CFA Level I Exam · Asset-Backed Security (ABS) Instrument and Market Features

Residential Mortgage-Backed Securities Basics: Pass-Throughs and Prepayment Risk

Updated 7 October 2026 · Fact-checked

A mortgage pass-through security pools residential loans and passes the borrowers' monthly interest, scheduled principal and prepayments to investors, after servicing and guarantee fees. Prepayment risk makes cash flows uncertain: falling rates cause contraction risk, rising rates cause extension risk. Agency RMBS carry a guarantee; non-agency RMBS need credit enhancement.

Understand Residential Mortgage-Backed Securities Basics

A residential mortgage-backed security (RMBS) is a bond backed by a pool of home loans. A bank or other originator makes the loans and sells them to a special purpose entity. The entity issues securities backed by the pool. Investors then receive the cash flows from the borrowers.

The simplest RMBS is the mortgage pass-through security. Each investor owns a pro rata share of the pool. Every month, the borrowers' payments are passed through: interest, scheduled principal, and any prepayments (extra principal paid early). The servicer keeps a servicing fee, and the guarantor may keep a guarantee fee. So the pass-through rate paid to investors is lower than the weighted average coupon (WAC) of the underlying loans.

Prepayment is the central risk. Borrowers can repay early when they refinance or sell the house. Defaults can also lead to early principal: for agency RMBS, a guarantor's repurchase of a defaulted loan passes principal to investors and acts like an involuntary prepayment. Investors therefore do not know when they will get their principal back. The weighted average maturity (WAM) of the pool is the stated term, but the real life of the security depends on prepayments.

Contraction risk arises when rates fall. Borrowers refinance, prepayments rise and principal comes back early. You must reinvest at lower rates, and the security's price gains are capped. Extension risk arises when rates rise. Prepayments slow, the security's life lengthens, and you are stuck with a below-market coupon for longer, so the price falls more. Both effects are features of negative convexity: capped price gains when rates fall and larger price declines when rates rise. Both risks together are prepayment risk.

Prepayment speed is quoted with the single monthly mortality rate (SMM), the share of the month's starting balance (after scheduled principal) that is prepaid, and the conditional prepayment rate (CPR), its annualized form. The PSA benchmark is a CPR path that rises with loan age. A faster speed than the benchmark means a higher PSA number.

Agency RMBS are issued or guaranteed by government agencies or government-sponsored enterprises. They carry little credit risk, so the main risk is prepayment. Non-agency RMBS have no such guarantee. They face credit risk, so they use credit enhancement such as subordination, overcollateralization and excess spread. Their loans often do not conform to agency standards.

Key formulas to remember

Pass-through rate: Pass-through rate = WAC − servicing fee − other fees (such as guarantee fee); Investors receive less than the borrowers pay. The WAC is the balance-weighted average of loan rates.
Single monthly mortality rate: SMM = Prepayment in month ÷ (Beginning balance − Scheduled principal payment); Monthly prepayment rate. Do not forget to subtract scheduled principal in the denominator.
SMM to CPR: CPR = 1 − (1 − SMM)^12; Annualizes SMM with compounding. Use the keys y^x or ^ on your calculator.
CPR to SMM: SMM = 1 − (1 − CPR)^(1/12); Reverse conversion. CPR is an annual rate; SMM is monthly.
PSA benchmark (100 PSA): CPR = 0.2% × months since origination, up to month 30; then 6% CPR; Month 30 gives 6%. A speed of 150 PSA means 1.5 times the benchmark CPR at each age.
Rate effect on prepayment: Rates fall → prepayments rise → contraction risk. Rates rise → prepayments fall → extension risk.; Negative convexity covers both: capped price gains when rates fall and larger price declines when rates rise.

How to solve Residential Mortgage-Backed Securities Basics questions

Use this approach for any RMBS question, whether it is conceptual or numerical.

1Identify the security: agency or non-agency pass-through, and what the question asks (cash flow, risk or rate).
2For rate questions, subtract the servicing and guarantee fees from the WAC to get the pass-through rate.
3For direction questions, ask what happens to interest rates, then to refinancing, then to prepayment speed.
4Map speed to risk: faster prepayment means contraction risk; slower means extension risk.
5For numbers, convert between SMM and CPR with the correct formula and check monthly versus annual.
6For credit questions, decide whether the security is agency (little credit risk) or non-agency (needs credit enhancement).
7Check the answer: SMM must be smaller than CPR, and the pass-through rate must be below the WAC.
8Eliminate the two options that reverse the rate-prepayment link or confuse the risk labels.

Quickest way: Rate, Speed, Risk in three words

When to use it: Use this for conceptual MCQs about contraction, extension, agency versus non-agency or price behaviour.

