# The Risks of Mortgage-Backed Securities

A mortgage or a group of mortgages serves as the security for a mortgage-backed securities (MBS), a form of asset-backed security. A broker may be used to trade MBS. It is either issued by a government-sponsored enterprise (GSE), a federal government agency with authorization, or a private financial institution.

## Features of MBS

Despite being appealing for a variety of reasons, MBS have several special characteristics that increase risk when compared to standard bonds.

- Residential mortgages form the pool used as security for MBS.
- A third-party investor receives monthly payments after “passing through” the source bank.
- In addition to monthly interest payments, mortgages amortize over the course of their life, which means that a portion of the principle is paid off with each payment, as opposed to a bond, which typically pays the whole total at maturity.
- Investors also get unplanned principal prepayments resulting from refinancing, foreclosure, and home sales on a pro rata basis in addition to scheduled amortizations. Even though the average mortgage has a length of 30 years, they are often paid off considerably sooner. Predicting the maturity of the MBS is challenging because of these unforeseen prepayments.

This article will introduce the idea of weighted average life (WAL) and describe how it is used to mitigate prepayment risk with a focus on the prepayment component of MBS.

## What Is Weighted Average Life?

The WAL, which is also referred to as simply “average life,” is a metric that is often employed as a gauge of an MBS’s effective maturity. The WAL is calculated by multiplying the date of each payment (represented as a fraction of years or months) by the percentage of the total principal that is paid off at that date. The results are then added. The WAL therefore tracks the effect of principal paydowns during the security’s tenure.

On a timeframe that extends from the date of origination to the eventual maturity date, the WAL may be seen as the pivot point. Similar to how children of various weights balance a seesaw by having varying placements on the bar, the fulcrum “balances” the principal payments. For a 30-year mortgage pool, the WAL is shown in Figure 1 below.

Image by Sabrina Jiang © Investopedia2021

## Yields and the Internal Rate of Return

Based on changes in the rates in the present market, MBS are marketable and may trade at premiums, discounts, or par value. A current-coupon pass-through trades at par, but high-coupon pass-throughs and low-coupon securities trade at premiums and discounts, respectively. The internal rate of return, which equalizes the present value of all future cash flows with the security’s current price, is known as the quoted yield. As a result, a prepayment assumption is always a prerequisite for the stated yield on an MBS.

For mortgage pass-through securities, the prepayment assumption is essential. Investors are aware that prepayment is possible and will happen, but they are unsure of the timing and amount. These factors need to be predicted and taken for granted. Due to the asymmetric impact, where premium MBS have an incentive to prepay more rapidly and cheap MBS have the opposite motivation, there is no single, conservative assumption that can be applied to all pass-throughs.

## What Is the Realized Yield?

In contrast to the expected prepayments that were utilized to determine the stated yield, the realized yield on a pass-through security refers to the yield that the purchaser actually gets while owning the instrument. Prepayments that occur quicker or slower than anticipated have an unbalanced impact on the premium and discount pass-throughs.

Let’s say the pass-through security is trading for more than it is worth. Cash flows from prepayments at par value can only be reinvested at the current rate since it is lower. Therefore, faster-than-anticipated prepayments deprive the investor of the strong cash flows that originally supported the premium price. Slower prepayments, on the other hand, provide the investor more time to recoup the higher coupon rate. Therefore, delayed prepayments increase realized yield above stated rate, and quicker prepayments decrease realized yield.

Faster than expected prepayments benefit a discount pass-through since such cash flows may be reinvested at par in current-coupon securities. Since the prepayment is at par, the investor may effectively swap the low coupon for a higher one. The actual yield will thus be higher than the advertised yield. In contrast, when prepayments are slower than anticipated, the opposite occurs. The longer the investor is forced to hold the lower coupons, the lower the realized yield will be.

## What Is the Prepayment Assumption?

Many common specifications of assumed prepayment rates have been produced throughout the years. Every one has benefits and drawbacks.

### Standard Mortgage Yield

The first and easiest specification is to use “prepaid in 12” or the “normal mortgage yield.” Prior to the twelfth year, when all of the mortgages in the pool payback in full, there are expected to be no prepayments at all in this specification.

The effective maturity of the majority of mortgage pools is far shorter than the ultimate maturity date, hence this specification has the benefit of being computationally simple and conforming to this reality. There isn’t much more that can be offered to support this supposition. The early prepayments made by a mortgage pool are completely ignored. The potential yield on a pass-through instrument trading at a significant discount is thus considerably understated by a yield computed and quoted on the basis of this “normal” prepayment assumption, while the potential yield on a premium pass-through is grossly overstated.

### FHA Experience Method

A prepayment definition that is based on real-world Federal Housing Administration experiences is at the opposite extreme of the range (FHA).On the mortgage loans it insures, the FHA gathers historical statistics on the actual incidence of prepayment. This information includes a broad variety of coupon rates and origination dates.

Since it included reasonable and historically supported assumptions, the FHA experience approach was undoubtedly an improvement over the normal mortgage yield, but it was not without its own issues. The secondary mortgage market encountered the difficult situation of having securities based on series from various years since the FHA releases a new series virtually every year.

### Constant Prepayment Rate

The constant prepayment rate (CPR), often referred to as the “conditional prepayment rate,” is another definition that has been used. This specification makes the assumption that the proportion of the main balance that is paid off each year is a fixed amount.

Because the appropriate prepayment rate for each year is a one constant figure rather than one of 30 different variables, the CPR technique is simpler to analyze than the FHA experience. As a result, comparing stated yields for a certain holding term under various prepayment assumptions is simpler. The CPR technique has the non-obvious benefit of making the subjective character of the prepayment assumption clear. The FHA experience method suggests a level of accuracy that may be wholly irrational.

A CPR version is known as “single-monthly mortality” (SMM).Simply said, the SMM is the yearly CPR’s monthly equivalent. It is based on the assumption that the proportion of the principal amount that is paid off each month remains constant.

### PSA Standard Prepayment Model

The typical prepayment experience provided by the Public Securities Association (PSA), an industry trade body, is the prepayment rate assumption that is most often employed. The PSA’s objective was to standardize the industry. For the first 30 months of the normal prepaid experience, a CPR that starts at zero and increases by 0.2% each month is required; beyond that, a CPR of six percent is utilized. However, yields are sometimes predicated on a prepayment assumption that is quicker or slower than this norm. A percentage above or below 100% is used to signify this change in prepayment assumption.

- An MBS reported at 200%PSA implies an initial 30-month CPR spike of 0.4%CPR per month, followed by a level CPR of 12%.
- When an MBS is quoted at 50%PSA, it is assumed that the CPR will climb by 0.1% per month until it reaches a level of 3%.

## The Bottom Line

As was said, employing weighted average life is far from accurate and entails a lot of assumptions. However, it aids in reducing the inherent prepayment risk by assisting investors in making more accurate forecasts about the yield and term of an MBS.

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