The basic form of a mortgage backed security is that of a mortgage pass-through security. Among the mortgage-related securities, the mortgage pass-through securities form a very large class. Several federally supported (government supported) bodies made these securities popular, provided credit support and standards of uniformity. The support given by these bodies made the pools of mortgages underlying the pass-through more readily marketable. The most popular pass-through securities backed by such entities are Government National Mortgage Association Pass-Through Securities, Federal Home Loan Mortgage Corporation Participation Certificates, and Federal National Mortgage Association Mortgage-Backed Security.
A mortgage pass-through security is a share or participating certificate issued by a collection pool comprising several mortgages. The mortgage is said to be securitized when the mortgage in the pool of mortgages acts as a collateral to mortgage pass-through security. The cash flow to the investors of these securities depends on the cash flow generated by the pool which is in the form of interest payments, planned repayment of principal and any prepayments. The security holders receive monthly payments, whose timings and amount may not be identical to the ones received from the pool. The amount the holders receive is the monthly cash flow from mortgages less the servicing and other fees like the fee charged by the issuer or guarantor.
Since a pool consists of different mortgages which may vary in terms of the mortgage rate and the timing of the cash flows, the pool actually has a Weighted Average Coupon Rate (WAC) and Weighted Average Maturity (WAM). These are calculated by multiplying the mortgage rates and months remaining till maturity with their weights (amount outstanding on a mortgage divided by the total amount outstanding).
These securities are exposed to two risks namely the prepayment risk and the extension risk. As said earlier, the owner of a pass-through does not know the timing and amount of cash flow as these depend on the actual payments and prepayments. This exposes one to prepayment risk. To understand better, lets take an example. Suppose the coupon rate is 8% and the mortgage rate is 9%. A decline in mortgage rates to 5% may result in two adverse consequences. As a pass-through security is like an option-free bond, the price of the security rises. However, security price rise may not be as great as that of an option-free bond. This is because, when interest rates fall, the borrower will be inclined to prepay the loan and refinance the debt at a lower rate, resulting in an adverse impact to the security holders. The second adverse impact is that the cash flows may have to be reinvested at lower rates. These effects are mainly due to the shortening of the timing of cash flows.
In case of an increase in the mortgage rates, say in the above example, to 14%, the price of the security declines. Since the rates are higher, the prepayments will decline, in reality increasing the amount invested at coupon rate (this rate is lower than the market rate). This adverse consequence is called as extension risk. These adverse effects are due to the lengthening of the timing of cash flows.
These risks make the pass-through securities unattractive to hold for the financial institutions.