Explore how Weighted Average Maturity (WAM) and Weighted Average Coupon (WAC) define a mortgage pool’s interest rate profile, timing of cash flows, and implications for MBS valuation.
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Mortgage-Backed Securities (MBS) are created by pooling individual mortgages—each with its own maturity date, coupon rate, and outstanding balance—into a single instrument. If you think about it, it can feel like stuffing a bunch of puzzle pieces together to form one big mortgage “picture.” But how do we measure the overall maturity and coupon characteristics of this huge aggregate mortgage puzzle? That’s where Weighted Average Maturity (WAM) and Weighted Average Coupon (WAC) step in. These metrics help us summarize a mortgage pool’s behavior in terms of interest rates and expected cash flows.
Weighted Average Maturity (WAM)
WAM is the weighted average of the remaining maturities of the mortgages in a pool. Each mortgage in the pool has its own principal balance and maturity date, and WAM reflects how many years (on average) remain before the entire pool’s principal is scheduled to be repaid. Mathematically, if we have mortgages i ∈ {1, 2, …, N}, each with remaining maturity Mᵢ (in months or years) and an outstanding principal balance of Bᵢ, then:
WAM = ( Σ ( Mᵢ × Bᵢ ) ) / ( Σ Bᵢ )
Weighted Average Coupon (WAC)
WAC is the weighted average of the coupon rates across all mortgages in the pool, again assigning weights based on each mortgage’s outstanding principal. If Cᵢ is the coupon rate for each mortgage i and Bᵢ is its outstanding principal:
WAC = ( Σ ( Cᵢ × Bᵢ ) ) / ( Σ Bᵢ )
In practice, these formulas are typically implemented in specialized software or spreadsheets that automatically pull loan-level data and compute the pool-level metrics.
WAM and WAC can feel like fancy acronyms, but they significantly impact anyone who analyzes or invests in an MBS:
• WAM helps gauge the timing of cash flows. A pool with a higher WAM generally implies that principal repayments will take place further in the future—unless, of course, prepayments drastically alter that schedule.
• WAC tells you the average interest rate the pool is paying to mortgage holders. A higher WAC indicates a larger stream of coupon income, but it might also hint at higher prepayment risk if interest rates decline and induce refinancing.
These two metrics serve as the backbone of MBS cash flow modeling and yield forecasting. Investors and analysts juggle changes in WAM and WAC to evaluate how much principal or interest might arrive each month, which ties directly to the bond’s pricing.
In mortgage land, there’s this constant risk (or opportunity, depending on how you see it) that borrowers will pay off their loans ahead of schedule. They might move, refinance to get a lower interest rate, or just plain pay off the mortgage whenever it suits them. Here’s how it matters:
• Refinancing Shortens WAM: Imagine a borrower with 25 years left on a mortgage at 7%. If market rates fall to 5%, the borrower may refinance, paying off the original mortgage in full. That mortgage disappears from the pool, effectively lowering the WAM if many borrowers do the same.
• Prepayment Patterns Affect WAC: If high-coupon loans refinance first (the borrowers get out faster), the remaining pool might lean toward loans with lower coupons. Over time, the average coupon (WAC) may decrease, which can reduce the interest payments for the pool.
These dynamics are precisely why MBS valuations are tricky. The shape of the yield curve, housing market trends, borrower credit profiles, and interest rate movements all conspire to shift WAM and WAC in ways that can improve or erode your expected returns.
Few things in finance change as fast as mortgage pools—each month, borrowers make payments, some default, others refinance, some pay off a portion of principal early. Naturally, WAM and WAC update regularly. In an MBS analysis context:
• Monthly Pool Factor Updates: Agencies or loan servicers distribute monthly “pool factor” statements that detail changes in total outstanding principal. These statements feed into updated WAM and WAC calculations.
• Seasonal Patterns: Home-buying and refinancing can follow seasonal trends (hello spring homebuying season). This can lead to monthly or quarterly shifts in the pool that must be reflected in WAM/WAC estimates.
So if you’re evaluating an MBS for potential purchase, or just trying to forecast your existing position’s returns, it’s crucial to stay on top of how these metrics evolve. What was once a pool with a 25-year WAM and 6.5% WAC might slide to a 23-year WAM and 6.2% WAC within a year—altering its prepayment profile and cash flow expectations.
WAM and WAC form the backbone of MBS valuation models. If your Weighted Average Coupon is significantly above current market mortgage rates, you can guess that many borrowers will refinance—and thus your WAM might drop sharply, accelerating principal repayment. Similarly, if your Weighted Average Maturity is very long (like 28 or 29 years on average) in a low prepayment environment, you might expect stable but slow principal returns, which can be valuable if your portfolio needs a longer duration asset.
