What Is the Weighted Average Coupon (WAC)?
The weighted average coupon (WAC) is the average gross interest rate of the underlying mortgages in a mortgage-backed security at the time the security was issued. The WAC on a mortgage-backed security is used by investors and analysts to estimate the security’s pre-pay characteristics. The WAC will change over time as the mortgages underlying the security are repaid.
Key Takeaways
- WAC measures the rate of return on a mortgage-backed security (MBS) at the time of issuance.
- Calculating WAC involves using each mortgage’s principal balance as the weighting factor.
- WAC changes over time as mortgages within the security are repaid at different rates.
- MBS investments can become risky if backed by subprime loans, as seen in the 2007-2008 financial crisis.
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How the Weighted Average Coupon (WAC) Works
Banks often sell the mortgages they issue on a secondary market to institutional investors like hedge funds and investment banks. These investors then bundle the mortgages into securities called mortgage-backed securities (MBS) for trading.
Important
In the weighted average calculation, the principal balance of each mortgage is used as its weighting factor.
MBS holders receive interest or coupon payments which are calculated as the weighted average of the underlying coupon of the mortgage loans backing the MBS.
How to Calculate the Weighted Average Coupon (WAC)
The WAC is calculated by weighting interest rates according to the percentage of the security that each mortgage represents. It’s the average interest rate of different pools of mortgages.
1. Determine the gross of the interest rates for the underlying mortgage in the MBS.
2. Multiply each mortgage’s interest rate by its corresponding principal balance to get the weighted product.
3. Sum the weighted products.
4. Divide the total of weighted products by the total principal balance of all mortgages in the MBS to obtain the WAC.
Another way to calculate the weighted average coupon is by taking the weights of each mortgage pool, multiplying by their respective coupon rates, and adding the result to get the WAC.
For example, imagine an MBS with three pools of mortgages totaling $11 million. The first pool, or tranche, holds $4 million with a 7.5% rate. The second pool is $5 million at a 5% rate, and the third is $2 million at 3.8%.
Using the first method outlined above:
WAC = [($4 million x 0.075) + ($5 million x 0.05) + ($2 million x 0.038)] / $11 million
WAC = ($300,000 + $250,000 + $76,000) / $11 million
WAC = $626,000/$11 million = 5.69%
Using the second method outlined above:
Pool 1 weight: $4 million / $11 million = 36.36%
Pool 2 weight: $5 million / $11 million = 45.45%
Pool 3 weight: $2 million / $11 million = 18.18%
Sum of the weights is 100%. The WAC is, therefore, calculated as:
WAC = (36.36 x 0.075) + (45.45 x 0.05) + (18.18 x 0.038)
WAC = 2.727 + 2.2725 + 0.6908 = 5.69%
The weighted average coupon rate may change over the life of the MBS, as various mortgage holders pay down their mortgages at different interest rates and on different timetables.
Risk Factors Associated with Mortgage-Backed Securities (MBS)
Discussing mortgage-backed securities often involves mentioning the 2007-2008 financial crisis, which was largely blamed on these securities.
Many MBS at that time were backed by mortgages from the housing bubble and were given to borrowers who couldn’t repay. When the bubble burst, defaults soared, and these assets lost value. They were, in fact, collateralized with subprime loans.
The Bottom Line
The weighted average coupon (WAC) is a critical metric investors use to understand the rate of return on mortgage-backed securities. It considers the principal balance and interest rates of underlying mortgages in an MBS. The WAC changes over time as mortgages are repaid and this affects the overall return on an MBS. Subprime mortgage loans that were pooled and securitized as mortgage-backed securities played a significant role in the 2008 financial crisis.