Pass through securities

What Is Pass Through Securities?

Pass-through securities are a fundamental type of mortgage-backed securities (MBS) that distribute collected principal and interest payments from an underlying pool of mortgages directly to investors. Belonging to the broader category of securitization within fixed income investments, these securities are designed to allow investors to participate in the cash flows generated by residential or commercial mortgages without directly holding the individual loans. Investors in pass-through securities receive a proportional share of the monthly payments made by the borrowers in the pool, after deducting servicing fees and any guarantee fees.

History and Origin

The genesis of modern pass-through securities can be traced back to the Great Depression, when high unemployment led to widespread loan defaults and a downturn in the U.S. housing market. In response, the Federal Housing Administration (FHA) was created in 1934 to insure mortgages, and the Federal National Mortgage Association (Fannie Mae) was chartered in 1938 to establish a secondary market for FHA-insured loans, providing liquidity to lenders²⁹, ³⁰.

A significant milestone occurred in 1968 with the Housing and Urban Development Act, which split Fannie Mae into two entities: the new Fannie Mae (focused on conventional mortgages) and the Government National Mortgage Association (Ginnie Mae). In 1970, Ginnie Mae developed and guaranteed the first mortgage-backed security, which was a pass-through security. This innovation allowed many loans to be pooled and used as collateral for a security that could be sold in the secondary market, fundamentally changing how mortgage loans were financed²⁵, ²⁶, ²⁷, ²⁸. Soon after, Freddie Mac and Fannie Mae also began issuing their own pass-through securities for conventional mortgages²⁴.

Key Takeaways

• Pass-through securities distribute proportional principal and interest payments from pooled mortgages directly to investors.
• They are a basic form of mortgage-backed securities (MBS).
• Investors in pass-through securities are exposed to prepayment risk, as homeowners can repay their mortgages early.
• The Government National Mortgage Association (Ginnie Mae) pioneered the first modern pass-through security in 1970.
• These securities provide a regular income stream, typically monthly, from the underlying mortgage payments.

Formula and Calculation

The cash flow to a holder of a pass-through security is derived directly from the payments made by the underlying mortgage borrowers, less servicing and guarantee fees. While there isn't a single "formula" for the security itself, the monthly payment an investor receives can be conceptualized as:

Where:

• Total Principal Payments: The aggregate principal portion of monthly mortgage payments from all loans in the pool.
• Total Interest Payments: The aggregate interest payments portion of monthly mortgage payments from all loans in the pool.
• Servicing Fees: Fees paid to the loan servicer for collecting payments and managing the loans.
• Guarantee Fees: Fees paid to the issuing agency (e.g., Ginnie Mae, Fannie Mae, Freddie Mac) for guaranteeing timely payment of principal and interest.
• Investor's Proportional Share: The investor's percentage ownership of the pass-through security pool.

Interpreting the Pass Through Securities

Interpreting pass-through securities primarily involves understanding the cash flow stream and the associated risks. Unlike traditional bonds that typically offer predictable coupon payments and a lump-sum principal repayment at maturity, pass-through securities present a more variable cash flow profile due to prepayment risk. When interest rates fall, homeowners may refinance their mortgages, leading to earlier-than-expected principal repayments to the pass-through security holders. Conversely, when rates rise, prepayments tend to slow, extending the security's duration.

Investors evaluate pass-through securities based on their expected yield, which is influenced by prevailing interest rates and anticipated prepayment speeds. The credit quality of agency pass-through securities (issued by Ginnie Mae, Fannie Mae, or Freddie Mac) is generally high, with Ginnie Mae securities backed by the full faith and credit of the U.S. government²³. Non-agency pass-through securities, issued by private entities, carry higher credit risk as they lack this government guarantee²².

Hypothetical Example

Imagine a pool of 1,000 mortgages, each with an original balance of $200,000, a 30-year term, and a 4% annual interest rate. This pool totals $200 million in mortgages. A financial institution packages these into a pass-through security.

An investor purchases $100,000 worth of this pass-through security, representing a 0.05% share of the total pool ($100,000 / $200,000,000 = 0.0005).

