CHAPTERS 9, 10, & 11:

FINANCING HOME
OWNERSHIP
Real Estate Principles: A Value Approach
Ling and Archer
Outline
■ Nature of financing home ownership
■ Notes and mortgage
■ Mortgage products
■ Mortgage markets – primary
■ Mortgage markets – secondary
Financing home ownership
■ Real estate transactions involve debt financing. Most homebuyers
lack the cash to purchase their residence outright,
■ Most businesses want their cash available in their core
business rather than tied up in real estate.
■ Most investors want to “leverage” their investment to increase
equity returns or acquire more assets for greater diversification.
■ In addition, many homeowners find that their best source of
financing for household needs is a credit line loan secured by their
house.
Mortgage loan
 In a mortgage loan, the borrower always conveys two
documents to the lender: (1) a note, and (2) a mortgage.
 The note details the financial rights and obligations between
borrower and lender, e.g., whether a loan can be paid off early
and at what cost, what fees can be charged for late payments,
etc.
 The mortgage pledges the property as security for the debt.
The note
■ Several aspects of a mortgage note are important for a borrower to
understand-
■ Computation of the interest rate (if adjustable)
■ whether a loan can be paid off early
■ whether there is personal liability for a mortgage
■ what fees can be charged for late payments
■ whether the loan must be repaid upon sale of the property
■ The borrower should know whether the lender has the right to
terminate the loan, calling it due
 The note: Interest charges
■ Interest rates can be fixed or variable.
■ The monthly interest rate = the annual stated contract interest rate / 12.
■ The actual monthly interest charged = the monthly interest rate × the
beginning-of-month balance.
■ Example: suppose that the contract rate is 6%. The balance on the first day of
January is $100,000.
■ The interest for January is: (6% / 12) × $100,000 = $500.
■ The $500 interest is payable on the first day of February.
 The note: adjustable rates, I
■ This loan type is known as ARM (adjusted rate mortgage) in the residential
loan markets.
■ The “ index rate” is a market determined interest rate that is the moving
part in the adjustable interest rate.
■ There is a markup in the adjustable rate, called “ margin.” For standard
ARM loans, the average margin is about 2.75%.
■ Whenever there is a change in interest rate, home mortgage lenders usually
need to notify borrowers at least 30 days in advance.
 The note: adjustable rates, II
■ Periodic cap: the cap that limits change in the interest rate from one
change date to the next.
■ Overall cap: the cap that limits interest rate change over the life of the
loan.
■ Teaser rate: many ARM loans are marketed with a temporarily reduced
interest rate.
■ Payment cap: some lenders offer ARM loans with a cap on payments
rather than on the interest rate. For example, the payment can be capped
at increases of no more than 5% in a single year. However, the unpaid
interest would usually added to the original balance, causing the loan
balance to increase (i.e., negative amortization).
 Negative amortization
■ For example, the monthly mortgage payment on a 30-year fixed-rate loan of
$100,000 at 6% is $600 (rounded). In the first month, the interest due the
lender is $500, which leaves $100 for amortization. The balance at the end of
month one would be $99,900.
■ Suppose that for some reason, your
mortgage payment in the first month was
only $400. Then there would be a shortfall in the interest payment, which
would be added to the loan balance. At the end of month one you would owe
$100,100.
■ In effect, the lender has made an additional loan of $100, which is added to
the amount you already owe.
■ When the payment does not cover the interest, the resulting increase in the
loan balance is called as negative amortization.
The note: payments

 Most standard, fixed loans are level payment and fully

amortizing. That is, zero balance at the maturity.
 Loans can be non-amortizing. That is, only periodic
(monthly) interest payments are made. The principal
payment is required at the maturity.
 A loan can also be partially amortizing or negatively
amortizing.
The mixture of the payments
Shows the pattern
of interest and
principal payments
on a fixed rate, 30-
year, level
payment, fully
amortizing loan.
Notice that the
payment is largely
interest for about
the first half of the
loan life before it
begins to decline.
 The note: term
■ Most loans have a definite term to maturity, usually stated in years.
❶ term for amortization: determines the payment, and the schedule of
interest and principal payments, just like a fully amortized loan,
❷ term to maturity: determines when the entire remaining balance
on the loan must be paid in full. (2) is shorter. Known as balloon
loan.
■ Balloon loans are popular for income-generating property.
 The note: right of prepayment
 Most standard home loans give the borrower the right to prepay any
time, without penalty.
 If the note says nothing about the right of prepayment, the
determination of the right will depend on the law of the country.
 Many subprime loans, those made to homeowners who do not
qualify for standard loans, have costly prepayment penalties.
 Commercial loans also often have repayment penalties that are more
costly for the first few years of the loan.
The note: late fees

