Charta is on Google Play: practise on the go. Get the app
Charta

Outline how mortgage-backed securities (MBS) are created through securitization, especially how mortgage pools are formed, including specific pools and to-be-announced (TBAs).

FRM® Part I · Financial Markets and Products · Mortgages and Mortgage-Backed Securities · FRM1.FM.18.c

The idea

Securitization turns pools of mortgage loans into tradable securities. Lenders sell loans to an agency or other issuer, which groups similar loans into a pool and issues pass-through certificates. These give investors a pro rata share of the pool's interest, scheduled principal and prepayments. Coupon = weighted average coupon − servicing and guarantee fees. Ginnie Mae securities carry the explicit guarantee of the US government, while Fannie Mae and Freddie Mac are government-sponsored enterprises. A specified pool is a particular identified pool, which can trade at a pay-up over the generic price when its loans prepay favourably, for example because balances are small. A TBA trade is a forward contract for a generic pool defined by agency, maturity and coupon, with the actual pools announced shortly before settlement. The exam point is that a TBA seller delivers the least valuable eligible pools.

Formulas

Pass-through coupon paid to investors

investor coupon = WAC − servicing fee − guarantee fee

WAC
the pool's weighted average coupon
servicing fee
the annual fee kept by the servicer
guarantee fee
the annual fee kept by the agency guarantor

Monthly interest to the investor is this coupon ÷ 12 on the current balance, not the gross rate borrowers pay.

A practice question

From the question bank, with the reason each wrong option is wrong.

What does an investor in an agency pass-through security receive?

  1. A pro rata share of interest net of fees, scheduled principal and prepayments each month. - correct
  2. A fixed coupon on the original balance, with all principal repaid in one payment at maturity.Why not: Describes a bullet bond; a pass-through pays principal monthly.
  3. Only the interest on the loans, with principal retained by the servicer until maturity.Why not: Confuses a pass-through with an interest-only strip; principal is passed through too.
  4. The gross mortgage rate paid by borrowers, including the servicing fee.Why not: The investor receives the net pass-through coupon after servicing and guarantee fees.

A pass-through passes through the borrowers' payments after servicing and guarantee fees. Principal arrives gradually as scheduled amortization and prepayments, not at maturity.

A harder one

A pool of loans has a weighted average coupon of 4.75%. The servicing fee is 0.25% and the guarantee fee is 0.50%. The pass-through coupon paid to investors is:

  1. 5.50%Why not: Adds the fees to the WAC instead of subtracting them.
  2. 4.00% - correct
  3. 4.25%Why not: Subtracts only the guarantee fee and forgets the servicing fee.
  4. 4.50%Why not: Subtracts only the servicing fee and forgets the guarantee fee.

Investor coupon = WAC - servicing fee - guarantee fee = 4.75% - 0.25% - 0.50% = 4.00%.

The hardest tier

A buyer wants a specified pool with an original face of USD 30 million and a current face of USD 20 million. The TBA price is 101-16 (in 32nds) and the pool trades at a pay-up of 8/32 over TBA. The principal amount paid, excluding accrued interest, is closest to:

  1. USD 30,525,000Why not: Applies the price to the original face instead of the current face.
  2. USD 20,316,000Why not: Reads the 8/32 pay-up as 0.08 of a point instead of 0.25.
  3. USD 20,350,000 - correct
  4. USD 20,300,000Why not: Omits the pay-up and pays only the TBA price on current face.

Price = 101 + 16/32 + 8/32 = 101.75. Payment is on current face: 20,000,000 x 1.0175 = 20,350,000.

In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.

Start free →

More in Mortgages and Mortgage-Backed Securities