FRM Exam Part II · Structured Credit Risk

ABS, MBS and Mortgage Products: Prepayment, CPR and PSA

Updated 11 October 2026 · Fact-checked

ABS are securities backed by pools of non-mortgage loans such as autos, cards and student loans. MBS are backed by mortgage pools. In a pass-through, borrower payments flow to investors, so prepayments shorten the life and cause prepayment risk. Measure speed with SMM, CPR and PSA, then judge the rate effect.

Understand ABS, MBS and Mortgage Products

A securitisation pools loans and sells claims on the cash flows. MBS are backed by mortgages. ABS, in the narrow sense, are backed by other receivables: auto loans, credit cards, student loans, equipment leases. Mortgage pools are often treated as a separate class because prepayment is so important to them.

In a pass-through, a servicer collects scheduled principal, interest and any prepayments, deducts servicing and guarantee fees, and passes the rest to investors pro rata. The pass-through rate (coupon) is lower than the weighted average coupon (WAC) of the underlying mortgages. Agency MBS carry a guarantee of timely payment, so the main risk is prepayment, not default. Non-agency MBS add credit risk, handled with subordination and tranching.

Prepayment risk is the risk that borrowers repay earlier or later than expected. When rates fall, borrowers refinance, so principal returns early and must be reinvested at lower yields. This is contraction risk. When rates rise, prepayments slow and the security lasts longer, which is extension risk. The borrower holds a prepayment option, so MBS show negative convexity: price gains are capped when rates fall and price losses grow when rates rise.

Prepayment speed is quoted as SMM (single monthly mortality, the fraction of the remaining balance prepaid in a month) or CPR (conditional prepayment rate, the annualised equivalent). The PSA benchmark is a standard ramp: 100% PSA means CPR starts at 0.2% in month 1, rises by 0.2% each month to 6% at month 30, then stays at 6%. 200% PSA doubles those CPRs. A higher PSA means faster prepayment.

Collateral matters too. Mortgage pools differ by loan type (fixed or adjustable rate, prime or subprime), age (seasoning), geography and loan-to-value. ABS collateral differs in prepayment behaviour: credit card pools revolve and have no fixed amortisation, so they use early amortisation triggers, while auto loans prepay in a more predictable way.

Key formulas to remember

SMM from CPR: SMM = 1 − (1 − CPR)^(1/12); CPR is annual. SMM is the monthly prepaid fraction of the balance after scheduled principal.
CPR from SMM: CPR = 1 − (1 − SMM)^12; Do not simply multiply SMM by 12. That is only a rough approximation.
Prepayment amount: Prepayment = SMM × (Beginning balance − Scheduled principal); Apply SMM after removing scheduled principal.
PSA CPR for month t: CPR = 6% × (t ÷ 30) × (PSA ÷ 100) for t ≤ 30; CPR = 6% × (PSA ÷ 100) for t > 30; Standard 100% PSA ramps 0.2% per month to 6%.
Pass-through rate: Pass-through rate = WAC − servicing and other fees; Investors receive the net coupon.
Effective duration: D = (P₋ − P₊) ÷ (2 × P₀ × Δy); Use option-adjusted cash flows. MBS have negative convexity.

How to solve ABS, MBS and Mortgage Products questions

Use this order for any ABS or MBS question.

1Identify the product: agency or non-agency, MBS or ABS, and the collateral type.
2Name the main risk: prepayment (contraction or extension), credit, or both.
3If speed is given, convert between SMM, CPR and PSA with the correct formula and units (annual or monthly).
4For PSA, find the month first. Ramp for months up to 30, flat after.
5Compute the cash flow: scheduled principal first, then prepayment = SMM × remaining balance.
6Link to rates: falling rates speed prepayment and shorten life, rising rates slow it and extend life.
7State the effect on price, duration and convexity, then check that your answer has the right sign and size.

Quickest way: Fast PSA and CPR check

When to use it: Use for MCQs that give a PSA multiple and a month, or ask which scenario hurts the investor.

Month ≤ 30: CPR = 0.2% × month × (PSA ÷ 100).
Month > 30: CPR = 6% × (PSA ÷ 100).
Convert to SMM only if a monthly figure is needed. SMM is a little below CPR ÷ 12.
Rates down: expect contraction, faster prepayment, capped price gain. Rates up: extension and larger price loss.
Eliminate options that confuse the direction of the risk.

Common mistakes in ABS, MBS and Mortgage Products

Dividing CPR by 12 to get SMM.
CPR is annual, so students treat it as simple interest.
Fix: Use SMM = 1 − (1 − CPR)^(1/12). Dividing by 12 is only an approximation.
Applying SMM to the beginning balance instead of the balance after scheduled principal.
The scheduled principal step is skipped.
Fix: Subtract scheduled principal first, then multiply by SMM.
Using the PSA cap of 6% for early months.
Students remember 6% and forget the ramp.
Fix: Check the month. Up to month 30 CPR = 0.2% × month × PSA multiple.
Saying MBS price rises without limit when rates fall.
Treating MBS like an option-free bond.
Fix: The borrower's prepayment option causes negative convexity, which caps upside.
Treating agency MBS as free of risk.
The guarantee is confused with protection from all risks.
Fix: The guarantee covers credit losses, but investors still bear prepayment and interest rate risk.
Mixing up the pass-through rate with the WAC.
Both are described as coupons.
Fix: The pass-through rate is the WAC net of servicing and guarantee fees.

Worked examples

Example 1

A mortgage pool prepays at 200% PSA. What is the CPR in month 12, and in month 40?

Show the solution

100% PSA CPR in month 12 = 0.2% × 12 = 2.4%.
At 200% PSA, month 12 CPR = 2 × 2.4% = 4.8%.
For month 40, the ramp is complete. 100% PSA CPR = 6%.
At 200% PSA, month 40 CPR = 2 × 6% = 12%.

Answer: CPR is 4.8% in month 12 and 12% in month 40.

Example 2

A pool has a beginning balance of $200 million, scheduled principal of $2 million and SMM of 0.5%. What is the month's prepayment, and what is the end balance? Ignore any other flows.

Show the solution

Balance after scheduled principal = 200 − 2 = $198 million.
Prepayment = 0.5% × 198 = $0.99 million.
End balance = 198 − 0.99 = $197.01 million.

Answer: Prepayment is $0.99 million and the ending balance is $197.01 million.

Exam tips

Check whether a speed is monthly or annual before any calculation.
For PSA questions, find the month first and apply the ramp or the cap accordingly.
Expect scenario questions: say whether contraction or extension risk dominates, and what happens to duration and convexity.
Separate agency questions (prepayment risk) from non-agency questions (credit risk, subordination).
In ABS questions, look at collateral features such as revolving pools and early amortisation triggers.

Practice questions from Structured Credit Risk

ABS, MBS and Mortgage Products in other exams

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

ABS, MBS and Mortgage Products: frequently asked questions

What is the difference between ABS and MBS?

MBS are backed by mortgage loans. ABS are backed by other receivables such as auto loans, credit cards and student loans. Both pool loans and pass cash flows to investors, but mortgage prepayment behaviour is a central feature of MBS.

What is the difference between CPR and SMM?

SMM is the fraction of the remaining balance prepaid in one month. CPR is the annualised rate. Convert with SMM = 1 − (1 − CPR)^(1/12).

What does 150% PSA mean?

It means prepayment speeds are 1.5 times the standard PSA ramp. CPR rises 0.3% per month to a cap of 9% from month 30.

Why do MBS have negative convexity?

Borrowers can prepay when rates fall, which limits price gains. When rates rise, prepayments slow and the security lengthens, which magnifies price losses.