The weighted average coupon (WAC) offers a powerful means of gauging the rate of return on a pool of mortgages bundled together as mortgage-backed securities (MBS). Given that underlying mortgages are typically repaid over varying periods, the WAC provides an initial snapshot of return rates, which may evolve over time.
Key Insights
- WAC Definition: The WAC signifies the average gross interest rate of underlying mortgages within an MBS at the time of issuance.
- Analytical Importance: Analysts leverage the WAC to predict and understand pre-payment characteristics of an MBS.
- Dynamic Nature: The WAC fluctuates as underlying mortgage loans are repaid across different timelines.
Revealing the Mechanism Behind the Weighted Average Coupon (WAC)
Banks actively engage in selling the mortgages they originate on a secondary mortgage market, attracting institutional investors like hedge funds and investment banks. These buyers then transform the mortgages into tradable market securities, establishing a realm where such investments can flourish. In essence, MBS holders receive interest, or coupon payments, derived as the weighted average of the coupons of the pooled mortgage loans backing the MBS, taking into account each mortgage’s principal balance.
Calculating the WAC
The calculation of WAC merges the interest rates viable on an MBS’s underlying mortgage pools, tailoring them in line with each individual mortgage’s contribution to the security. In practice, the calculation steps include:
- Weighing interest rates: The coupon rate on each mortgage is multiplied by its remaining principal balance.
- Summing results: The intermediate results are aggregated.
- Dividing: Summing outcomes is then divided by the remaining balance of the pool.
Alternatively, analysts may take the weights of each mortgage pool, multiply them by the associated coupon rates, and combine the aggregated values to derive the WAC.
For example, consider a hypothetical MBS comprising three mortgage pools with a total principal of $11 million:
- Mortgage tranche 1: $4 million at 7.5%
- Mortgage tranche 2: $5 million at 5%
- Mortgage tranche 3: $2 million at 3.8%
The WAC can be calculated using the following steps:
First Method Calculation:
WAC = [($4 million x 0.075) + ($5 million x 0.05) + ($2 million x 0.038)] / $11 million
WAC = ($300,000 + $250,000 + $76,000) / $11 million
WAC = $626,000 / $11 million = 5.69%
Alternative Method:
- Calculate each pool’s weight:
Pool 1 weight: $4 million / $11 million = 36.36%
Pool 2 weight: $5 million / $11 million = 45.45%
Pool 3 weight: $2 million / $11 million = 18.18%
- Apply weights to determine WAC:
WAC = (36.36 x 0.075) + (45.45 x 0.05) + (18.18 x 0.038)
WAC = 2.727 + 2.2725 + 0.6908 = 5.69%
These dynamic shifts in WAC embody the evolving behavior as diverse mortgage holders repay loans at individual timelines and rates.
The Risks of MBS: A Historical Context
No discussion surrounding mortgage-backed securities is complete without acknowledging the vulnerabilities exposed during the 2007-2008 financial crisis. These substantial MBS investments were substantially funded by mortgages originated during the preceding housing bubble, and troublingly, a significant portion of these loans were given to borrowers who lacked sufficient means for repayment.
When the bubble collapsed, a cascade of borrower defaults ensued, rendering the value of many MBS holdings heavily diminished. These highly precarious investments were often stabilized by subprime loans, making the aftermath notably turbulent and formative for modern financial contingencies.
Related Terms: Mortgage Rate, Coupon Payments, Weighted Average, Investment Analysis.
References
- Federal Deposit Insurance Corporation. “Crisis and Response: An FDIC History, 2008–2013”, Pages 23-24. Federal Deposit Insurance Corporation, 2017.
- Investor.gov. “Mortgage-Backed Securities and Collateralized Mortgage Obligations”.
- Financial Industry Regulatory Authority. “Regulatory Notice - 21-02 - MBA Dissemination”, Page2.
- Federal Deposit Insurance Corporation. “Crisis and Response: An FDIC History, 2008–2013”, Pages 3-6. Federal Deposit Insurance Corporation, 2017.
