Pass through security: Meaning, Criticisms & Real-World Uses

What Is a Pass Through Security?

A pass-through security is a type of fixed-income security that represents an investment in a pool of underlying assets, such as residential mortgage-backed securities (MBS) or auto loans. In the realm of debt instruments, this structure allows regular cash flows generated by these assets—primarily principal and interest payments—to be "passed through" from the borrowers, via a servicing intermediary, to the investors who hold the security. The intermediary typically deducts a servicing fee before remitting the remaining payments. Pass-through securities are a fundamental component of the broader securitization process, enabling originators to transform illiquid assets into tradable financial instruments.

History and Origin

The concept of pass-through securities gained prominence with the establishment of government-sponsored enterprises (GSEs) in the United States, particularly the Government National Mortgage Association (Ginnie Mae). Ginnie Mae was founded in 1968 as part of the U.S. Department of Housing and Urban Development (HUD) with the aim of promoting affordable homeownership by providing liquidity to the secondary mortgage market. In 1970, Ginnie Mae issued the first-ever mortgage-backed security, which operated on a pass-through structure, directly channeling borrower payments to investors.,

Prior to this innovation, mortgage lenders often held loans on their balance sheets, limiting their capacity to issue new loans. The introduction of the pass-through security allowed lenders to sell pools of mortgages to investors, thereby freeing up capital for further lending and expanding the availability of mortgage credit. Thi⁸s mechanism became a cornerstone of the housing finance system, evolving to include pools of various other assets, leading to the development of other forms of asset-backed security.

Key Takeaways

A pass-through security channels principal and interest payments from a pool of underlying assets directly to investors.
The most common type of pass-through security is a mortgage-backed security (MBS).
Investors in pass-through securities receive monthly payments, but these payments can fluctuate due to prepayment risk.
Government agencies like Ginnie Mae guarantee some pass-through securities, significantly reducing their credit risk.
These securities are crucial for enhancing liquidity in various lending markets.

Formula and Calculation

While there isn't a single universal "formula" for a pass-through security's price due to variables like market yield and prepayment speeds, the cash flow received by an investor holding a pass-through security can be conceptualized as the sum of pro-rata principal and interest payments from the underlying pool, less servicing and guarantee fees.

The monthly payment to an investor ((PMT_I)) can be represented as:

PMT_I = \sum_{j=1}^{N} (P_{j,monthly} + I_{j,monthly}) \times \frac{Share_{Investor}}{Share_{Pool}} - Fee_{Servicing}

Where:

(P_{j,monthly}) = Monthly principal payment from loan (j)
(I_{j,monthly}) = Monthly interest payment from loan (j)
(N) = Total number of loans in the pool
(Share_{Investor}) = Investor's ownership share in the pool
(Share_{Pool}) = Total ownership shares in the pool (usually 1 or 100%)
(Fee_{Servicing}) = Servicing and guarantee fees deducted by the intermediary

The challenge in calculating future cash flows lies in predicting (P_{j,monthly}) due to prepayment risk.

Interpreting the Pass Through Security

Understanding a pass-through security involves assessing its cash flow characteristics, particularly the impact of prepayments. Unlike traditional bonds that offer predictable coupon payments and a return of principal at maturity, pass-through securities provide a variable stream of income. Investors receive payments as borrowers make their mortgage or loan payments. This means that if interest rates fall, borrowers may refinance their loans, leading to faster-than-anticipated principal repayments to the investor, a phenomenon known as prepayment risk. Con⁷versely, if interest rates rise, prepayments might slow down.

Interpreting a pass-through security also involves understanding its underlying collateral and any guarantees. For instance, pass-through securities issued by Ginnie Mae are backed by the full faith and credit of the U.S. government, providing a high degree of credit risk protection. The expected yield on these securities reflects a combination of the underlying interest rates, the prepayment assumptions, and the creditworthiness of the guarantor.