Write the chain: rates down → prepay up → contraction; rates up → prepay down → extension.
Agency means guaranteed, so remove any option that says agency RMBS have significant credit risk to investors.
Non-agency means credit enhancement; remove options that say none is needed.
For SMM to CPR, compute (1 − SMM)^12, subtract from 1, and check CPR is clearly larger than SMM.

Common mistakes in Residential Mortgage-Backed Securities Basics

Mixing up contraction and extension risk.
The names sound alike and students memorize them without the cause.
Fix: Contraction means the investment life shortens when rates fall. Extension means the life lengthens when rates rise.
Multiplying SMM by 12 to get CPR.
It looks like a normal annualization.
Fix: Use CPR = 1 − (1 − SMM)^12. Multiplying overstates CPR.
Leaving scheduled principal out of the SMM denominator.
Students divide by the beginning balance only.
Fix: Divide the prepayment by the beginning balance minus scheduled principal.
Saying investors receive the WAC.
The WAC is the loan rate and is easy to confuse with the coupon.
Fix: The pass-through rate equals the WAC minus servicing and other fees.
Believing agency RMBS have no risk.
The guarantee is read as total safety.
Fix: Agency RMBS remove most credit risk but still carry prepayment risk and interest rate risk.
Thinking higher PSA means slower prepayment.
Students read the number as a price or a safety level.
Fix: A higher PSA number means faster prepayment than the benchmark, so the average life is shorter.

Worked examples

Example 1

A mortgage pool has a WAC of 5.60%. The servicing fee is 0.30% and the guarantee fee is 0.20%. Rates then fall sharply. Which is correct? A) Pass-through rate is 5.10% and extension risk rises. B) Pass-through rate is 5.10% and contraction risk rises. C) Pass-through rate is 5.60% and contraction risk rises.

Show the solution

Pass-through rate = 5.60% − 0.30% − 0.20% = 5.10%.
Falling rates push borrowers to refinance, so prepayments rise.
Faster prepayments shorten the security's life, which is contraction risk.
Option A has the wrong risk. Option C ignores the fees.

Answer: B

Example 2

In a month, a pool has a beginning balance of $200 million. The scheduled principal payment is $1 million and prepayments are $4.975 million. What is the SMM, and what is the approximate CPR? A) SMM 2.50%, CPR about 12.9% B) SMM 2.50%, CPR about 26.2% C) SMM 2.50%, CPR about 30.0%

Show the solution

SMM = 4.975 ÷ (200 − 1) = 4.975 ÷ 199 = 0.025, or 2.50%.
CPR = 1 − (1 − 0.025)^12 = 1 − 0.975^12.
0.975^12 ≈ 0.7380 (0.975^2 = 0.950625; ^4 = 0.903688; ^8 = 0.816626; ^12 = 0.816626 × 0.903688 ≈ 0.7380).
CPR = 1 − 0.7380 = 0.2620, or about 26.2%.
Simple multiplication 2.5% × 12 = 30% is the trap, which is option C.

Answer: B

Exam tips

Expect direction questions: given a rate move, name the risk. Always use the chain rate, refinancing, prepayment, risk.
Memorize the CPR formula. The exam may give SMM and ask for CPR, or the reverse, with three close numerical options.
Remember agency versus non-agency: guarantee versus credit enhancement. Options that mix them are traps.
Pass-throughs show negative convexity: price gains are capped when rates fall, and price declines are larger when rates rise. Use this to remove wrong price-behaviour options.

Practice questions from Asset-Backed Security (ABS) Instrument and Market Features

Residential Mortgage-Backed Securities Basics in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

FRM Part IAgency Mortgage Pass-Through Securities

Residential Mortgage-Backed Securities Basics: frequently asked questions

How do mortgage pass-through securities work?

A pool of mortgage loans is placed in a trust, and investors own shares of the pool. Each month the borrowers' interest and principal, including prepayments, are passed to investors after servicing and guarantee fees are deducted.

What is prepayment risk in MBS?

It is the uncertainty about when investors get their principal back because borrowers can repay early. It has two forms: contraction risk when rates fall and extension risk when rates rise.

What is the difference between agency and non-agency RMBS?

Agency RMBS are issued or guaranteed by government agencies or government-sponsored enterprises, so credit risk is low. Non-agency RMBS have no such guarantee and rely on credit enhancement like subordination and overcollateralization.

Contraction risk vs extension risk: which hurts more?

Neither is always worse; they hit in different rate moves. Contraction forces reinvestment at lower rates and limits price gains. Extension keeps your money in a below-market coupon for longer as prices fall.