 They are usually accessed on payments received after

the 15th of the month the payment is due.
 Late fees are usually about 4-5% of the late monthly
payment.
The note: personal liability
 For home loans, borrowers usually assume personal
liability. That is, if they fail to meet the terms of the
note, they are in the condition of default, and can be
sued.
 These loans are called recourse loans because the
lenders have legal recourse.
 For commercial loans, borrowers frequently do not
assume personal liability. But the property is still used
as collateral for the loan.
The mortgage
 The mortgage is a special contract by which the borrower
(mortgagor) conveys to the lender (mortgagee) a security
interest in the mortgaged property.
 In general, the mortgage gives the lender the right to rely
on the property as security for the debt obligation defined
in the note, but this right only can be exercised in the event
of default on the note.
The mortgage: clauses, I
The major clauses in a standard home loan mortgage:
❶ Description of the property.
❷ Insurance clause: requires the maintenance of
property casualty insurance against fire, windstorm,
etc.
❸ Escrow clause: requires a borrower to make monthly
deposits into an escrow account for property taxes,
casualty insurance premiums, etc.
The mortgage: clauses, II
❹ Acceleration clause: enables the lender to declare the
entire loan balance due and payable when the borrower
defaults on the loan.
❺ Due-on-sale clause: gives the lender the right to
accelerate the loan, requiring the borrower to pay it off
when the property is sold.
❻ Hazardous substances clause and preservation and
maintenance clause: the borrower is prohibited from
using or storing hazardous substances on the property
and is required to maintain the property in its original
condition.
When things go wrong: Default
 Default: failure to meet the requirements of the note
(and the mortgage).
 Technical defaults: minor violations of the note that do
not disrupt the payments on the loan.
 Example: hazard insurance no longer good.
 These usually do not trigger legal actions.
 Substantive defaults: when payments are missed,
typically for 90 days. In this case, the ultimate
response is the process of foreclosure.
Possible responses to default
 Lenders may help borrowers improve their household financial
management, e.g., credit counseling, a temporary reduction of
payments, facilitating the sale of the property; e.g., short sale.
 Short sale typically occurs at or below market value and is
successful only when the lien holder agrees to accept less than
what’s owed.
 Foreclosure: a legal process of terminating all claims of
ownership by the borrower, and all liens inferior to the
foreclosing lien.
 Foreclosure
 The ultimate recourse of the lender.
 Risk of failing to notify a claimant; it is sometimes difficult to
identify and notify all claimants to the property; legal
procedure need to be perfect.
 Presence of superior liens (senior debts).
 Costly and time consuming.
 Distressed, sub-optimal sale because legal complexities and
lower marketability often prevent buyers from debt financing.
In US law, a lis
pendens is a written
notice that a lawsuit
has been filed
concerning real
estate
2 methods of sale in foreclosure

 Judicial foreclosure: court-administered public auction.

 Power of sale: public auction conducted by trustee or

mortgagee (the lender)
 This method is preferred by lenders.
 Cheaper and faster.
Residential mortgage products
 Conventional mortgage loans
 (Fixed-rate) level-payment mortgages (LPMs)
 Adjustable rate mortgage (ARMs)
 Government-sponsored mortgage loans
 Federal Housing Administration (FHA)-insured loans
 Veteran Affairs (VA)-guaranteed loans
 Other mortgage products
 Home equity loan
 Interest-only mortgage
 Option ARMs
 And more
Conventional mortgage loans
 Any standard home loan that is not insured or guaranteed
by an agency of the U.S. government.
 Conventional mortgages can be either fixed rate (LPMs) or
adjustable rate (ARMs).
 Conventional mortgage loans can be conforming or
nonconforming. A conforming conventional loan is one
that meets the standards (e.g., $ limit) required for purchase
in the secondary market by Fannie Mae (Federal National
Mortgage Association) or Freddie Mac (Federal Home Loan
Mortgage Corporation).
LPMs vs ARMs
 LPMs
 Fixed monthly payments; no surprises.
 Over 75% of outstanding first mortgage home loans are LPMs.
 30-year LPMs are the predominant form of conventional loan.
 LPMs usually require a higher monthly payment.
 ARMs
 Payments are not fixed.
 ARMs tend to have a lower monthly payment; but this may not
always the case.
 Insured loans
 FHA insured loans
 The federal housing administration was established in 1934 to
stabilize the housing industry.
 FHA sells mortgage insurance to low-income households.
 FHA mortgage insurance covers any lender loss after foreclosure.
 VA-guaranteed loans
 The Department of Veterans Affairs provides VA-guaranteed loans that
help veterans obtain home mortgage loans with favorable terms.
 Home equity loan

 Some home equity loans are closed-end, fixed-term loans.

