Residential Mortgage-backed Securities

The bonds created from the securitization of mortgages are called residential mortgage-backed securities (RMBS). In the US, securities backed by residential mortgages are divided into 3 groups:

• those guaranteed by a federal agency;
• those guaranteed by a GSE (government-sponsored enterprises such as Fannie Mae and Freddie Mac); and
• those issued by private entities.

The first 2 groups are referred to as agency RMBS, and the third is referred to as non-agency RMBS.

There are specific underwriting standards such as the maximum size of the loan, the requisite loan documentation, and the maximum loan-to-value ratio. If a loan satisfies the underwriting standards for inclusion as collateral for an agency RMBS, it is a conforming mortgage. If a loan fails to satisfy the underwriting standards, then it is a non-conforming mortgage.

Mortgage Pass-Through Securities

A mortgage pass-through security is a security created when a pool of mortgages sells shares – often called participation certificates. A pool can consist of thousands of mortgages. The cash flows of such securities depend on the cash flows of the underlying pool of mortgages, and these payments are made to securityholders each month. However, these cash flows are usually reduced by the “service and other administrative fees” of the mortgages.

Weighted Average Coupon and Weighted Average Maturity

The pass-through rate the investor receives is said to be “net interest” or “net coupon.” As a result, a weighted average coupon rate and a weighted average maturity are determined for each mortgage pass-through security. The Weighted Average Coupon (WAC) is the weighted-average interest rate of mortgages that underlie a mortgage-backed security (MBS) when the securities are issued. It represents the average interest rate of a pool of mortgages with varying interest rates. The Weighted Average Maturity (WAM) is simply the weighted average amount of time until the maturity of the MBS.

Collateralized Mortgage Obligations

A Collateralized Mortgage Obligation (CMO) is a fixed income security that uses mortgage-backed securities as collateral. Like MBSs, CMOs are subdivided into tranches whose interest and risk vary depending on the maturity structures of the mortgages. Collateralized Mortgage Obligations offer investors an opportunity to profit from a diversified, and therefore risk-reduced, set of mortgage-backed securities.

Question

Assume that there are 3 different mortgages of $100 million, $150 million, and $200 million , in that order, in a mortgage pool. The remaining maturities are 200 months, 240 months, and 320 months. What is the weighted average maturity (WAM)?

1. 250 months
2. 260 months
3. 267 months

Solution

The correct answer is C.

The weights are:

$$\left(\frac{100}{450} × 200\right) + \left(\frac{150}{450} × 240\right) + \left(\frac{200}{450} × 320\right) = 267\  \text{months.}$$