR for the remaining years. This benchmark, referred to as “100% PSA”
or simply “100 PSA,” and can be expressed as follows: if t ≤ 30: CPR = 6% (t / 30); if t > 30: CPR
= 6% where t is the number of months since the mortgage originated.

Slower or faster speeds are then referred to as some percentage of PSA. For example, 75 PSA
means 0.75 times the CPR of the PSA benchmark prepayment rate; and, 320 PSA means 3.2 times
the CPR of the PSA benchmark prepayment rate. A prepayment rate of 0 PSA means that no
prepayments are assumed.

Given the above information and the months from the above table, we compute the CPRs as given
below.

With 100 PSA, we get the below CPR values.

For month 1: CPR = 6%(1 / 30) = 0.2%; 100 PSA = 1.00(0.2%) = 0.2% or 0.002.
For month 4: CPR = 6%(4 / 30) = 0.8%; 100 PSA = 1.00(0.8%) = 0.8% or 0.008.
For month 9: CPR = 6%(9 / 30) = 1.8%; 100 PSA = 1.00(1.8%) = 1.8% or 0.018.
For month 27: CPR = 6%(27 / 30) = 5.4%; 100 PSA = 1.00(5.4%) = 5.4% or 0.054.
For months 40, 120, & 340: CPR = 6.0%; 100 PSA = 1.00(6.0%) = 6.0% or 0.060.

With 70 PSA, we get the below CPR values.

For month 1: CPR = 6%(1 / 30) = 0.2%; 70 PSA = 0.70(0.2%) = 0.14% or 0.0014.
For month 4: CPR = 6%(4 / 30) = 0.8%; 70 PSA = 0.70(0.8%) = 0.56% or 0.0056.
For month 9: CPR = 6%(9 / 30) = 1.8%; 70 PSA = 0.70(0.1.8%) = 1.26% or 0.0126.
For month 27: CPR = 6%(27 / 30) = 5.4%; 70 PSA = 0.70(5.4%) = 3.78% or 0.0378.
For month 40, 120, & 340: CPR = 6.0%; 70 PSA = 0.70(6.0%) = 4.20% or 0.0420.

With 320 PSA, we get the below CPR values.

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For month 1: CPR = 6%(1 / 30) = 0.2%; 320 PSA = 3.20(0.2%) = 0.64% or 0.0064.
For month 4: CPR = 6%(4 / 30) = 0.8%; 320 PSA = 3.20(0.8%) = 2.56% or 0.0256.
For month 9: CPR = 6%(9 / 30) = 1.8%; 320 PSA = 3.20(1.8%) = 5.76% or 0.0576.
For month 27: CPR = 6%(27 / 30) = 5.4%; 320 PSA = 3.20(5.4%) = 17.28% or 0.1728.
For months 40, 120, & 340: CPR = 6%; 320 PSA = 3.20(6.0%) = 19.20% or 0.1920.

Inserting the CPR values into the above table, we have:

CPR Assuming:
Month 100% PSA 70% PSA 320% PSA
1 0.2% 0.14% 0.64%
4 0.8% 0.56% 2.56%
9 1.8% 1.26% 5.76%
27 5.4% 3.78% 17.28%
40 6.0% 4.20% 19.20%
120 6.0% 4.20% 19.20%
340 6.0% 4.20% 19.20%

(b) Complete the following table:

