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CFA Level I Exam · Fixed-Income Securitization

Mortgage Pass-Through Securities and Prepayment Risk

Updated 7 October 2026 · Fact-checked

A mortgage pass-through security pays investors a pro rata share of the interest, scheduled principal and prepayments from a pool of mortgages, net of fees. Prepayment speed is measured by SMM (monthly) and CPR (annualized). Falling rates cause contraction risk; rising rates cause extension risk. Convert with CPR = 1 − (1 − SMM)^12.

Understand Mortgage Pass-Through Securities and Prepayment Risk

A mortgage pass-through security is created when a pool of mortgage loans is securitized. Borrowers make monthly payments. After the servicer and guarantor take their fees, the rest is passed to investors in proportion to their ownership. Investors receive interest, scheduled principal and any prepayments.

Two pool statistics describe the collateral. The weighted average coupon (WAC) is the average mortgage rate of the loans in the pool, weighted by outstanding balance. The weighted average maturity (WAM) is the average remaining term in months, also weighted by balance. The pass-through rate paid to investors is lower than the WAC, because servicing and other fees are deducted.

Agency pass-throughs are issued or guaranteed by Ginnie Mae, Fannie Mae or Freddie Mac in the United States. Each guarantees payment of interest and principal, so credit risk is minimal. The timing of principal payments can differ by program. The strength of the guarantee also differs. Ginnie Mae securities are backed by the full faith and credit of the US government. Fannie Mae and Freddie Mac are government-sponsored enterprises (GSEs), and their guarantees are backed by the GSEs only, not by the full faith and credit of the US government. Non-agency pass-throughs are issued by private entities. They have no such guarantee, so they need credit enhancement such as subordination and they carry credit risk.

Borrowers can repay early. That is prepayment. It happens when they refinance, sell the home, or pay extra. Because of this, the cash flows of a pass-through are uncertain. Two measures describe the speed. SMM (single monthly mortality rate) is the share of the pool's balance, after scheduled principal, that prepays in one month. CPR (conditional prepayment rate) is the same idea expressed as an annual rate. The PSA benchmark gives a standard prepayment path: CPR rises by 0.2 percentage points a month for the first 30 months, then stays at 6%. That path is 100 PSA. 150 PSA is 1.5 times those CPRs.

Prepayment creates two risks. Contraction risk: when rates fall, borrowers refinance, principal returns early, and you must reinvest at lower rates. The price rises less than for a normal bond. Extension risk: when rates rise, prepayments slow, the security's life lengthens, and its price falls more. Together this gives the pass-through negative convexity over some rate ranges.

Key formulas to remember

Single monthly mortality (SMM)
SMM = prepayment in the month ÷ (beginning balance − scheduled principal payment)
The denominator is the balance after scheduled principal, not the beginning balance.
CPR from SMM
CPR = 1 − (1 − SMM)^12
Do not multiply SMM by 12. That overstates CPR.
SMM from CPR
SMM = 1 − (1 − CPR)^(1/12)
Use when the question gives an annual CPR and asks for monthly prepayment.
Weighted average coupon (WAC)
WAC = Σ (loan balance ÷ pool balance) × loan rate
Weights are outstanding balances.
Weighted average maturity (WAM)
WAM = Σ (loan balance ÷ pool balance) × remaining months
Remaining term, not original term.
Pass-through rate
Pass-through rate = WAC − servicing and other fees
Investors earn the pass-through rate, which is below WAC.
PSA benchmark
100 PSA: CPR = 0.2% × month for months 1 to 30; CPR = 6% after month 30. For x PSA, multiply by x ÷ 100
Example: at 150 PSA in month 10, CPR = 0.2% × 10 × 1.5 = 3.0%.

How to solve Mortgage Pass-Through Securities and Prepayment Risk questions

Use this order for any question on pass-throughs and prepayment. It separates the calculation questions from the risk questions.

  1. 1Identify what is asked: a pool statistic (WAC, WAM), a prepayment measure (SMM, CPR, PSA), or a risk judgement (contraction or extension).
  2. 2For WAC or WAM, list each loan's balance, then compute weights as balance ÷ total balance. Apply the weights to rates or remaining months.
  3. 3For SMM, first subtract scheduled principal from the beginning balance. Then divide the prepayment by that result.
  4. 4To move between SMM and CPR, use the power formulas. Check which one is given and which one is wanted.
  5. 5For PSA questions, find the base CPR for the month (0.2% × month up to month 30, then 6%). Multiply by the PSA speed ÷ 100.
  6. 6For risk questions, ask what rates did. Falling rates mean faster prepayments and contraction risk. Rising rates mean slower prepayments and extension risk.
  7. 7Sense-check: SMM is small, CPR is much larger than SMM but below 12 × SMM, and WAM lies between the shortest and longest remaining terms.

Quickest way: Fast SMM, CPR and risk check

When to use it: Use when time is short and you must pick among three numerical or conceptual options.

