What Is the Weighted Average Coupon (WAC)?
The weighted average coupon (WAC) is a measurement of the rate of return on a pool of mortgages that is sold to investors as a mortgage-backed security (MBS). The underlying mortgages are repaid at different lengths of time, so the WAC represents its return at the time it was issued and may differ from its WAC later.
- The WAC is the average gross interest rate of the underlying mortgages in a mortgage-backed security at the time it was issued.
- The WAC on a mortgage-backed security is used by analysts of these investments to estimate its pre-pay characteristics.
- The WAC will change over time as the mortgages underlying the security are repaid.
Understanding a Weighted Average Coupon (WAC)
Banks routinely sell the mortgages they issue on a secondary mortgage market. The buyers are institutional investors such as hedge funds, and investment banks. These buyers package the mortgages into marketable securities that can be traded to investors on the open market as mortgage-backed securities (MBS).
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.
Calculating the WAC
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.
To calculate the WAC, the coupon rate of each mortgage or MBS is multiplied by its remaining principal balance. The results are 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 bundle, or 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%
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.
When an MSB Gets Risky
No mention of mortgage-backed securities is complete without a reference to the 2007-2008 financial crisis, which was blamed on them in large part.
Many of the MBS investments of that period were backed by mortgages issued during the nationwide housing bubble and, in many cases, issued to borrowers who could not afford to repay them. When the bubble burst, many of these borrowers were forced into default and the value of the securitization of these assets melted away.
They were, in fact, collateralized with subprime loans.