What Is the Weighted Average Coupon (WAC)?
Let me explain the weighted average coupon, or WAC, directly to you. It's a measurement of the rate of return on a pool of mortgages that gets sold to investors as a mortgage-backed security, or MBS. These underlying mortgages are repaid over different periods, so the WAC shows the return at the time of issuance and can change from the later WAC.
Key Takeaways
You should know that the WAC is the average gross interest rate of the underlying mortgages in an MBS at issuance. Analysts use the WAC on an MBS to estimate its prepayment characteristics. And remember, the WAC will shift over time as those underlying mortgages get repaid.
Understanding a Weighted Average Coupon (WAC)
Banks regularly sell the mortgages they originate on the secondary mortgage market. The buyers are institutional investors like hedge funds and investment banks. These buyers then package those mortgages into marketable securities traded on the open market as MBS.
In the weighted average calculation, I want you to note that the principal balance of each mortgage serves as its weighting factor. Holders of MBS receive interest or coupon payments, calculated as the weighted average of the underlying coupon rates of the mortgage loans backing the MBS.
Calculating the WAC
To calculate the weighted average coupon, or WAC, you take the gross interest rates owed on the underlying mortgages of the MBS and weight them by the percentage of the security each mortgage represents. The WAC stands for the average interest rate across different pools of mortgages with varying rates. Again, the principal balance of each underlying mortgage acts as the weighting factor.
Here's how you do it: multiply the coupon rate of each mortgage or MBS by its remaining principal balance, add those results together, and divide the sum by the total remaining balance. You can also calculate it by finding the weights of each mortgage pool, multiplying by their respective coupon rates, and adding up the results to get the WAC.
Example Calculation
Suppose an MBS consists of three different pools of mortgages with a total principal balance of $11 million. The first tranche has $4 million in mortgages yielding 7.5%. The second has $5 million at 5%, and the third has $2 million at 3.8%.
Using the first method: WAC = [($4 million x 0.075) + ($5 million x 0.05) + ($2 million x 0.038)] / $11 million = ($300,000 + $250,000 + $76,000) / $11 million = $626,000 / $11 million = 5.69%.
Alternatively, compute the weights first: Pool 1 weight is $4 million / $11 million = 36.36%, Pool 2 is 45.45%, Pool 3 is 18.18%. Then WAC = (36.36 x 0.075) + (45.45 x 0.05) + (18.18 x 0.038) = 2.727 + 2.2725 + 0.6908 = 5.69%.
The weighted average coupon rate can change over the MBS's life as mortgage holders pay down their loans at different rates and schedules.
When an MBS Gets Risky
I can't discuss mortgage-backed securities without mentioning the 2007-2008 financial crisis, which was largely blamed on them. Many MBS investments back then were backed by mortgages from the housing bubble, often issued to borrowers who couldn't repay. When the bubble burst, defaults surged, and the value of these securitized assets collapsed. In reality, they were collateralized with subprime loans.
