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 sectors are referred to as agency RMBS, and the third one is referred as non-agency RMBS.
There are specific underwriting standards such as the maximum size of the loan, the loan documentation needed, 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 sell shares – often called participation certificates. A pool can consist of several thousand 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 security holders each month. 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 investor receives is said to be “net interest” or “net coupon”. As a result, for each mortgage pass-through security, a weighted average coupon rate and a weighted average maturity are determined. The weighted average coupon (WAC) is the weighted-average interest rate of mortgages that underlie a mortgage-backed security (MBS) at the time the securities were 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. Just like MBSs, CMOs are subdivided into tranches that vary in interest and risk based on the maturity structure of the mortgages. Collateralized mortgage obligations offer investors an opportunity to profit from a diversified, and therefore risk-reduced, set of mortgage-backed securities.
Suppose that there are 3 different mortgages of $100 million, $150 million, and $200 million respectively in a mortgage pool. The remaining maturities are 200 months, 240 months, and 320 months. What is the weighted average maturity (WAM)?
A. 250 months
B. 260 months
C. 267 months
The correct answer is C.
The weights are (100/450 × 200) + (150/450 × 240) + (200/450 × 320) = 267 months.
Reading 45 LOS 45e:
Describe types and characteristics of residential mortgage-backed securities including mortgage pass-through securities and collateralized mortgage obligations, and explain the cash flows and risks for each type