 Mostly open-end or credit-line loans.
 Tax deductible interest (in contrast, the interest expenses on
credit card loans are not tax deductible).
 Strength of the house as security provides favorable rate and
longer term.
 Usually limited to total mortgage debt (sum of all mortgage
loans) of 75% to 80% of value.
Interest-only (I-O) mortgage

 I-O with balloon has interest-only payments for 5 to 7

years, ending with a full repayment of principal.
 I-O amortizing has interest-only payments for up to 15
years, then converts to a fully amortizing payment for
the remainder of the term.
 Option ARMs
■ Typically, borrowers can select among 3 types of payments: fully
amortizing, interest-only, and a minimum payment.
■ Borrowers usually choose the minimum payment, which is initially based
on a very low interest rate: say, 1.5 %.
■ The payment would increase in yearly steps, but unpaid interest would
cause the balance to grow
■ Interest rate charged is adjustable, and often is deeply reduced for the first
few months.
■ Typically, with minimum payment, the loan balance grows due to
“ negative amortization.”
■ At the end of 5 years, or when the balance reaches 125% of the original
loan, the payment is recast to fully amortize the loan over its remaining
term.
Private mortgage insurance (PMI)
 Protect lender against losses due to default.
 Generally required for loans over 80% of value, i.e., loan-
to-value (LTV) > 80%.
 Protect lender for losses up to 20% of loan.
 Premium can be paid in lump sum or in monthly
installments. 2 possible terms:
 2.5 % of loan in single up-front premium.
 50 bp annual premium (4.1 bp per month).
 Termination may be allowed if loan falls below 80% of
current value and borrower is in good standing.
Mortgage markets
 Primary mortgage market: the loan origination market.
 For example, you go to a mortgage broker and get a
mortgage loan from a mortgage lender.
 Secondary mortgage market: investors and mortgage
originators buy and sell mortgage loan portfolios in the
secondary mortgage market.
 Fannie Mae and Freddie Mac are the largest buyer of
residential mortgages in the secondary market.
Primary market: depository lenders
 They are financial intermediaries.
 Pool small amounts of savings.
 Channel to large-scale uses (e.g.; mortgage loans).
 Types
 Savings associations (S&Ls, savings banks).
 Commercial banks.
 Credit unions.
Non-depository lenders: mortgage
companies
■ Mortgage banker: not a bank – accepts no deposits.
– Originates loans to sell.
– Often retains right to service the loan for a fee.
■ Mortgage broker: brings borrower and lender together
for a fee; never owns the loan.
Servicing: Mortgage banker
 Collects monthly payments, remits to investor (loan
buyer).
 Collects and remits payments for property taxes,
hazard insurance and mortgage insurance.
 Manages late payments, defaults, foreclosures.
 Receives fee of 25 to 44 bp.
Mortgage loan decisions (loan underwriting)

■ In order to decide whether a mortgage loan should be

sanctioned, lender’s consider few factors.
■ 3 “ Cs” of traditional residential underwriting:
– Collateral: Uniform Residential Appraisal Report
required.
– Creditworthiness: credit report and scoring.
– Capacity: ability to pay (payment ratios).
Capacity ratio, I

 Housing expense ratio = PITI / GMI.

 PITI is principal, interest, (property) taxes and
insurance.
 GMI is gross monthly income.
 Traditionally, maximum at 28% for conventional
mortgage loans.
Capacity ratio, II

■ Total debt ratio = (PITI + LTO) ÷ GMI.

