Agency pass throughs

What Are Agency Pass-Throughs?

Agency pass-throughs are a type of fixed-income security representing an ownership interest in a pool of mortgage loans. These securities are issued or guaranteed by U.S. government agencies or government-sponsored enterprises (GSEs) such as the Government National Mortgage Association (Ginnie Mae), the Federal National Mortgage Association (Fannie Mae), and the Federal Home Loan Mortgage Corporation (Freddie Mac). When investors purchase agency pass-throughs, they are essentially buying a share of the expected principal and interest payments from the underlying mortgage pool. The term "pass-through" refers to the mechanism by which the principal and interest collected from homeowners' monthly mortgage payments are "passed through" to the investors, after deducting servicing and guarantee fees. This makes them a fundamental component of the broader mortgage-backed securities (MBS) market.

History and Origin

The concept of pooling mortgages and selling interests in those pools to investors began to formalize in the mid-20th century. A significant milestone in the history of agency pass-throughs was the establishment of Ginnie Mae in 1968. As part of the Housing and Urban Development Act of 1968, Congress partitioned Fannie Mae, which had been created in 1938, into two entities: the newly privatized Fannie Mae and the government-owned Ginnie Mae. This restructuring aimed to further broaden the capital base available for mortgages. Ginnie Mae became the first organization to create and guarantee mortgage-backed securities products in 1970, providing a full faith and credit guarantee of the U.S. government on the timely payment of principal and interest on these securities.⁶ This guarantee was crucial in encouraging broader investor participation in the housing finance system, leading to the widespread adoption of agency pass-throughs.

Key Takeaways

• Agency pass-throughs are mortgage-backed securities issued or guaranteed by U.S. government agencies (like Ginnie Mae) or government-sponsored enterprises (like Fannie Mae and Freddie Mac).
• They represent a direct claim on the cash flows from a pool of underlying mortgage loans, with principal and interest payments passed through to investors.
• Ginnie Mae securities carry the "full faith and credit" guarantee of the U.S. government, providing the highest level of credit protection to investors.
• Investors in agency pass-throughs are exposed to prepayment risk, as homeowners may refinance or pay off their mortgages early, altering the expected cash flow stream.
• These securities offer investors attractive yields compared to Treasury securities and typically provide monthly payouts.

Interpreting the Agency Pass-Throughs

Interpreting agency pass-throughs primarily involves understanding the expected cash flow stream and the associated risks. Unlike traditional bonds where the coupon rate and maturity are fixed, the cash flows from agency pass-throughs can be variable due to prepayments. A key factor in their interpretation is the "weighted average maturity" or "weighted average life" of the underlying mortgage pool, which helps investors estimate when they might receive their principal back.

Investors evaluate agency pass-throughs based on factors such as their liquidity, the credit quality of the underlying mortgages, and the issuing agency's guarantee. For instance, Ginnie Mae pass-throughs are viewed as having virtually no default risk due to the U.S. government's explicit guarantee. In contrast, while Fannie Mae and Freddie Mac also provide guarantees, their securities are not directly backed by the full faith and credit of the U.S. government, though they are implicitly understood to have government support. Understanding these nuances is crucial for an investor looking to incorporate agency pass-throughs into their investment portfolio.

Hypothetical Example

Imagine an investor, Sarah, wants to invest in agency pass-throughs. She decides to purchase a Ginnie Mae pass-through security. This security represents a pro-rata share in a pool of 1,000 FHA-insured mortgage loans, with a total outstanding principal balance of $100 million.

Each month, homeowners in this pool make their mortgage payments, which include both principal and interest. Let's say in one month, the total payments received from the homeowners are $600,000, consisting of $200,000 in principal and $400,000 in interest. Ginnie Mae, or its approved issuer, collects these payments, deducts a small servicing fee and its guarantee fee. The remaining amount is then "passed through" to investors like Sarah, proportional to their ownership stake. If Sarah owns 0.1% of the security, she would receive $600 (0.1% of $600,000) for that month, representing her share of the principal and interest payments. This regular distribution continues until all the underlying mortgages are paid off, or until Sarah sells her share of the agency pass-through.

Practical Applications

Agency pass-throughs are widely used in financial markets, particularly within the realm of securitization. They provide a vital source of funding for the housing market, enabling lenders to originate more mortgages by selling existing ones into the secondary market. This process creates liquidity for mortgage originators.

