Level 1 CFA® Exam:
Mortgage Pass-Through Securities

Last updated: January 04, 2023

Intro to Mortgage Pass-Through Securities for CFA Candidates

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Mortgage pass-through securities are securities created by holders of mortgages who form a pool of the mortgages they own and then sell shares or participation certificates in the pool of these mortgages.

monthly cash flow for a mortgage pass-through security = monthly mortgage payments representing interest + scheduled repayment of principal + prepayments – servicing and other fees

pass-through rate (%) = mortgage rate (%) – servicing and other fees (%)

Because the mortgages in the pool differ in terms of maturity and mortgage interest, it is convenient to compute:

  • weighted average coupon (WAC),
  • weighted average maturity (WAM).
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CFA Exam: Prepayment Rate & Prepayment Risk

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Because the monthly cash flow from a mortgage pass-through security depends also on not scheduled prepayments of the loans, investors don’t know what the future cash flows will be. We call this a prepayment risk.

Prepayment risk divides into:

  • contraction risk,
  • extension risk.

Contraction risk occurs when interest rates decrease. In this case, the prepayment of loans increases because borrowers will refinance using lower market interest rates.

Extension risk occurs when interest rates increase. In this case, the prepayment of loans decreases because borrowers will prefer the interest they have agreed to.

Prepayment Risk Measures

2 most important prepayment risk measures are:

  • single monthly mortality rate (SMM),
  • conditional prepayment rate (CPR).

Remember: The CPR is an annualized SMM.

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Single Monthly Mortality Rate
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\(SMM=\frac{PREP}{BAL-REP}\)

  • \(SMM\) - single monthly mortality rate
  • \(PREP\) - prepayment for the month
  • \(BAL\) - mortgage balance outstanding at the beginning of the month
  • \(REP\) - scheduled  principal repayment for the month
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Public Securities Association (PSA) Prepayment Benchmark

Generally, prepayment rates for the collateral of pass-through securities are lower for new mortgages and increase over time.

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Level 1 CFA Exam Takeaways: Mortgage Pass-Through Securities

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  1. Mortgage pass-through securities are securities created by holders of mortgages who form a pool of the mortgages they own and then sell shares or participation certificates in the pool of these mortgages.
  2. Prepayment risk divides into contraction risk and extension risk.
  3. Contraction risk occurs when interest rates decrease.
  4. Extension risk occurs when interest rates increase.
  5. 2 most important prepayment risk measures are the single monthly mortality rate (SMM) and conditional prepayment rate (CPR).
  6. The CPR is an annualized SMM.
  7. 100 PSA means that investors can expect the prepayment rates to be in line with the standard PSA model.
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