■ LTO is long-term obligation: the sum of payments for
other repeating obligations, e.g., car leasing payments
and child support.
■ Traditionally maximum at 36% for conventional
mortgage loans.
 FICO
■ Credit scoring is used not only to determine whether credit should
be approved but also to determine the credit limits and rates.
■ The most widely used credit scores are FICO Scores, the credit
scores created by the Fair Isaac Corporation
■ The credit score FICO (maximum 850) has been widely used for
underwriting in recent years.
■ A FICO of above 720-730 gives one the best mortgage rate.
■ A FICO of above 660 is viewed as high quality (prime).
 Subprime lending

■ Many households are unable to qualify for “ affordable”

home loans.
■ Subprime targets three borrower deficiencies:
– Lack of income documentation.
– Weak credit score
– Seeking financing for 100% LTV or higher.
■ More expensive than standard home loans.
Securitization: Secondary mortgage market
■ Securitization is a process by which intangible and illiquid assets are monetized into
cash. Various types of contractual debts such as residential mortgages, commercial
mortgages, auto loans or credit card debt obligations are pooled and sold to 3rd party
investors as securities.
■ Fifty years ago, if you got a mortgage from a bank, it was very likely that the bank
would keep the loan on its balance sheet until the loan was repaid. That is no longer true.
Today, the party/bank that you deal with in order to get the loan (the originator) is highly
likely to sell the loan to a third party.
■ The third party can be Ginnie Mae, a government agency; Fannie Mae or Freddie Mac,
which are government sponsored entities (GSEs); or a private sector financial institution
(Goldman Sachs).
Why originators issue MBS (aka mortgage pass-through or just pass-
through)

■ Transform relatively illiquid, individual financial assets into

liquid and tradeable capital market instruments.
■ Allow mortgage originators to replenish their funds, which
can then be used for additional origination activities.
■ are frequently a more efficient and lower cost source of
financing in comparison with other bank and capital markets
financing alternatives.
■ allow issuers to diversify their financing sources, by offering
alternatives to more traditional forms of debt and equity
financing.
Mortgage-
backed
securities
(MBS)
Parties involved in MBS
■ Borrower. The borrower is responsible for payment on the
underlying loans and therefore the ultimate performance of
the asset/mortgage-backed security.
■ Originator. Originators create and often service the assets
that are sold or used as collateral for asset/mortgage-backed
securities.
■ Special purpose entity/Trustee. The SPE/trustee is a third
party retained for a fee to administer the trust that holds the
underlying assets supporting an asset-backed security.
Parties involved in MBS
■ Acting in a fiduciary capacity, the SPE/trustee is
– primarily concerned with preserving the rights of the
investor.
– The trustee oversees the disbursement of cash flows, and
monitors compliance with appropriate covenants by other
parties to the agreement.
– The trustee is responsible that the underlying assets produce
adequate cash flow to service the securities.
– The trustee is responsible for declaring an event of default or
an amortization even
Parties involved in MBS
■ Credit Enhancer. Credit enhancement is a method of
protecting investors in the event that cash flows from the
underlying assets are insufficient to pay the interest and
principal due for the security in a timely manner.
– Credit enhancement is used to improve the credit rating,
and therefore the pricing and marketability of the security.
■ Underwriter. The asset-backed securities underwriter is
responsible for advising the seller on how to structure the
security, and for pricing and marketing it to investors.
Parties involved in MBS
■ Investors. The largest purchasers of securitized assets are
typically
– pension funds,
– insurance companies,
– fund managers, and, to a lesser degree,
– commercial banks.

