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CFA Level I Exam · Mortgage-Backed Security (MBS) Instrument and Market Features

Mortgage Pass-Through Securities for CFA Level I

Updated 7 October 2026 · Fact-checked

A mortgage pass-through security pools mortgage loans and passes the borrowers' payments to investors pro rata, after deducting servicing and guarantee fees. The pool has a WAC and a WAM. Investors earn the pass-through rate, which is below the WAC. Agency securities carry a guarantee; non-agency ones need credit enhancement.

Understand Mortgage Pass-Through Securities

A mortgage pass-through security is created when a lender or sponsor pools many residential mortgage loans and sells investors shares in that pool. Each investor gets a proportional share of the pool's cash flows. The security is a form of residential mortgage-backed security (RMBS).

The cash flows come from the borrowers: scheduled interest, scheduled principal and any prepayments. The servicer collects payments and keeps a servicing fee. A guarantor, in agency deals, takes a guarantee fee. What is left is passed to investors. So the rate investors earn, the pass-through rate (net coupon), is lower than the rate borrowers pay.

Because loans in a pool differ, two pool-level figures describe it. The weighted average coupon (WAC) is the average of the mortgage rates, weighted by each loan's outstanding balance. The weighted average maturity (WAM) is the average of the loans' remaining terms to maturity, weighted by outstanding balance. Both change over time as loans pay down or prepay. WAC is a gross rate. The pass-through rate is net of fees.

Agency and non-agency securities differ in credit risk. Agency RMBS are issued or guaranteed by government agencies or government-sponsored enterprises, such as Ginnie Mae, Fannie Mae and Freddie Mac in the US. Their loans must meet conforming standards, and the guarantee covers timely payment of principal and interest, so investors bear little credit risk but still bear prepayment risk. Non-agency RMBS are issued by private entities, have no such guarantee, and rely on credit enhancement such as subordination to protect senior tranches.

Because borrowers can repay early, the actual cash flow is uncertain. When rates fall, prepayments rise (contraction risk). When rates rise, prepayments slow (extension risk). Pass-throughs carry both risks, which is why CMOs were created to redistribute them.

Key formulas to remember

Pass-through rate
Pass-through rate = WAC − servicing fee − other fees (e.g., guarantee fee)
Fees are stated as annual rates. Investors earn the pass-through rate, never the WAC.
Weighted average coupon (WAC)
WAC = Σ [ (loan balance ÷ total pool balance) × loan rate ]
Weights are outstanding balances, not the number of loans.
Weighted average maturity (WAM)
WAM = Σ [ (loan balance ÷ total pool balance) × remaining months to maturity ]
Uses remaining term, not original term.
Monthly investor interest
Interest to investors = beginning pool balance × pass-through rate ÷ 12
Use the balance at the start of the month. Payments are monthly.
Investor principal
Principal to investors = scheduled principal + prepayments
Prepayments reduce the balance and so reduce later interest.

How to solve Mortgage Pass-Through Securities questions

Use this order for any question on pass-through securities. It keeps gross and net figures apart.

  1. 1Identify what is asked: a pool statistic (WAC or WAM), an investor cash flow, or a risk or classification point.
  2. 2For WAC or WAM, compute each loan's weight as its balance divided by the total pool balance.
  3. 3Multiply each weight by the loan's rate (WAC) or remaining months (WAM), then add.
  4. 4For investor interest, subtract all fees from the WAC to get the pass-through rate, then apply it to the beginning balance and divide by 12.
  5. 5Add scheduled principal and prepayments for total principal. Reduce the balance for the next period.
  6. 6For concept questions, decide agency or non-agency, then name the main risk: prepayment for both, credit risk mainly for non-agency.
  7. 7Check your answer is in the right range: pass-through rate below WAC, and numbers sensible against the options.

Quickest way: Fee-strip and balance-weight shortcut

When to use it: Use for numerical questions where you need the investor rate or a pool average and have about 90 seconds.

  1. Write the WAC. Subtract the fees at once to get the pass-through rate.
  2. Eliminate any option that equals or exceeds the WAC when asked for investor interest.
  3. For pool averages, if balances are equal, a simple average is enough. Otherwise weight by balance.
  4. Interest = balance × rate ÷ 12. Estimate it first, then match it to the three options, which are listed smallest to largest.
  5. For concept items, remember: guarantee means little credit risk, never no prepayment risk.

