The Weighted Average Coupon (WAC) is a key financial metric used to calculate the average rate of return on a pool of mortgages packaged together into a mortgage-backed security (MBS). It represents the average interest rate of the individual mortgages weighted by their respective principal balances.
Importance of WAC in Mortgage-Backed Securities
Understanding Mortgage-Backed Securities (MBS)
Mortgage-backed securities are investment instruments that represent claims on the cash flows from pools of mortgage loans. These securities provide investors with an opportunity to earn returns from mortgage payments made by borrowers.
Significance of WAC
The WAC is crucial for investors in mortgage-backed securities because it provides insight into the expected rate of return on the investment. A higher WAC generally indicates a higher return but may come with increased risk, while a lower WAC might suggest lower expected returns but also potentially lower risk.
How to Calculate Weighted Average Coupon
The WAC Formula
The WAC can be calculated using the following formula:
Where:
- \(\text{Coupon Rate}\) is the annual interest rate of each individual mortgage.
- \(\text{Principal}\) is the outstanding principal balance of each individual mortgage.
Example Calculation
Consider a pool with three mortgages with the following details:
- Mortgage 1: Principal $200,000, Coupon Rate 4.5%
- Mortgage 2: Principal $300,000, Coupon Rate 5%
- Mortgage 3: Principal $500,000, Coupon Rate 4%
The WAC would be calculated as:
Historical Context and Evolution of WAC
Initially developed as part of the broader mortgage-backed securities market, the WAC emerged as a standard for evaluating the interest earnings from various mortgage pools. Its adoption allowed for clearer comparison between different MBS offerings and facilitated the growth of the secondary mortgage market.
Comparisons and Related Terms
Weighted Average Life (WAL)
Weighted Average Life (WAL) is another important measure used alongside WAC. It represents the average time until principal is expected to be repaid on the mortgages within the MBS. WAL provides insight into the duration risk of the investment.
Current Coupon
The Current Coupon refers to the yield on newly issued mortgage-backed securities coming into the market. It is a reference point for comparison with the WAC of existing MBS.
FAQs on Weighted Average Coupon
What factors can influence the WAC of an MBS?
Factors affecting WAC include the original interest rates of the individual mortgages, the remaining balance of each mortgage, and prepayment rates.
Why is WAC important for investors?
WAC helps investors gauge potential returns and risks from investing in an MBS, aiding in making informed investment decisions.
How does prepayment affect the WAC?
Prepayments can reduce the principal balances of higher or lower coupon loans disproportionately, thus changing the WAC over time.
Summary
The Weighted Average Coupon (WAC) is an essential metric for understanding the average rate of return from a pool of mortgages bundled within a mortgage-backed security. It provides investors with valuable information on expected returns, helping them navigate the complexities of the MBS market. Understanding how to calculate and interpret WAC can greatly enhance investment decision-making and risk assessment in the realm of mortgage-backed securities.