In a given month, the borrowers collectively make their scheduled principal and interest payments. Suppose the total scheduled principal is $500,000 and total interest is $600,000. Additionally, due to some homeowners refinancing, there are unscheduled prepayments totaling $200,000. After deducting servicing and guarantee fees (e.g., $10,000), the net cash flow from the pool for that month is:

Net Cash Flow = ($500,000 + $600,000 + $200,000) - $10,000 = $1,290,000

The investor would then receive their proportional share:

Investor's Payment = $1,290,000 × 0.0005 = $645

This $645 represents a blend of principal and interest from the underlying mortgages, including any prepayments, directly "passed through" to the investor. This demonstrates how the investor's monthly payment can fluctuate based on the actual payment behavior of the borrowers in the pooled collateral.

Practical Applications

Pass-through securities are central to the mortgage finance system, enabling mortgage lenders to free up capital for new loans by selling existing ones. This securitization process enhances liquidity in the housing market, potentially leading to lower mortgage rates for borrowers.²⁰, ²¹

Beyond facilitating mortgage lending, pass-through securities are widely used by various institutional investors, including pension funds, insurance companies, and mutual funds, to generate consistent income. Their fixed income characteristics make them attractive for portfolio diversification.

Furthermore, these securities play a significant role in monetary policy. Central banks, such as the Federal Reserve, have historically purchased large quantities of mortgage-backed securities, including pass-throughs, to stimulate economic growth and reduce interest rates, particularly during times of financial crisis.¹⁷, ¹⁸, ¹⁹ For example, after the 2008 financial crisis, the Fed acquired over $1 trillion in mortgage bonds to support the housing market.¹⁶

Limitations and Criticisms

While pass-through securities offer benefits, they come with inherent limitations, primarily due to the unpredictable nature of the underlying mortgage payments. The most significant concern is prepayment risk, which occurs when homeowners pay off their mortgages earlier than expected, often through refinancing when interest rates decline. This means investors receive their principal back sooner than anticipated, forcing them to reinvest those funds in a lower interest rate environment, potentially reducing their overall yield.¹⁵ Conversely, if interest rates rise, prepayments slow down, extending the security's expected life and potentially locking investors into lower-yielding assets for longer.

Another criticism, particularly evident during the 2008 financial crisis, pertains to the transparency and credit risk of non-agency pass-through securities. Before the crisis, lax underwriting standards for some pooled mortgages led to a surge in defaults, causing significant losses for investors in private-label MBS.¹³, ¹⁴ This highlighted the importance of robust disclosure regarding the quality of the underlying loans. Post-crisis, the U.S. Securities and Exchange Commission (SEC) implemented new rules to enhance disclosure requirements for mortgage-backed and asset-backed securities to improve investor assessment of risks.¹¹, ¹² The Federal Reserve Bank of San Francisco has also discussed how issues stemming from the mortgage market can trigger broader financial instability and credit crunches.¹⁰

Pass Through Securities vs. Collateralized Mortgage Obligation

Pass-through securities and Collateralized Mortgage Obligation (CMO) are both types of mortgage-backed securities, but they differ significantly in their structure and how they distribute cash flows.

While pass-through securities offer a simpler way for investors to gain exposure to mortgage payments, CMOs were developed to provide more predictable cash flows and cater to a wider range of investor demands by segmenting risk.⁶, ⁷, ⁸, ⁹

FAQs

Q: Who issues pass-through securities?

A: Pass-through securities are primarily issued by government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac, and by a government agency, Ginnie Mae. Private financial institutions also issue non-agency pass-through securities.⁵

Q: Are pass-through securities considered safe investments?

A: Agency pass-through securities (Ginnie Mae, Fannie Mae, Freddie Mac) are generally considered very safe due to their implicit or explicit government backing, ensuring timely payment of principal and interest payments. Non-agency pass-through securities carry higher credit risk as they lack this government guarantee.³, ⁴

Q: How do pass-through securities affect the housing market?

A: Pass-through securities facilitate the flow of capital into the mortgage market. By allowing lenders to sell mortgages to investors, they free up funds for new loans, which can increase the availability of mortgages and potentially lead to more competitive mortgage rates, thus supporting homeownership.²

Q: What happens if a homeowner defaults on a mortgage within the pool?

A: If a homeowner defaults on a mortgage in an agency pass-through security, the issuing agency (Ginnie Mae, Fannie Mae, or Freddie Mac) typically guarantees the timely payment of principal and interest to the investors, mitigating the default risk for the security holders.¹ For non-agency securities, other forms of credit enhancement or subordination structures would determine how such a default impacts investors.