1. Global Edition Chapter 11
 Agency Mortgage Pass-Through Securities 1

2. Learning Objectives After reading this chapter, you will understand
what a mortgage-backed security is
the different sectors of the residential mortgage- backed securities market
what a mortgage pass-through security is
the cash flow characteristics of mortgage pass- through securities
the importance of prepayment projections in estimating the cash flow of a mortgage pass-through security
the weight average contract rate and weighted average maturity of a pass-through security
the different types of agency pass-through securities

3. Learning Objectives (continued)
After reading this chapter, you will understand
what the Public Securities Association prepayment benchmark is and how it is used for determining the cash flow of a pass-through security
the factors that affect prepayments for agency mortgage-backed securities
what the cash flow yield is and its limitations
how the average life of a mortgage pass-through security is calculated
why prepayment risk can be divided into contraction risk and extension risk
the market trading conventions of mortgage pass- through securities

4. Sectors of the RMBS 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
loans that satisfy the underwriting standard of Ginnie Mae, Fannie Mae, and Freddie Mac (i.e., conforming loans)
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.

5. Sectors of the RMBS Market (continued)
All of the prime and subprime 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)
agency stripped MBS

6. Sectors of the RMBS Market (continued)
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.
While Exhibit 11-1 (see Overhead 11-7) provides a summary of the RMBS market, in recent years, there have been issuances of agency MBS where the loan pool consists of subprime loans.

7. Subprime Mortgage Loan
Exhibit Breakdown of Residential Mortgage Loan Market and the Sectors of the RMBS Market
Residential
Mortgage
Loan
Agency MBS
Prime Mortgage Loan
Subprime Mortgage Loan
Conforming Loans
Private Label MBS
“Prime Deals”
“Residential Deals”
RMBS
Nonconforming Loans
Residential Mortgage Loan Market
Nonagency MBS
Subprime MBS
“Mortgage-Related
Asset-Backed Securities”
b. Sectors of the RMBS Market

8. 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.

9. General Description of an Agency Mortgage Pass-Through Security (continued)
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.

10. General Description of an Agency Mortgage Pass-Through Security (continued)
Payments of a pass-through security are made 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.

11. General Description of an Agency Mortgage Pass-Through Security (continued)
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).

12. Issuers of Agency Pass-Through Securities
Agency pass-through securities are issued by
i. Governmental National Mortgage Association (Ginnie Mae)
ii. Federal National Mortgage Association (Fannie Mae)
iii. Federal Home Loan Mortgage Corporation (Freddie Mac)
The pass-through securities that they issue are referred to as:
i. Ginnie Mae Mortgage-Backed Securities (MBS)
ii. Fannie Mae Guaranteed Mortgage Pass-Through
iii. Certifications (MBS)
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.

13. Issuers of Agency Pass-Through Securities (continued)
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.”

14. Issuers of Agency Pass-Through Securities (continued)
Ginnie Mae
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.
The next overhead summarizes the differences between the two Ginnie Mae programs.

15. Summary of the Differences between Ginnie Mae Programs
Issuers of Agency Pass-Through Securities (continued)
Summary of the Differences between Ginnie Mae Programs
Ginnie Mae I Program
Ginnie Mae II Program
All mortgages in the pool must have the same note rate.
The note rates for the mortgages in the pool may vary.
The securities issued must have a fixed interest rate.
Some of the securities issued may have an adjustable interest rate.
There is a single issuer who forms the pool.
There may be a single issuer or multiple issuers.

16. Issuers of Agency Pass-Through Securities (continued)
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
buying MBS

17. Issuers of Agency Pass-Through Securities (continued)
Fannie Mae and Freddie Mac
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.

18. 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.

19. Prepayment Conventions and Cash Flow (continued)
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:
Federal Housing Administration (FHA) experience
the conditional prepayment rate
the Public Securities Association (PSA) prepayment benchmark
The first convention is no longer used.

20. Prepayment Conventions and Cash Flow (continued)
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.
It is referred to as a conditional rate because it is conditional on the remaining mortgage balance.