Institutional investors, such as pension funds, insurance companies, and mutual funds, frequently include agency pass-throughs in their portfolios due to their relatively attractive yields and, in the case of Ginnie Mae, explicit government backing. These securities serve as a key component for managing interest rate risk and diversifying fixed-income holdings. The U.S. Securities and Exchange Commission (SEC) provides guidance for investors on understanding the various structures and risks associated with mortgage-backed securities, including agency pass-throughs.⁵ Furthermore, during periods of financial stress, such as the 2008 financial crisis, the Federal Reserve has actively purchased agency mortgage-backed securities to stabilize financial markets and lower borrowing costs, demonstrating their systemic importance.

Limitations and Criticisms

Despite their advantages, agency pass-throughs are not without limitations and criticisms. The primary concern for investors is prepayment risk. When interest rates fall, homeowners are more likely to refinance their mortgages, leading to faster-than-expected principal repayments for MBS investors. This forces investors to reinvest their capital at potentially lower interest rates, negatively impacting their overall returns. Conversely, during periods of rising interest rates, homeowners are less likely to refinance, leading to "extension risk," where the average life of the security extends beyond initial expectations.

Another point of consideration, particularly for securities issued by Fannie Mae and Freddie Mac, is the nature of their guarantee. While they are government-sponsored enterprises, their securities are generally backed by their own financial ability, not the explicit full faith and credit of the U.S. government, unlike Ginnie Mae.⁴,³ This distinction became critical during the 2008 subprime mortgage crisis when Fannie Mae and Freddie Mac faced significant losses and were placed into government conservatorship, highlighting the potential credit risk associated with their implicit, rather than explicit, government backing.² This event spurred discussions about the structure and government support for these entities.

Agency Pass-Throughs vs. Collateralized Mortgage Obligation (CMO)

While both agency pass-throughs and Collateralized Mortgage Obligations (CMOs) are types of mortgage-backed securities, their structures differ significantly in how they distribute cash flows and allocate risk. Agency pass-throughs are simpler, giving each investor a pro-rata share of all principal and interest payments from the underlying mortgage pool. This means all investors in a pass-through security are equally exposed to prepayment risk; if homeowners prepay, all investors receive an early return of principal.

In contrast, a Collateralized Mortgage Obligation (CMO) is a more complex, multi-class security. It takes the principal and interest payments from a pool of mortgages (which could include agency pass-throughs as collateral) and structures them into different "tranches" or classes. Each tranche has a different payment priority, interest rate, and maturity profile, designed to appeal to investors with varying risk tolerances and investment objectives. For example, some tranches might receive all principal payments first, making them less sensitive to prepayment risk, while others might receive payments later, taking on more of that risk in exchange for potentially higher yields. This re-packaging allows for a more tailored allocation of prepayment risk among investors, which is not possible with a standard agency pass-through.

FAQs

Q: What is the main difference between Ginnie Mae, Fannie Mae, and Freddie Mac pass-throughs?

A: The key difference lies in the government backing. Ginnie Mae agency pass-throughs are explicitly backed by the "full faith and credit" of the U.S. government, meaning timely payment of principal and interest is guaranteed. Fannie Mae and Freddie Mac are government-sponsored enterprises (GSEs), and while they provide guarantees on their securities, these are not direct obligations of the U.S. government but rather backed by the enterprises themselves.¹

Q: Are agency pass-throughs considered safe investments?

A: Agency pass-throughs are generally considered relatively safe fixed-income securities, especially those guaranteed by Ginnie Mae due to the explicit U.S. government backing. Fannie Mae and Freddie Mac securities also carry high credit quality due to their government sponsorship, though they are not explicitly backed by the U.S. Treasury. However, all agency pass-throughs are subject to prepayment risk, which can affect their actual yield and maturity.

Q: How do rising or falling interest rates affect agency pass-throughs?

A: Agency pass-throughs are sensitive to changes in interest rates. When interest rates fall, homeowners are more likely to refinance their mortgages, leading to an increase in prepayments. This means investors receive their principal back sooner than expected, potentially forcing them to reinvest at lower prevailing rates. Conversely, when interest rates rise, prepayments slow down, extending the expected life of the security, which can be disadvantageous if investors could otherwise earn higher rates elsewhere.