Mortgage Pass-through Securities: Characteristics and Risks

Pass-through Rate = Mortgage Rate - Service Fee

• Note that while mortgage payments are due on the first of the month, investors do not receive the pass-through payment for several days thereafter, enabling the servicing institution to collect several days worth of interest (which is called the "float").

• WAC = weighted average coupon rate of the mortgages in the security pool

• WAM = weighted average of maturity of the mortgage in the security pool

Pass-through Types

• Agency Pass-throughs: Guaranteed by U.S. government agencies (Fannie Mae, Freddie Mac, and Ginnie Mae).

• Technically, Fannie Mae and Freddie Mac pass-throughs are corporate and do not carry the full faith and credit of the U.S. government, but there has been considerable debate over the "implied backing" of these securities.

• Mortgage Pass-throughs: Issued by Ginnie Mae and Fannie Mae

• Participation Certificates: Issued by Freddie Mac

• Conforming Mortgages: Meet standards to obtain agency backing

• Jumbo Mortgages: Mortgages that do not qualify for agency backing because of their size (too large)

• Non-agency Pass-throughs: Are issued by private financial institutions and do not have the backing of a government agency; the mortgages in a non-agency pass-through are usually non-conforming.

Risks of Mortgage Pass-through Securities

• Interest Rate Risk: As rates rise, the security's value will fall.

• Prepayment Risk: Because mortgages can usually be prepaid at any time without penalty, mortgages essentially take the form of a callable bond that has a strike price at par.

• Prepayments are unpredictable, but directionally they increase as interest rates fall and decrease as interest rates rise.

• Prepayment risk is form of reinvestment risk, as the investor will be forced to re-invest at lower interest rates.

• MBS securities exhibit negative convexity as a result of the ability to prepay.

• Credit Risk: Agency securities tend to have low credit risk.