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Gnma pass through

What Is GNMA Pass-Through?

A GNMA pass-through, commonly known as a Ginnie Mae pass-through, is a type of mortgage-backed security (MBS) issued by the Government National Mortgage Association (GNMA), or Ginnie Mae. It represents an investment in a pool of mortgages, where the principal and interest payments collected from homeowners are "passed through" to investors on a monthly basis, less a servicing fee. This financial instrument belongs to the broader category of fixed-income securities and is distinguished by its explicit guarantee from the full faith and credit of the United States government. This guarantee significantly reduces the credit risk for investors.

History and Origin

The genesis of the GNMA pass-through can be traced back to the Great Depression, which spurred the creation of the Federal Housing Administration (FHA) in 1934 to insure mortgages. In 1938, the Federal National Mortgage Association (Fannie Mae) was chartered to provide liquidity to the mortgage market by buying FHA-insured loans. However, a significant turning point occurred with the Housing and Urban Development Act of 1968, which split Fannie Mae into two distinct entities: Fannie Mae, focusing on conventional mortgages, and the Government National Mortgage Association (GNMA), or Ginnie Mae, tasked with guaranteeing government-backed loans8, 9.

In 1970, Ginnie Mae developed the first mortgage-backed security, which allowed many loans to be pooled and used as collateral in a security that could be sold in the secondary market. With Ginnie Mae's explicit guarantee for the timely receipt of principal and interest, these early GNMA pass-through securities became attractive investments, channeling global investment capital into the U.S. housing finance system7.

Key Takeaways

  • GNMA pass-through securities are a type of mortgage-backed security (MBS) guaranteed by the Government National Mortgage Association (Ginnie Mae).
  • They provide investors with monthly payments representing a proportional share of principal and interest from a pool of underlying government-insured or guaranteed mortgages.
  • These securities carry the explicit guarantee of the full faith and credit of the U.S. government, making them among the safest fixed-income investments in terms of credit risk.
  • The underlying mortgages typically include those insured by the Federal Housing Administration (FHA) and guaranteed by the Department of Veterans Affairs (VA) or the United States Department of Agriculture (USDA).
  • Despite their low credit risk, GNMA pass-throughs are subject to prepayment risk and interest rate risk.

Interpreting the GNMA Pass-Through

Interpreting a GNMA pass-through involves understanding its fundamental characteristics as an investment designed to provide a steady stream of income. The value and performance of a GNMA pass-through are primarily driven by the underlying pool of mortgages and the behavior of the homeowners making payments on those mortgages. Investors receive monthly distributions of principal and interest, which can fluctuate due to prepayments.

Because the GNMA pass-through carries the full faith and credit guarantee of the U.S. government, its credit quality is considered exceptionally high, often comparable to U.S. Treasury securities. However, this guarantee does not protect against all market risks, such as changes in interest rates or the impact of prepayments. The yield an investor receives can be influenced by how quickly borrowers repay their mortgages, which affects the timing and total amount of interest received over the life of the security.

Hypothetical Example

Consider an investor who purchases a GNMA pass-through security with an initial face value of $100,000 and a stated coupon rate of 4%. This security represents a pro-rata share in a pool of government-backed mortgages.

Each month, as homeowners in the underlying mortgage pool make their payments, the investor receives their proportional share of the principal and interest, minus a small servicing fee retained by the mortgage servicer.

For example, in a given month:

  • Total interest collected from the pool applicable to the investor's share: $333.33 (based on the annual 4% rate on a portion of the principal balance).
  • Scheduled principal repayment from the pool applicable to the investor's share: $150.
  • Additional principal due to prepayments (e.g., homeowners refinancing or selling): $50.
  • Total payment received by the investor for that month: $333.33 (interest) + $150 (scheduled principal) + $50 (prepayment principal) = $533.33.

The investor's principal balance in the GNMA pass-through is reduced by the total principal received ($150 + $50 = $200), and subsequent interest payments will be calculated on the new, lower outstanding principal balance. This monthly flow of payments continues until all underlying mortgages in the pool are paid off or mature.

Practical Applications

GNMA pass-through securities are widely used by various types of investors seeking stable, high-credit-quality income streams. They are a staple in portfolios of institutional investors such as pension funds, insurance companies, and mutual funds due to their government backing and consistent cash flow. Individual investors can access GNMA pass-throughs through bond funds, exchange-traded funds (ETFs), or by purchasing individual certificates through brokerage firms, though individual certificate purchases are less common due to large denominations and complexity.

These securities play a crucial role in the U.S. housing finance system by enabling continuous liquidity for government-insured mortgage programs. Ginnie Mae's guarantee ensures that lenders can sell these loans in the secondary market, freeing up capital to originate new mortgages for eligible borrowers, including first-time homebuyers, low- to moderate-income borrowers, veterans, and rural residents6. This mechanism helps maintain the affordability and availability of housing finance across the nation.

Limitations and Criticisms

While GNMA pass-through securities are highly regarded for their low credit risk due to the explicit U.S. government guarantee, they are not without limitations and criticisms. The primary concern for investors is prepayment risk. This risk arises when homeowners pay off their mortgages earlier than expected, often through refinancing when interest rates fall or by selling their homes. For an investor in a GNMA pass-through, accelerated principal payments mean that the capital must be reinvested, potentially at lower prevailing interest rates, leading to a reduced overall yield5.

Conversely, in a rising interest rate environment, GNMA pass-through securities are also subject to interest rate risk. As new mortgages are issued with higher rates, the market value of existing GNMA pass-throughs with lower coupon rates may decline. Investors who need to sell their securities before maturity might experience losses4. Another consideration is that income generated from GNMA pass-through securities is generally considered taxable at both federal and state levels.

GNMA Pass-Through vs. Fannie Mae/Freddie Mac MBS

While both GNMA pass-throughs and mortgage-backed securities (MBS) issued by Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation) pool mortgages and pass payments to investors, a crucial distinction lies in their backing.

GNMA pass-through securities are explicitly guaranteed by the full faith and credit of the U.S. government. This means that if the underlying mortgage payments are not made, the government is legally obligated to ensure investors receive their scheduled principal and interest payments. The mortgages underlying GNMA pass-throughs are typically those insured or guaranteed by federal agencies like the FHA, VA, or USDA.

In contrast, Fannie Mae and Freddie Mac are government-sponsored enterprises (GSEs). While they operate under a perceived implicit government backing (which became explicit during the 2008 financial crisis when they were placed into conservatorship), their MBS are not direct obligations of the U.S. government. The mortgages they purchase and securitize are primarily conventional loans that meet certain underwriting standards. This difference in explicit versus implicit backing contributes to slight variations in perceived risk and yield between the two types of MBS.

FAQs

Are GNMA pass-throughs risk-free?

While GNMA pass-throughs have virtually no credit risk due to the full faith and credit guarantee of the U.S. government, they are not entirely risk-free. They are subject to prepayment risk (if borrowers pay early) and interest rate risk (if interest rates change)3.

How do I invest in GNMA pass-through securities?

Individual investors typically gain exposure to GNMA pass-throughs through mutual funds or exchange-traded funds (ETFs) that specialize in mortgage-backed securities or fixed-income investments. It is also possible to buy individual GNMA certificates through a brokerage account, though this is less common for retail investors due to higher denominations and complexities.

Do GNMA pass-throughs pay monthly?

Yes, investors in GNMA pass-through securities typically receive monthly payments, which represent their proportional share of the principal and interest collected from the underlying pool of mortgages1, 2. These payments can vary month-to-month based on the payment behavior of the homeowners in the pool.