What is the Weighted Average Coupon - WAC
The weighted average coupon (WAC) is the weighted-average gross interest rates of the pool of mortgages that underlie a mortgage-backed security (MBS) at the time the securities were issued. A mortgage-backed security's current WAC can differ from its original WAC as the underlying mortgages pay down at different speeds.
BREAKING DOWN Weighted Average Coupon - WAC
Banks usually sell a large percentage of newly originated mortgages on the secondary mortgage market to investors, such as pension funds, hedge funds, investment banks, etc. These investors securitize these mortgages into a marketable security that can be traded on the open markets, creating a mortgage-backed security. In effect, a mortgage-backed security (MBS) is a security that is backed by a collection or pool of mortgages. MBS holders receive interest or coupon payments which is calculated as the weighted average of the underlying coupon of the mortgage loans backing the MBS.
The weighted average coupon (WAC) is calculated by taking the gross of the interest rates owed on the underlying mortgages of the MBS and weighting them according to the percentage of the security that each mortgage represents. The WAC represents the average interest rate of different pools of mortgages with varying interest rates. In the weighted average calculation, the principal balance of each underlying mortgage is used as the weighting factor. In other words, the average of the mortgages is measured according to their weight in the mortgage-backed security. To calculate the WAC, the coupon rate of each mortgage or MBS is multiplied by its remaining principal balance. The result gotten from each security is added together, and the sum total is divided by the remaining balance.
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, suppose a MBS is composed of three different pools of mortgages with a principal balance of $11 million. The first mortgage tranche consists of $4 million worth of mortgages that yield 7.5%. The second pool has a $5 million mortgage balance at a 5% rate. The third pool has $2 million worth of mortgages with a rate of 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%
Alternatively, the WAC an be computed by evaluating the weight of each of the mortgage tranches first:
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%
As different mortgage holders pay down their mortgages with different rates and different tenures, the weighted average coupon rate may change over the life of the MBS.
The WAC on a mortgage-backed security is an important piece of information used by analysts to estimate the pre-pay characteristics of that security. It is an important relative value tool in MBS portfolio management and analysis.