SMM Assuming:
Month 100% PSA 70% PSA 320% PSA
1
4
9
27
40
120
340

With 100% PSA, we get the below SMM values using the formula: SMM = 1 – (1 – CPR)1/12.
For month 1: CPR = 6%(1 / 30) = 0.2% = 0.002; 100 PSA = 1.00(0.002) = 0.002;
SMM = 1 – (1 – 0.002)1/12 = 1 – (0.998)0.083333 = 0.0001668 or 0.01668%.
For month 4: CPR = 6%(4 / 30) = 0.08% = 0.008; 100 PSA = 1.00(0.008) = 0.008;
SMM = 1 – (1 – 0.008)1/12 = 1 – (0.992)0.083333 = 0.0006691 or 0.06691%.
For month 9: CPR = 6%(9 / 30) = 1.8% = 0.018; 100 PSA = 1.00(0.018) = 0.018;
SMM = 1 – (1 – 0.018)1/12 = 1 – (0.982)0.083333 = 0.0015125 or 0.15125%.
For month 27: CPR = 6%(27 / 30) = 5.4% = 0.054; 100 PSA = 1.00(0.054) = 0.054;
SMM = 1 – (1 – 0.054)1/12 = 1 – (0.946)0.083333 = 0.0046154 or 0.46154%.
For month 40, 120, and 340: CPR = 6% = 0.06; 100 PSA = 1.00(0.06) = 0.06;
SMM = 1 – (1 – 0.06)1/12 = 1 – (0.94)0.083333 = 0.0051430 or 0.51430%.
With 70 PSA, we get the below SMM values.
For month 1: CPR = 6%(1 / 30) = 0.2% = 0.002; 70 PSA = 0.70(0.002) = 0.0014.
SMM = 1 – (1 – 0.0014)1/12 = 1 – (0.9986)0.083333 = 0.0001167 or 0.01167%.

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For month 4: CPR = 6%(4 / 30) = 0.8% = 0.008; 70 PSA = 0.70(0.008) = 0.0056.
SMM = 1 – (1 – 0.0056)1/12 = 1 – (0.9944)0.083333 = 0.0004679or 0.04679%.
For month 9: CPR = 6%(9 / 30) = 1.8% = 0.018; 70 PSA = 0.70(0.018) = 0.0126.
SMM = 1 – (1 – 0.0126)1/12 = 1 – (0.9874)0.083333 = 0.0010561 or 0.10561%.
For month 27: CPR = 6%(27 / 30) = 5.4% = 0.054; 70 PSA = 0.70(0.054) = 0.0378.
SMM = 1 – (1 – 0.0378)1/12 = 1 – (0.9622)0.083333 = 0.0032059 or 0.32059%.
For month 40, 120, & 340: CPR = 6% = 0.06; 70 PSA = 0.70(0.06) = 0.0420.
SMM = 1 – (1 – 0.042)1/12 = 1 – (0.958)0.083333 = 0.0035692 or 0.35692%.

With 320 PSA, we get the below SMM values.

For month 1: CPR = 6%(1 / 30) = 0.2% = 0.002; 320 PSA = 3.20(0.002) = 0.0064.
SMM = 1 – (1 – 0.064)1/12 = 1 – (0.9936)0.083333 = 0.0005349 or 0.05349%.
For month 4: CPR = 6%(4 / 30) = 0.8% = 0.008; 320 PSA = 3.20(0.008) = 0.0256.
SMM = 1 – (1 – 0.0256)1/12 = 1 – (0.9744)0.083333 = 0.0021588 or 0.21588%.
For month 9: CPR = 6%(9 / 30) = 1.8% = 0.018; 320 PSA = 3.20(0.018) = 0.0576.
SMM = 1 – (1 – 0.0576)1/12 = 1 – (0.9424)0.083333 = 0.0049316 or 0.49316%.
For month 27: CPR = 6%(27 / 30) = 5.4% = 0.054; 320 PSA = 3.20(0.054) = 0.1728.
SMM = 1 – (1 – 0.01728)1/12 = 1 – (0.8272)0.083333 = 0.0156848 or 1.56848%.
For month 40, 120, & 340: CPR = 6% = 0.06; 320 PSA = 3.20(0.06) = 0.1920.
SMM = 1 – (1 – 0.1920)1/12 = 1 – (0.8080)0.083333 = 0.0176092 or 1.76092%.
Inserting the SMM values into the above table, we have:

SMM Assuming:
Month 100% PSA 70% PSA 320% PSA
1 0.01668% 0.01167% 0.05349%
4 0.06691% 0.04679% 0.21588%
9 0.15125% 0.10561% 0.49316%
27 0.46154% 0.32059% 1.56848%
40 0.51430% 0.35692% 1.76092%
120 0.51430% 0.35692% 1.76092%
340 0.51430% 0.35692% 1.76092%

16. Complete the following table (in thousands of dollars) assuming a prepayment rate of
165 PSA:
Original balance: $ 100,000,000
Pass-through rate: 9.0%
WAM: 360 months

Outst. Mortg. Sch. Pre-pay Total Cash

Month Balance SMM Paym. Interest Princ. m. Princ. Flow
1 $100,000 $841
2 $ 99,934 $841

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We now construct a monthly cash flow for a pass-through of 9.0%, 165 PSA and WAM of 360 months.
The underlying mortgages for this pass-through are assumed to be fixed-rate level-payment mortgages
of $841. It will be assumed that the WAC rate is 9.00%. The exhibit below will show the cash flow for
months 1 and 2. The cash flow will be broken down into three components: (1) interest (based on the
pass-through rate), (2) the regularly scheduled principal repayment, and
(3) prepayments based on 165 PSA. We will now walk through the exhibit column by column with
dollar values given in thousands.

Column 1. This column gives the months, which are month 1 and month 2.
Column 2. This column gives the outstanding mortgage balance at the beginning of the month. It
is equal to the outstanding balance at the beginning of the preceding month reduced by the total
principal payment in the preceding month. The outstanding balances are given as $100,000 for
month 1 and $99,934 for month 2.
Column 3. This column shows the SMM for 165PSA for months 1 and 2. Below we show the
derivations of the values. We have:

For month 1: CPR = 6%(1 / 30) = 0.2% = 0.002; 165 PSA = 1.65(0.002) = 0.0033.
SMM = 1 – (1 – 0.0033)1/12 = 1 – (0.9967)0.083333 = 0.0002754 or 0.02754%.
For month 2: CPR = 6%(2 / 30) = 0.4% = 0.004; 165 PSA = 1.65(0.004) = 0.0066.
SMM = 1 – (1 – 0.0066)1/12 = 1 – (0.9934)0.083333 = 0.0005517 or 0.05517%.

Column 4. The total monthly mortgage payment is shown in this column. For simplicity, we
assume mortgage payments of $841 for each month. However, the total monthly mortgage
payment declines over time as prepayments reduce the mortgage balance outstanding.
Column 5. The monthly interest paid to the pass-through investor is found in this column. This value
is determined by multiplying the outstanding mortgage balance at the beginning of the month by the
pass-through rate of 9.0% and dividing by 12. For month 1, we get $100,000(0.09 / 12) = $750.00.
For month 2, we get $99,934.39(0.09 / 12) = $749.51. (The $99,934.39 will be
computed later.)
Column 6. This column gives the regularly scheduled principal repayment. This is the difference
between the total monthly mortgage payment (the amount shown in column 4) and the gross
coupon interest for the month. For the exhibit below, we assume the gross coupon interest rate is
9.635% (the coupon interest rate or weighted-average coupon rate for a pool of the mortgage
outstanding is greater that the pass-through rate of 9.00% to take into account fees). We multiply
the outstanding mortgage balance at the beginning of the month by the coupon interest rate divided
by 12. For month 1, we first compute the gross interest and get: $100,000(0.09635 / 12) = $802.92.
Subtracting this amount from the mortgage payment, we get the scheduled principal payment. We
have: $841 – $802.92 = $38.08. For month 2, we compute the gross interest and get:
$99,934.39(0.09 / 12) = $802.39. Subtracting this amount from the mortgage payment we get the
scheduled principal payment. We have: $841 – $802.39 = $38.61.
Column 7. The prepayment for the month is reported in this column. The prepayment for each
month is found by using the equation:
prepayment = SMM × (beginning mortgage balance – scheduled principal payment).