Common mistakes in Mortgage Pass-Through Securities

  • Using the WAC as the rate investors earn.

    The WAC is the headline mortgage rate and is easy to grab.

    Fix: Always subtract servicing and guarantee fees first. Investors earn the pass-through rate.

  • Weighting WAC or WAM by the number of loans or the original balance.

    A simple average feels natural.

    Fix: Weight by current outstanding balance. Check if the balances differ.

  • Using original term for WAM.

    Loans are described as 30-year mortgages.

    Fix: WAM uses remaining months to maturity at the measurement date.

  • Thinking an agency guarantee removes all risk.

    The word guarantee sounds complete.

    Fix: The guarantee covers credit risk (timely payment). Prepayment, contraction and extension risk remain, as does interest rate risk.

  • Applying interest to the ending balance or forgetting to divide by 12.

    Rates are annual but payments are monthly.

    Fix: Use the beginning balance and divide the annual pass-through rate by 12.

Worked examples

Example 1

A pool has three loans: $200 million at 5.0% with 300 months remaining, $300 million at 6.0% with 240 months remaining, and $500 million at 4.0% with 360 months remaining. The servicing and guarantee fees total 0.50% a year. What are the WAC, WAM and pass-through rate? Options for the pass-through rate: A) 4.30%, B) 4.80%, C) 5.30%.

Show the solution
  1. Total balance = 200 + 300 + 500 = $1,000 million. Weights are 0.20, 0.30 and 0.50.
  2. WAC = 0.20 × 5.0% + 0.30 × 6.0% + 0.50 × 4.0% = 1.0% + 1.8% + 2.0% = 4.8%.
  3. WAM = 0.20 × 300 + 0.30 × 240 + 0.50 × 360 = 60 + 72 + 180 = 312 months.
  4. Pass-through rate = 4.8% − 0.50% = 4.30%.

Answer: WAC is 4.80%, WAM is 312 months, and the pass-through rate is 4.30%, so A.

Example 2

A pass-through pool has a beginning-of-month balance of $144 million and a WAC of 6.00%. Fees total 0.75% a year. Scheduled principal is $0.40 million and prepayments are $1.10 million. What are the interest paid to investors and the ending balance? Options for interest: A) $0.45 million, B) $0.63 million, C) $0.72 million.

Show the solution
  1. Pass-through rate = 6.00% − 0.75% = 5.25%.
  2. Monthly interest = 144 × 0.0525 ÷ 12 = 7.56 ÷ 12 = $0.63 million.
  3. Total principal = 0.40 + 1.10 = $1.50 million.
  4. Ending balance = 144 − 1.50 = $142.50 million.

Answer: Investor interest is $0.63 million (B) and the ending balance is $142.50 million.

Exam tips

  • Expect three-option items asking which rate investors earn. The answer is the pass-through rate, below the WAC.
  • Numerical options are ordered smallest to largest. Compute the fee-adjusted rate first to remove two options quickly.
  • For agency versus non-agency, link guarantee to credit risk and credit enhancement to non-agency, and keep prepayment risk in both.
  • Remember that WAC and WAM change each month as loans pay down or prepay.
  • Keep the contraction and extension links straight: falling rates mean faster prepayments and contraction risk.

Practice questions from Mortgage-Backed Security (MBS) Instrument and Market Features

Mortgage Pass-Through Securities 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: frequently asked questions

What is the difference between WAC and the pass-through rate?

WAC is the balance-weighted average of the borrowers' mortgage rates. The pass-through rate is the WAC minus servicing and guarantee fees. Investors are paid the pass-through rate.

What do WAM and WAC tell you about a pool?

WAC shows the average rate borrowers pay. WAM shows the average remaining term. Both are weighted by outstanding loan balance and change as the pool amortizes and prepays.

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

Agency RMBS are issued or guaranteed by government agencies or government-sponsored enterprises and face little credit risk. Non-agency RMBS are private-label, have no such guarantee, and use credit enhancement such as subordination. Both carry prepayment risk.

How do mortgage pass-through securities work?

A pool of mortgages is created, and investors own shares of it. Borrowers' interest, scheduled principal and prepayments are collected, fees are deducted, and the rest is passed to investors each month in proportion to their share.