Which of the following statements is (are) true with respect to the characteristics associated with mortgage pass-through securities?

I. The prepayment privileges that mortgagors possess is effectively the equivalent of issuing straight debt and then purchasing a bond call option.
II. The pass-through coupon rate that MBS investors will receive will always be slightly less than the mortgage rate applicable to the pool.
III. The timing of the cash flow stream from a mortgage passthrough security is just as uncertain as that of a callable bond.
IV. The weighted average maturity (WAM) of a mortgage pool is also its effective duration.

Correct Answer: I and II

I is true. The prepayment privileges allow the investor to benefit from a decline in interest rates. This is effectively the equivalent of owning a bond call option, which also pays off when interest rates decline.

II is true. The pass-through coupon rate that MBS investors will receive will always be slightly less than the mortgage rate applicable to the pool because the financial intermediary keeps a service fee.

III is incorrect. With an MBS, the principal may be repaid either partially or in whole at any time. With a callable bond, investors know exactly when a bond becomes callable; when it is called, the whole principal will be repaid. Hence, the timing of the cash flow stream from a mortgage pass-through security is much more uncertain than that of a callable bond.

IV is incorrect. The weighted average maturity of a mortgage pool is just that; it's the maturity of each individual mortgage in the pool, weighted by the size of that mortgage relative to the entire pool. The effective duration of the pool will be considerably less than the WAM, as the contraction of duration is directly affected by the size and timing of the mortgage payments made before the maturity date.