 The most compelling reason for investing in asset-backed

securities has been their high rate of return relative to other
assets of comparable credit risk.
 Agency MBS
■ There are three major types of pass-throughs, guaranteed by
three organizations:
■ Government National Mortgage Association (Ginnie Mae),
■ Federal Home Loan Mortgage Corporation (Freddie Mac), and
■ Federal National Mortgage Association (Fannie Mae).
■ These are called agency pass-through.
 Agency MBS
■ An agency can provide one of two types of guarantees:
1. One type of guarantee is the timely payment of both interest and
principal even if some of the mortgagors fail to make their monthly
mortgage payments. Pass-throughs with this type of guarantee are
referred to as fully modified pass-throughs.
2. The second type also guarantees both interest and principal payments,
but it guarantees only the timely payment of interest. The scheduled
principal is passed through as it is collected, with a guarantee that the
scheduled payment will be made no later than a specified date. Pass-
throughs with this type of guarantee are called modified pass-throughs.
 Cash flow of a mortgage pass-through
■ security
The cash flow of a mortgage pass-through security depends on the cash
flow of the underlying mortgages.
■ The cash flow consists of monthly mortgage payments representing
interest, the scheduled repayment of principal, and any prepayments.
Payments are made to security holders each month.
■ Neither the amount nor the timing, however, of the cash flow from the
pool of mortgages is identical to that of the cash flow passed through to
investors.
■ The monthly cash flow for a pass-through is less than the monthly cash
flow of the underlying mortgages by an amount equal to servicing and
other fees.
 Collateralized Mortgage Obligations
■ Pass-throughs does not fully address the different needs of investors for
instruments with various maturities. 
■ While pension funds and life insurance companies looked for securities with long
maturity, banks and thrifts wanted to invest in shorter term instruments. 
■ As an answer to those drawbacks and the demands of different types of investors,
Collateralized Mortgage Obligations (CMOs) were created.  CMOs provided less
uncertainty as to the average life of the investment, and they offered a full
spectrum of maturities that appeal to investors with different perspectives. 
■ The mortgage cash flows are distributed to investors by the MBS issuer based on a
set of predetermined rules.  Some investors will receive their principal payments
before others according to the schedule. 
 CMOs: Mechanics
■ The issuer structures the security in classes, called tranches, which are
retired sequentially.
■ With the payments from the underlying mortgages, the CMO issuer first
pays the coupon rate of interest to the all investors in each tranche. 
■ After that, all the principal payments are directed first to the bond class
with the shortest maturity. 
■ When the first bond class is retired, the principal payments are directed to
the bond class with the next shortest maturity. 
■ This process continues until all the tranches are paid fully and if there is
any collateral remaining, the residual may be traded as a separate
security. 
CMOs: Mechanics
■ In the figure below class A is the class with the shortest maturity. 
After class A is retired, principal payments go to class B.  The last
class D has the longest maturity.  The above described CMO is
known as sequential pay or plain vanilla CMO.
 Valuation of pass through securities
■ To value a pass-through security, it is necessary to project its
cash flow. The difficulty is that the cash flow is unknown
because of prepayments and defaults.
■ The only way to project a cash flow is to make some
assumption about the prepayment rate over the life of the
underlying mortgage pool.
■ The prepayment rate assumed is called the prepayment speed
or, simply, speed. If the assumed prepayment rate is inaccurate
or misleading, the resulting cash flow is not meaningful for
valuing pass-throughs.
 Prepayment risk for pass through securities
■ If the borrower pays more than the monthly scheduled payment, the extra payment will be used to
pay down the outstanding balance faster than the original amortization schedule, resulting in a
prepayment.
■ If the outstanding balance is paid off in full, the prepayment is a “complete prepayment”; if only a
portion of the outstanding balance is prepaid, the prepayment is called either a “partial prepayment”
or “curtailment.”
■ A commonly used methodology for projecting prepayments and the cash
flow of a pass-through assumes that some fraction of the remaining
principal in the pool is prepaid each month for the remaining term of
the mortgage.
■ The prepayment rate assumed for a pool, called the conditional prepayment rate (CPR). It is
referred to as a conditional rate because it is conditional on the remaining mortgage balance.
Single Monthly Mortality Rate (SMM)
■ The CPR is an annual rate. However, because mortgage cash flows
are a monthly phenomenon, calculating the CPR requires the
generation of a monthly prepayment rate, called the single monthly
mortality rate.

■
 Single Monthly Mortality Rate: Example
■ If the pool balance at month zero is $10,000,000, assuming an interest rate of 12%,
the scheduled principal and interest payments are $2,920.45 and $100,000 in month
one, respectively. If the actual payment in month one is $202,891.25, the SMM rate
is calculated as

■ Therefore, if a mortgage loan prepaid at 1% SMM in a particular

month, this means that 1% of that month’s scheduled balance (last
month’s outstanding balance minus the scheduled principal payment) has been
prepaid.
Relationship between SMM and CPR
■ Given the SMM, a CPR can be computed using the following formula:

■ For example, if the SMM is 1%, then the CPR is

■ To convert an SMM into a CPR, the following formula is used:

 PSA prepayment model
■ The basic PSA (Public Securities Association ) model assumes that prepayment rates
are low for newly originated mortgages and high for seasoned or old mortgages.
■ The PSA standard benchmark assumes the following prepayment
rates for 30-year mortgages:
--- A CPR of 0.2% for the first month, increased by 0.2% per year per month for the
next 29 months when it reaches 6% per year.
--- A 6% CPR for the remaining years.

■ This benchmark, referred to as “100% PSA” or simply “100 PSA.”

