Mortgage-Backed Securities (MBS) - Pass-Through Mechanics
Now that you know which agencies issue MBS, let's examine how pass-through securities actually work and the unique risks they carry.
How Pass-Through Securities Work
A lender pools mortgage loans and sells interests (certificates) in the pool to investors. Each investor owns a pro rata share of all principal and interest payments from the pool.
Monthly payments consist of three components:
- Scheduled interest on the outstanding principal balance
- Scheduled principal (amortization), the normal paydown of the mortgage
- Prepayments, unscheduled principal payments from borrowers who pay off loans early, refinance, or sell homes
The pass-through rate (coupon received by investors) is lower than the rate charged to borrowers. The difference covers servicing and guarantee fees.
Example: If borrowers pay 6.5% on their mortgages and the servicing/guarantee fee is 0.5%, investors receive a 6.0% pass-through rate.
Exam Tip: Gotchas
- MBS pay monthly, not semiannually like Treasuries.
- The pass-through rate is LOWER than the mortgage rate (servicing fees are deducted). The exam may ask which rate investors receive.
Prepayment Risk
Prepayment risk is the primary risk unique to MBS and has two distinct components:
Contraction Risk
- Occurs when interest rates fall
- Borrowers refinance at lower rates, returning principal to investors sooner than expected
- Investors must reinvest the returned principal at lower prevailing rates
- The MBS "contracts" (shortens) in average life
Extension Risk
- Occurs when interest rates rise
- Borrowers hold onto their existing low-rate mortgages longer, returning principal later than expected
- Investors are locked into below-market yields while rates have risen
- The MBS "extends" (lengthens) in average life
| Scenario | Interest Rates | Borrower Behavior | Effect on MBS Investor |
|---|---|---|---|
| Contraction | Fall | Refinance/prepay faster | Principal returned early; must reinvest at lower rates |
| Extension | Rise | Hold mortgages longer | Principal returned late; locked into below-market yield |
Think of it this way: Contraction and extension are two sides of the same coin. When rates drop, borrowers rush to refinance and you get your money back too soon (contraction). When rates rise, borrowers stay put and you are stuck waiting (extension). Either way, the timing works against you.
Exam Tip: Gotchas
- Prepayment risk is NOT the same as default risk. Prepayment risk is about timing (when you get paid), not whether you get paid.
- Contraction = rates fall = principal returned early. Bad for investors wanting steady income.
- Extension = rates rise = principal returned late. Bad for investors wanting liquidity or higher yields.
Weighted Average Life (WAL)
Because prepayment speeds are unpredictable, mortgage-backed securities have an uncertain duration:
- Traditional maturity dates are unreliable since borrowers can prepay at any time
- Weighted average life (WAL) is used instead of maturity to estimate when principal will be returned
- WAL changes as prepayment speeds change
Other MBS Risks
- Interest rate risk: Like all bonds, MBS prices fall when rates rise.
- Reinvestment risk: Monthly cash flows must be reinvested; in a falling-rate environment, reinvestment rates are lower.
- Credit risk: Minimal for Government National Mortgage Association (GNMA) securities (full government guarantee); low for Federal National Mortgage Association (FNMA) and Federal Home Loan Mortgage Corporation (FHLMC) securities (government-sponsored enterprise implied guarantee); varies for private-label MBS.
Exam Tip: Gotchas
- Only GNMA carries a full U.S. government guarantee. FNMA and FHLMC are government-sponsored enterprises (GSEs) with an implied guarantee, not an explicit one.