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For month 1, we have prepayment = (0.0002754)($100,000 – $38.08) = $27.53. For month 2, we
have prepayment = (0.0005517)($99,881.48 – $38.61) = $55.11.
Column 8. The total principal payment, which is the sum of columns 6 and 7, is shown in this
column. For month 1, we have: total principal payment = scheduled principal payment +
prepayment = $38.08 + $27.53 = $65.61. For month 2, we have: total principal payment = $38.61
+ $55.11 = $93.72.
Column 9. The projected monthly cash flow for this pass-through is shown in this last column. The
monthly cash flow is the sum of the interest paid to the pass-through investor (column 5) and the total
principal payments for the month (column 8). The below exhibit shows cash flows for months 1 and
2 for the same pass-through assuming 165 PSA. For month 1, we have: cash flow
= $750 + $65.61 = $815.61. For month 2, we have: cash flow = $749.51 + $93.72 = $843.23.
Inserting the computed values for each column into the above table, we have:

Column Column Column Column Column Column Column Column Column

(1) (2) (3) (4) (5) (6) (7) (8) (9)
Outst. Mortg. Sch. Pre-pay Total Cash
Month Balance SMM Paym. Interest Princ. m. Princ. Flow
1 100,000 0.02754 841 750.00 38.08 27.53 65.61 815.61
2 99,934 0.05517 841 749.51 38.61 55.11 93.72 843.23

17. Answer the below questions.

(a) What is meant by prepayments due to housing turnover?

Housing turnover means existing home sales. The two factors that impact existing home sales
include (1) family relocation due to changes in employment and family status (e.g., change in
family size, divorce), and (2) trade-up and trade-down activity attributable to changes in interest
rates, income, and home prices. In general, housing turnover is insensitive to the level of mortgage
rates.

(b) What is meant by prepayments due to cash-out refinancing?

Cash-out refinancing means refinancing by a borrower in order to monetize the price appreciation
of the property. Prepayments due to cash-out refinancing will depend on the increase in housing
prices in the economy or region where the property is located. Adding to the incentive for
borrowers to monetize price appreciation is the favorable tax law regarding the taxation of capital
gains. The federal income tax rules exempt gains up to $500,000. Thus,
cash-out refinancing may be economic despite a rising mortgage rate and considering transaction
costs. Basically, cash-out refinancing is more like housing turnover refinancing because of its tie
to housing prices and its insensitivity to mortgage rates.

(c) What is meant by prepayments due to rate/term refinancing?

Rate/term refinancing means that the borrower has obtained a new mortgage on the existing
property to save either on interest cost or shortening the life of the mortgage with no increase in the

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monthly payment. The homeowner’s incentive to refinance is based on the projected present value
of the dollar interest savings from the lower mortgage rate after deducting the estimated
transaction costs to refinance.

18. Answer the below questions.

(a) What factor can be used as a proxy for cash-out refinancing incentives?

Cash-out refinancing is driven by price appreciation that has occurred since the origination of the
loans in the pool. A proxy measure for price appreciation must be used. For the Bear Stearns
agency prepayment model, the pool’s HPI is used and Exhibit 11-11 illustrates the cash-out
refinancing incentives for four assumed rates of appreciation of the HPI. The horizontal axis in the
exhibit is the ratio of the pool’s WAC to the prevailing market rate. A ratio greater than 1 means
that there is an incentive to refinance while a ratio below 1 means that the borrower will incur a
higher interest rate to refinance.

According to the Bear Stearns agency model, projected prepayments attributable to cash-out
refinancing (1) exist for all ratios greater than 0.6, (2) prepayments increase as the ratio increases,
and (3) the greater the price appreciation for a given ratio, the greater the projected prepayments.

(b) Why are prepayments attributable to cash-out refinancing likely to be insensitive to

changes in mortgage rates?