Some best practices and common pitfalls to keep in mind:
• Best Practices:
– Always examine historical prepayment speeds for the specific borrower type or region. Some pools are more sensitive to slight interest rate changes than others.
– Combine your WAM and WAC analysis with economic data. For instance, if interest rates are projected to remain unchanged, prepayment might slow. If they’re likely to drop, get ready for potential wave of refinancing.
– Monitor changes monthly. Even small changes can become material over time.
• Common Pitfalls:
– Assuming that WAM or WAC remain static when interest rates are volatile. They can shift quickly.
– Falling into “averages trap.” A pool’s average coupon can hide variability. Sometimes, half the pool might have a coupon near 8%, while the other half lingers near 4%. A single average can mask that distribution, making your prepayment estimates less accurate.
– Ignoring borrower behavior. It might be easy to assume that if interest rates fall, everyone refinances. But real-world borrowers behave differently. Some are locked out by credit constraints or personal factors, while others jump on the refinancing wagon immediately.
If you’re feeling adventurous (and you have a big chunk of mortgage data)—or if you just have a good MBS analytics tool—you can compute WAM and WAC yourself. Here’s how you might do it in a spreadsheet:
• Gather Loan-Level Data: For each mortgage, track its outstanding principal balance, remaining term, and current coupon rate.
• Compute Weighted Values: For WAM, multiply the remaining term by the mortgage’s principal balance. For WAC, multiply the coupon by the mortgage’s principal balance.
• Divide by Total Principal: Sum the results and divide by total outstanding principal for both WAM and WAC.
• Refresh Monthly: Update the data each month based on servicer tapes. Factor in new principal balances and any refinanced (or defaulted) loans that drop out of the pool.
Most investors, however, rely on specialized MBS analytics platforms that incorporate advanced prepayment models (like PSA, CPR, or more sophisticated data-driven approaches). These programs automatically recast WAM and WAC after each monthly payment cycle, offering yield and spread projections under various interest-rate scenarios.
Below is a simple diagram illustrating how an MBS pool’s WAM and WAC ultimately feed into valuation:
flowchart LR
A["Mortgage Pool <br/> (Various Loans)"] -- "Weighted by <br/>Principal" --> B["WAM <br/>Calculation"]
A["Mortgage Pool <br/> (Various Loans)"] -- "Weighted by <br/>Principal" --> C["WAC <br/>Calculation"]
B["WAM <br/>Calculation"] --> D["MBS <br/>Pricing Models"]
C["WAC <br/>Calculation"] --> D["MBS <br/>Pricing Models"]
Weighted Average Maturity (WAM): “The overall average time to maturity for an entire mortgage pool, weighted by outstanding principal balance.”
Weighted Average Coupon (WAC): “The average interest rate of the mortgages in an MBS pool, weighted by each loan’s outstanding principal balance.”
Resource Pooling: “The practice of combining multiple mortgages with different maturities and coupons into a single MBS.”
Refinancing Incentive: “The potential savings in interest for borrowers who replace their existing mortgage with a new one at a lower rate.”
It’s sometimes tempting to oversimplify MBS analysis by focusing on broad-based prepayment assumptions, but ignoring the nuance of WAM and WAC can be hazardous. They don’t just give us an academic sense of what the “average” loan in the pool looks like; they transform into real-time indicators of how the mortgage pool might behave next month or next year. As you progress in your CFA studies—and even more so in your actual day-to-day as a finance professional—try to keep a close eye on these metrics. They’re like the vital signs of mortgage-backed securities, telling you how fast the heart is beating and how well the lungs are working.
In the next sections, as you learn more about advanced MBS products like Collateralized Mortgage Obligations (CMOs), you’ll see these metrics broken out by tranche, each with its own WAM and WAC profile. So, keep your WAM and WAC knowledge sharp—it’s going to serve you well in the practice vignettes and your real-world MBS analysis.
• Fabozzi, Frank J. and Mann, Steven V. “The Handbook of Fixed Income Securities.”
(link: https://www.mhprofessional.com)
• “U.S. Securities and Exchange Commission (SEC) - Mortgage-Backed Securities”
(link: https://www.sec.gov)
• Consider reviewing Chapter 14: “Collateralized Mortgage Obligations (CMOs)” in this same Volume for deeper insights into how WAM and WAC factor into more complex MBS structures.
• For a refresher on prepayment modeling, revisit Chapter 13.2: “Prepayment Risk and Contraction/Extension.”
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