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
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
Payments are made to the security holders each month. However, neither the amount nor the
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
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
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.
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.
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.
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
Estimating the cash flow from a pass-through requires making an assumption about future
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
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:
Single-Monthly Mortality Rate and Monthly Prepayment
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.
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.
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
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
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
©2013 Pearson Education
239
shorthand enabling market participants to quote yield and/or price, but as a convention in
deciding 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.
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
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
Rate/Term Refinancing Component
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
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.
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
semiannual cash flow yield; that is,
©2013 Pearson Education
241
bond-equivalent yield = 2[(1 + yM)6 – 1].
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
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.
Average Life
The average life of a mortgage-backed security is the average time to receipt of principal
1
12(total principal)
t
=
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.
©2013 Pearson Education
242
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 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
KEY POINTS
• The residential mortgage-backed securities market is divided into two sectors: agency MBS
and nonagency MBS.
• 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
• 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
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
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
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
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
3. What are the two types of private–label MBS?
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
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
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
©2013 Pearson Education
246
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.
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
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
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.
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?
8. While 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.
9. What are the different types of agency pass-through securities?
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
©2013 Pearson Education
248
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.
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:
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