In general, housing turnover is insensitive to the level of mortgage rates. This is because housing
turnover is driven largely by family relocation due to changes in employment and family status as
well as changes in income and the housing market. None of these factors are necessarily related to
the level of mortgage rates.

19. What is the S-curve for prepayments? Explain the reason for the shape.

The S-curve for prepayment is a graph where values for the “CPR%” are given along the vertical
line and values for the “WAC/Mortgage Rate” ratio are found along the horizontal axis.

The reason for the observed S-curve for prepayments is that as the rate ratio increases, the CPR
(i.e., prepayment rate) increases. There is some level of the rate ratio, however, at which the
prepayment rate tends to level off. The reason for this leveling of the prepayment rate is because
the only borrowers remaining in the pool are those that cannot obtain refinancing or those who
have other reasons why refinancing does not make sense.

The S-curve is not sufficient for modeling the refinancing rate/term refinancing. This is because
the S-curve fails to adequately account for two dynamics of borrower attributes that impact
refinancing decisions: (1) the burnout effect and the threshold media effect.

20. What is the burnout effect?

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The burnout effect refers to the incentive to refinance being “extinguished.” This occurs because
the composition of borrowers in a mortgage pool changes over time due to seasoning and
refinancing patterns. More specifically, as mortgage rates decline, those borrowers in the pool who
are the most interest-rate sensitive prepay. The balance of the borrowers in the pool are less rate
sensitive but as mortgage rates continue to decline, these borrowers prepay. As mortgage rates
continue down, there is less additional prepayment activity and at some point, the incentive to
refinance is “burned out.”

21. Answer the below questions.

(a) What is the cash flow yield of a mortgage pass-through security?

Given the projected cash flow and the price of a pass-through, its yield can be calculated. The yield
is the interest rate that will make the present value of the expected cash flow equal to the price. A
yield computed in this manner is known as a cash flow yield.

(b) What are the limitations of cash flow yield measures for a mortgage pass-through
security?

The yield corresponding to a price must be qualified by an assumption concerning prepayments.

Although yields are frequently quoted, remember that the yield is based on some underlying
prepayment assumption. Consequently, a yield of 9% based on 150% PSA means that it is
assumed that the underlying mortgages will prepay at a rate equal to 150% PSA. A yield number
without qualification as to the prepayment assumption is meaningless.

In fact, even with specification of the prepayment assumption, the yield number is meaningless in
terms of the relative value of a pass-through. For an investor to realize the yield based on some PSA
assumption, a number of conditions must be met: (1) the investor must reinvest all the cash flows at
the calculated yield, (2) the investor must hold the pass-through security until all the mortgages have
been paid off, and (3) the assumed prepayment rate must actually occur over the life of the
pass-through. Moreover, in the case of private-label pass-throughs, the assumed default and
delinquencies must actually occur. Now, if all this is likely, we can trust the yield numbers.
Otherwise, investors must be cautious in using yield numbers to evaluate pass-through securities.

22. What is the bond-equivalent yield if the monthly cash flow yield is 0.7%?

The yield on a pass-through must be calculated so as to make it comparable to the yield to maturity
for a bond. This is accomplished by computing the bond-equivalent yield, which is simply a
market convention for annualizing any fixed-income instrument that pays interest more than once
a year. The bond-equivalent yield is found by doubling a semiannual yield. For a
pass-through security, the semiannual yield is

semiannual cash flow yield = (1 + yM)6 – 1

where yM is the monthly interest rate that will equate the present value of the projected monthly
cash flow to the price of the pass-through. The bond-equivalent yield is found by doubling the

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semiannual cash flow yield; that is,

bond-equivalent yield = 2[(1 + yM)6 – 1].

Inserting in our values, we get:

semiannual cash flow yield = (1 + yM)6 – 1 = (1 + 0.007)6 – 1 = 0.0427419 or about 4.274%.

Thus, the bond-equivalent yield is 2[0.0427418] = 0.0854837 or about 8.548%.

