A client holds a GNMA pass-through and asks why her principal is coming back early. Rates dropped two points. Homeowners refinanced. Her "safe" government-guaranteed security just shortened its life by five years, and she has to reinvest at lower rates. That is prepayment risk in action.
A pass-through pools residential mortgages and sends monthly payments of principal and interest directly to investors. You receive your proportional share of whatever the borrowers pay. That includes both scheduled payments and unscheduled prepayments.
Three agencies dominate this market. GNMA (Ginnie Mae) is the only one backed by the full faith and credit of the U.S. government. FNMA (Fannie Mae) and FHLMC (Freddie Mac) are government-sponsored enterprises. Their securities carry an implied guarantee, not an explicit one. The exam tests this distinction repeatedly.
KEY: GNMA = full faith and credit (explicit government guarantee). FNMA and FHLMC = implied guarantee only. All three carry prepayment risk.
Pass-throughs pay monthly, not semiannually like most bonds. That matters for cash flow comparisons. And because homeowners can prepay at any time, your principal comes back on an unpredictable schedule.
Common mistakes
- Confusing prepayment risk with extension risk. Rates fall = prepayment risk (principal comes back early, reinvest at lower rates). Rates rise = extension risk (principal stays locked up longer). The exam gives a rate scenario and asks which risk applies. Mixing them up sends you to the wrong answer every time.
- Thinking GNMA eliminates all risk. GNMA carries the full faith and credit guarantee, meaning zero credit/default risk. But GNMA pass-throughs still carry full prepayment risk, interest rate risk, and reinvestment risk. The government guarantee covers timely payment of principal and interest, not price stability. Trap answer: "GNMA securities are risk-free."
- Assuming the 5% markup policy is a hard cap. It is a guideline. A markup above 5% is not automatically a violation, and a markup below 5% is not automatically fair. The exam tests factors that determine fairness: security type, availability, transaction size, and prevailing conditions.
Bottom line
- Pass-throughs pay monthly principal plus interest; GNMA carries full faith and credit of the U.S. government, while FNMA and FHLMC have implied guarantees only
- CMO tranches redistribute prepayment risk: PAC is most stable, the companion absorbs the shock, and the Z-tranche accrues interest into principal until prior tranches retire
- CDO loss waterfall: equity tranche absorbs first, then mezzanine, then senior tranche last
- Hedge funds: '2 and 20' fee structure, accredited or qualified purchaser requirements, lock-up periods, and a high-water mark that prevents double-dipping on performance fees
Exam shortcut
When the question gives you a rate-change scenario for mortgage-backed securities, match the direction: rates down = prepayment risk (contraction), rates up = extension risk. For CMO tranches, remember the companion absorbs the shock so the PAC stays stable. For SIPC, remember the numbers as a pair: 500/250. $500,000 total, $250,000 cash cap. If cash exceeds $250,000, the excess is unprotected even if the total account is under $500,000.
The full lesson (about 3,953 words, 26 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- C11
- C12
- C13
- C14
- C15
- C16
- C17
- C18
- C19
- C20
- C21
- C22
- C23
- C24
- C25
- C26
- C27
- C28
- C29
- C30
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