  1. For SMM, compute prepayment ÷ (beginning balance − scheduled principal). Reject any option that uses the full beginning balance.
  2. For CPR, key the SMM into the calculator. On the BA II Plus: 1 − SMM, then press y^x, 12, = and subtract the result from 1. Example: 0.98 y^x 12 = gives 0.7847, so CPR = 21.5%.
  3. Sense-check CPR: it must be below 12 × SMM. If an option equals 12 × SMM exactly, it is the trap.
  4. For WAC and WAM, a simple average is usually the trap. The weighted answer sits closer to the larger loan.
  5. For risk, link rates to prepayments in one line: rates down, prepayments up, contraction; rates up, prepayments down, extension.

Common mistakes in Mortgage Pass-Through Securities and Prepayment Risk

  • Multiplying SMM by 12 to get CPR

    It looks like a normal monthly-to-annual conversion.

    Fix: CPR is compounded: CPR = 1 − (1 − SMM)^12. The answer is always a bit below 12 × SMM.

  • Dividing prepayment by the beginning balance when computing SMM

    Students forget that scheduled principal is paid before prepayment is measured.

    Fix: Subtract scheduled principal from the beginning balance first, then divide.

  • Using a simple average for WAC or WAM

    The names include 'average', so students average the loan rates or terms.

    Fix: Weight each loan by its outstanding balance.

  • Mixing up contraction and extension risk

    Both words describe changes in the security's life, and the rate direction is easy to reverse.

    Fix: Contraction: rates fall, prepayments rise, the life shortens. Extension: rates rise, prepayments slow, the life lengthens.

  • Assuming agency pass-throughs have no risk

    The guarantee is read as protection from everything.

    Fix: The guarantee covers credit risk only. Agency pass-throughs still carry prepayment risk (contraction and extension) and interest rate risk.

  • Treating the pass-through rate as the WAC

    Both are described as a coupon of the pool.

    Fix: The pass-through rate equals WAC minus servicing and other fees, so it is lower.

Worked examples

Example 1

A mortgage pool has a beginning balance of $500 million for the month. The scheduled principal payment is $2 million and prepayments are $9.96 million. What is the CPR? A) 2.00% B) 21.5% C) 24.0%

Show the solution
  1. Balance after scheduled principal = 500 − 2 = $498 million.
  2. SMM = 9.96 ÷ 498 = 0.02, or 2.00%.
  3. CPR = 1 − (1 − 0.02)^12 = 1 − 0.98^12.
  4. 0.98^12 = 0.7847 (calculator: 0.98 y^x 12 =).
  5. CPR = 1 − 0.7847 = 0.2153, or about 21.5%.
  6. Option A is the SMM. Option C is the trap 12 × SMM.

Answer: B) 21.5%

Example 2

A pool has two loans. Loan 1: $60 million at 5.0% with 300 months remaining. Loan 2: $40 million at 6.0% with 240 months remaining. What is the pool's WAM? A) 270 months B) 276 months C) 300 months

Show the solution
  1. Pool balance = 60 + 40 = $100 million.
  2. Weights are 60% for Loan 1 and 40% for Loan 2.
  3. WAM = 0.60 × 300 + 0.40 × 240 = 180 + 96 = 276 months.
  4. Option A is the simple average (300 + 240) ÷ 2, which ignores balances.
  5. For reference, WAC = 0.60 × 5.0% + 0.40 × 6.0% = 5.4%.

Answer: B) 276 months

Exam tips

  • Expect three-option items that test the SMM to CPR link. The trap option is almost always 12 × SMM or an SMM computed on the unadjusted balance.
  • Risk questions are usually verbal. Read the rate move in the stem, then name the prepayment response and the risk. Do not overthink it.
  • Remember that a guarantee on an agency security covers credit risk, not prepayment risk. Non-agency securities need credit enhancement.
  • Practice the y^x key on your approved calculator (TI BA II Plus or HP 12C) until a CPR calculation takes under 30 seconds.
  • At 90 seconds per question, answer WAC and WAM items by weighting quickly. The result must lie between the lowest and highest loan values.

Practice questions from Fixed-Income Securitization

Mortgage Pass-Through Securities and Prepayment Risk in other exams

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

Mortgage Pass-Through Securities and Prepayment Risk: frequently asked questions

How do you calculate SMM and CPR?

SMM is the month's prepayment divided by the beginning balance less scheduled principal. CPR then equals 1 − (1 − SMM)^12. To go back, SMM = 1 − (1 − CPR)^(1/12).

What is the difference between contraction risk and extension risk?

Contraction risk arises when rates fall and borrowers prepay faster, so principal returns early and is reinvested at lower rates. Extension risk arises when rates rise and prepayments slow, so the security's life lengthens just when you would like higher-yielding cash. Both are forms of prepayment risk.

What is weighted average coupon and maturity?

WAC is the balance-weighted average mortgage rate in the pool. WAM is the balance-weighted average remaining term in months. Both describe the collateral, and the pass-through rate paid to investors is WAC less fees.

What is the difference between agency and non-agency pass-throughs?

Agency securities are issued or guaranteed by Ginnie Mae, Fannie Mae or Freddie Mac, and each guarantees payment of interest and principal. The timing of principal payments can differ by program. Ginnie Mae's guarantee is backed by the full faith and credit of the US government, while Fannie Mae and Freddie Mac guarantees are backed by the GSEs only. Non-agency securities are issued by private entities, carry credit risk, and rely on credit enhancement.