21. Prepayment Conventions and Cash Flow (continued)
Conditional Prepayment 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

22. Prepayment Conventions and Cash Flow (continued)
Single-Monthly Mortality Rate
SMM Example. Suppose that the CPR used to estimate prepayments is 6%. The corresponding SMM is what?
Using our formula to determine the SMM for a given CPR, we get:
SMM = 1 – (1 – CPR)1/12 = 1 – (1 – 0.06)1/12 
SMM = 1 – (0.94) =

23. Prepayment Conventions and Cash Flow (continued)
SMM 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.
That is, prepayment for month t =
SMM × (beginning mortgage balance for montht –
scheduled principal payment for montht)
EXAMPLE. Suppose that an investor owns a pass-through in which the remaining mortgage balance at the beginning of some month is $290 million. Assuming that the SMM is % and the scheduled principal payment is $3 million, the estimated prepayment for the month is
($290,000,000 – $3,000,000) = $1,476,041

24. Prepayment Conventions and Cash Flow (continued)
PSA 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 with seasoning
The PSA benchmark assumes the following CPRs for 30-year mortgages:
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
a 6% CPR for the remaining years
The benchmark, referred to as “100% PSA” or simply “100 PSA,” is depicted graphically in Exhibit 11-5 (see Overhead ).

25. Exhibit 11-5 Graphic Depiction of 100 PSA6 30
Annual CPR Percentage
100% PSA
Mortgage Age (Months)

26. Prepayment Conventions and Cash Flow (continued)
PSA Prepayment Benchmark
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.
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

27. Prepayment Conventions and Cash Flow (continued)
Beware of Convention
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 value it has many limitations.

28. Factors Affecting Prepayments and Prepayment Modeling
A prepayment model is a statistical model 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.

29. Factors Affecting Prepayments and Prepayment Modeling (continued)
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
seasoning effect,
housing price appreciation effect, and
seasonality effect.

30. Factors Affecting Prepayments and Prepayment Modeling (continued)
Housing Turnover Component
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.
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.

31. Factors Affecting Prepayments and Prepayment Modeling (continued)
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.

32. Factors Affecting Prepayments and Prepayment Modeling (continued)
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 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.

33. Factors Affecting Prepayments and Prepayment Modeling (continued)
Rate/Term Refinancing Component
The refinancing decision is not based solely on the mortgage rate relative to the prevailing market rate but a host of other borrower circumstances.
This is reflected in the S-curve for prepayments, which is graphically illustrated in Exhibit 11-8 (see Overhead 11-34).
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 refinancing rate/term refinancing.
This is because the S-curve fails to adequately account for two dynamics of borrower attributes that impact refinancing decisions:
the burnout effect
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.

34. Exhibit 11-8 Example of an S-Curve for Prepayments
WAC / Mortgage Age
CPR (%) 40
1.1 20 60
1.0
1.2
1.3

35. 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 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]

36. Cash Flow Yield (continued)
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.

37. Cash Flow Yield (continued)
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.

38. Cash Flow Yield (continued)
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:
where T is the number of months.
The average life of a pass-through depends on the PSA prepayment assumption.
To see this, the average life is shown in Exhibit 11-9 (see Overhead 11-39) for different prepayment speeds for the pass-through used in the text to illustrate the cash flow for 100 PSA and 165 PSA.

39. Exhibit 11-9 Average Life or-a-Pass-Through Based on Different PSA Prepayment Assumptions
PSA speed 50
100
165
200
300
Average life
15.11
11.66
8.76
7.68
5.63
400
500
600
700
4.44
3.68
3.16
2.78

40. 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.

41. Prepayment Risk and Asset / Liability Management (continued)
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.

42. Secondary Market Trading
Pass-throughs are quoted in the same manner as U.S. Treasury coupon securities.
A quote of means 94 and 5/32nds of par value, or % 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.

43. 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.

44. Key Points (continued)
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.

45. Key Points (continued)
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.
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.