How do mortgage pass-through securities work and what is prepayment risk?

Mortgage pass-through securities are the simplest form of MBS. A pool of residential mortgages is packaged into a trust, and investors receive a pro rata share of all principal and interest payments — passed through monthly, minus a servicing fee.

Cash Flow Mechanics:

Each month, homeowners in the pool make mortgage payments. These consist of:

1. Scheduled principal (amortization per the original mortgage terms)
2. Interest on the outstanding balance
3. Prepayments — any extra principal payments, including refinancings, home sales, and defaults (where insurance/guarantees cover the principal)

Investors receive all three components, minus the servicing and guarantee fees (typically 25-50 bps).

Example:

Lakewood Mortgage Trust pools $500 million of 30-year, 5.5% mortgages. Servicing fee: 0.50%.

• Gross coupon: 5.50%
• Net pass-through rate: 5.00%
• Monthly cash flow to investors = Scheduled principal + Prepayments + Interest at 5.00%

Prepayment Risk — The Unique Feature:

Unlike corporate bonds where cash flows are largely predictable, MBS cash flows depend on when homeowners choose to pay off their mortgages. This is called prepayment risk and has two components:

1. Contraction risk: When rates FALL, homeowners refinance aggressively. The pool pays down faster than expected, and investors get principal back early — at the worst possible time (when reinvestment rates are low).

1. Extension risk: When rates RISE, homeowners hold onto their low-rate mortgages. Prepayments slow dramatically, extending the pool's life. Investors are stuck holding a below-market-rate asset for longer.

The PSA Prepayment Model:

The Public Securities Association benchmark assumes:

• Month 1: 0.2% CPR (conditional prepayment rate)
• Increases linearly by 0.2% per month
• Month 30: reaches 6.0% CPR
• Months 30+: stays at 6.0% CPR

This is called "100% PSA" or "100 PSA." Speeds are quoted relative to this benchmark:

• 150 PSA: Prepayments are 1.5x the benchmark (faster)
• 75 PSA: Prepayments are 0.75x the benchmark (slower)

If rates drop sharply, actual speeds might reach 300-500 PSA as refinancings surge.

Why This Matters for Valuation:

Pass-throughs have "negative convexity" — when rates fall, price appreciation is capped because prepayments accelerate (contraction risk). This is the opposite of option-free bonds where falling rates produce large price gains.

Exam Tip: Remember that pass-through investors face both contraction and extension risk. CMO tranches (covered separately) were created specifically to redistribute these prepayment risks among different investor classes.

Dive deeper into MBS analysis in our CFA Level II Fixed Income course.