PSA prepayment model
■ Mathematically, 100 PSA can be expressed as follows:
If t ≤ 30 then CPR = 6% × (t/30)
If t > 30 then CPR = 6%
■ where t is the number of months since the mortgage was originated.
■ Slower or faster speeds are then referred to as some percentage of PSA.
For example, 50 PSA means one-half the CPR of the PSA benchmark
prepayment rate; 150 PSA means 1.5 times the CPR of the PSA
benchmark prepayment rate
Conditional prepayment rate: Example
 Conditional prepayment rate: Example
■ That is, prepayment for month t is equal to
----SMM X (beginning mortgage balance for month t – scheduled
principal payment for month t)
■ For example, suppose that an investor owns a pass-through in
which the remaining mortgage balance at the beginning of some
month is $90 million. Assuming that the SMM is 0.69244% and the
scheduled principal payment is $1 million, the estimated
prepayment for the month (using the above equation) is:
0.0069244($90,000,000 – $1,000,000) =
0.0069244($89,000,000) = $616,270.05
 Prepayment calculation: Example
■ Mr. X is looking at the historical prepayment for a pass through security. He
finds the following:
mortgage balance in month 42 = $260,000,000
scheduled principal payment in month 42 = $1,000,000
prepayment in month 42 = $2,450,000

■ a. What is the SMM for month 42?

b. How should Mr. X interpret the SMM computed?
c. What is the CPR for month 42
d. How should Mr. X interpret the CPR computed?
 Prepayment calculation: Example
■ a. The SMM is equal to

■ b. Mr. X should interpret the SMM as follows: 0.9459% of the mortgage pool available to prepay in month 42 prepaid in the month.
■ c. Given the SMM, the CPR is computed using equation
Therefore,

■ d. Mr. X should interpret the CPR as follows: ignoring scheduled principal payments, approximately 10.79% of the outstanding mortgage
balance at the beginning of the year will be prepaid by the end of the year.
 Delinquency and default measures
■ When a borrower fails to make one or more timely payments, the loan is said to be delinquent.
■ When the underlying pool of assets is mortgage loans, the two commonly used methods for
classifying delinquencies are those recommended by the Office of Thrift Supervision (OTS)
and the Mortgage Bankers Association (MBA).
■ The OTS method uses the following loan delinquency classifications.
■ Payment due date to 30 days late: Current
■ 30–60 days late: 30 days delinquent
■ 60–90 days late: 60 days delinquent
■ More than 90 days late: 90+ days delinquent
■ The MBA method is a somewhat more stringent classification method,
classifying a loan as 30 days delinquent once payments are not received
after the due date.
Default measures
■ By definition, default is the point where the borrower loses title to the
property in question. Default generally occurs for loans that are 90+ days
delinquent. Default is generically defined as the event when a loan no
longer makes contractual payments and remains in this status till
liquidation.
■ Three measures for quantifying default are the conditional default
rate, the cumulative default rate, and the charge-off rate. The conditional
default rate (CDR) is the annualized value of the unpaid principal balance
of newly defaulted loans.
Default measures
■ Then this is annualized default rate is calculated as follows to get
the CDR:
Contraction and extension risk
■ The basic property of fixed-income securities that its price is negatively related to
interest rate.
■ When interest rate falls, the price of a bond should increase.
■ But in the case of a pass-through security, the rise in price will not be as large as that
of a bond because a fall in interest rates increases the borrower’s incentive to prepay
the loan and refinance the debt at a lower rate.
■ Thus, the upside price potential of a pass-through security is truncated/reduced
because of prepayments.
■ The second adverse consequence is that the cash flow must be reinvested at a lower
rate. These two adverse consequences when mortgage rates decline are referred to as
contraction risk
Contraction and extension risk
■ When the interest rate goes up price of the pass-through, like the price of
any bond, will decline.
■ But again it will decline more because the higher rates will tend to slow
down the rate of prepayment, in effect increasing the amount invested at the
coupon rate, which is lower than the market rate.
■ Prepayments will slow down because homeowners will not refinance or
partially prepay their mortgages when mortgage rates are higher than the
contract rate.
■ Of course, this is just the time when investors want prepayments to speed up
so that they can reinvest the prepayments at the higher market interest rate.
This adverse consequence of rising mortgage rates is called extension risk.
 WAC and WAM of a pass-through security
■ Not all of the mortgages that are included in a pool of mortgages that are
securitized have the same mortgage rate and the same maturity.
Consequently, when describing a pass-through security, a weighted-
average coupon rate and a weighted-average maturity are determined.
■ A weighted-average coupon rate (WAC) is found by weighting the
mortgage rate of each mortgage loan in the pool by the amount of the
mortgage outstanding.
■ A weighted-average maturity (WAM) is found by weighting the
remaining number of months to maturity for each mortgage loan in the
pool by the amount of the mortgage outstanding.