23. Answer the below questions.

(a) What is the average life of a pass-through, and what does it depend on?

A measure commonly used to estimate the life of a pass-through is its average life. Consider a
mortgage-back security guaranteed by Ginnie Mae, which is a fully modified pass-throughs. The
average life of a mortgage-backed security is the average time to receipt of principal payments
(scheduled principal payments and projected prepayments), weighted by the amount of principal
expected. Mathematically, the average life is expressed as follows:

T
t (principal received at time t)
average life = 
t 1 12(total principal)

where T is the number of months. The average life of a pass-through depends on the PSA
prepayment assumption.

(b) What are contraction risk and extension risk?

Contraction risk is the adverse result when mortgage rates decline, while extension risk is the
adverse consequence when mortgage rates rise. More details are given below.

An investor who owns pass-through securities does not know what the cash flow will be because
that depends on prepayments. To understand this prepayment uncertainty, suppose that an investor
buys a 9% coupon Ginnie Mae at a time when mortgage rates are 9%. There will be two adverse
consequences if mortgage rates decline to. First, we know from the basic property of fixed-income
securities that the price of an option-free bond will rise. But in the case of a
pass-through security, the rise in price will not be as large as that of an option-free bond because a
fall in interest rates increases the borrower’s incentive to prepay the loan and refinance the debt at
a lower rate. Thus, the upside price potential of a pass-through security is truncated because of
prepayments. This result should not be surprising, because a mortgage loan effectively grants the
borrower the right to call the loan at par value. The second adverse consequence is that the cash
flow must be reinvested at a lower rate. These two adverse consequences when mortgage rates
decline are referred to as contraction risk.

Now let’s look at what happens if mortgage rates rise to 12%. The price of the pass-through, like
the price of any bond, will decline. But again it will decline more because the higher rates will tend

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to slow down the rate of prepayment, in effect increasing the amount invested at the coupon rate,
which is lower than the market rate. Prepayments will slow down because homeowners will not
refinance or partially prepay their mortgages when mortgage rates are higher than the contract rate
of 9%. Of course, this is just the time when investors want prepayments to speed up so that they
can reinvest the prepayments at the higher market interest rate. This adverse consequence of rising
mortgage rates is called extension risk.

(c) Why would a pass-through with a WAM of 350 months be an unattractive investment for
a savings and loan association?

Prepayment risk makes pass-through securities unattractive for certain financial institutions to
hold from an asset-liability perspective. Thrifts and commercial banks want to lock in a spread
over their cost of funds. Their funds are raised on a short-term basis. If they invest in fixed-rate
pass-through securities with a WAM of 350 months (over 29 years), they will be mismatched
because a pass-through is a longer term security. In particular, a savings and loan association and
other depository institutions are exposed to extension risk when they invest in pass-through
securities. When interest rates rise investors will not refinance their homes.

25. Answer the below questions.

(a) Distinguish between a TBA and specified pool trade.

Pass-throughs are quoted in the same manner as U.S. Treasury coupon securities. They are
identified by a pool prefix and pool number. Many trades occur while a pool is still unspecified,
and therefore no pool information is known at the time of the trade. This kind of trade is known as
a “TBA” (to be announced) trade. The seller has the right in this case to deliver pass-throughs
backed by pools that satisfy the PSA requirements for good delivery.

(b) What delivery options are granted to the seller in a TBA trade?

When an investor purchases, say, $1 million GNMA 8s on a TBA basis, the investor can receive up
to three pools, with pool numbers being announced shortly before the settlement date. Three pools
can be delivered because the PSA has established guidelines for standards of delivery and
settlement of mortgage-backed securities, under which TBA trade permits three possible pools to
be delivered. The option of what pools to deliver is left to the seller, as long as selection and
delivery satisfy the PSA guidelines. In contrast to TBA trades, a pool number may be specified. In
this case the transaction will involve delivery of the pool specifically designated.

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