Hypothetical Example

Imagine a pool of 1,000 residential mortgages, each with an original principal balance of $200,000, totaling $200 million. A financial institution packages these into a pass-through security. An investor decides to purchase a $1 million share of this pass-through security.

Each month, as the 1,000 homeowners make their mortgage payments, the servicing institution collects these funds. Let's assume in a given month, the total principal paid across all loans is $500,000, and the total interest is $800,000. The servicing institution deducts a 0.25% annual servicing fee on the outstanding balance. After deducting this fee, the remaining principal and interest are "passed through" to the investors on a pro-rata basis.

For our investor with a $1 million share (0.5% of the initial pool), they would receive:
($500,000 principal + $800,000 interest) * 0.5% - (portion of servicing fee).
The exact servicing fee calculation would depend on the outstanding pool balance. Assuming a simplified monthly fee of 0.25% / 12 on the total pool:
$200,000,000 * (0.0025 / 12) = $41,666.67 (total monthly servicing fee).
Investor's share of fee: $41,666.67 * 0.005 = $208.33.

So, the investor receives approximately: ($1,300,000 * 0.005) - $208.33 = $6,500 - $208.33 = $6,291.67 for that month.

This example highlights that the investor receives a portion of both principal and interest, and that the amount can vary monthly due to factors like early loan payoffs (prepayments) or defaults.

Practical Applications

Pass-through securities are integral to various sectors of the financial market, facilitating capital flow and risk management.

Mortgage Finance: The most prominent application is in residential mortgage-backed securities (MBS), where they pool mortgages and allow banks to transfer the credit risk and free up capital for new lending. Ginnie Mae's pass-through programs, for example, play a vital role in ensuring that funds are available for government-insured mortgages.
⁶ Consumer Loans: Beyond mortgages, pass-through structures are used for other forms of asset-backed security, including pools of auto loans, credit card receivables, and student loans. This enables lenders to diversify their funding sources.
Investment Portfolios: Institutional investors, such as pension funds, insurance companies, and mutual funds, utilize pass-through securities to generate regular income and achieve diversification within their fixed-income portfolios. Their predictable, albeit variable, cash flows can be attractive.
Monetary Policy: Central banks, like the Federal Reserve, monitor and influence the markets for pass-through securities, particularly MBS, as part of their broader efforts to maintain financial stability and implement monetary policy. The functioning of these markets affects credit availability and overall economic conditions.

Limitations and Criticisms

Despite their benefits, pass-through securities come with specific limitations and have faced criticism, particularly during periods of financial stress.

Prepayment Risk: The primary limitation for investors is prepayment risk. When interest rates decline, borrowers tend to refinance their existing loans at lower rates, leading to an acceleration of principal payments in the pass-through pool. This means investors receive their principal back sooner than expected, forcing them to reinvest those funds at lower prevailing interest rates, potentially reducing their overall yield. Con⁵versely, in a rising interest rate environment, prepayments slow down, extending the average life of the security and locking investors into lower-yielding assets.
Extension Risk: This is the opposite of prepayment risk. If interest rates rise, borrowers are less likely to refinance or prepay, meaning the average life of the pass-through security extends beyond the initial expectations, and investors are stuck with lower-yielding assets when higher rates are available in the market.
Complexity and Lack of Transparency: Some pass-through structures, especially those beyond simple mortgage pools, can be complex, making it challenging for investors to fully assess the underlying credit risk of the diverse assets within the pool.
Role in Financial Crises: Mortgage-backed pass-through securities were heavily scrutinized during the 2008 financial crisis. While government-guaranteed pass-throughs (like Ginnie Maes) performed well due to their explicit U.S. government backing, privately issued MBS (non-agency MBS) experienced significant defaults and losses, contributing to systemic instability., Cr⁴i³ticisms focused on the inadequate assessment of risk in the underlying mortgages and the opacity of complex securitization structures.,

#²#¹ Pass Through Security vs. Collateralized Mortgage Obligation (CMO)

While both a pass-through security and a collateralized mortgage obligation (CMO) are types of mortgage-backed securities, they differ significantly in how they distribute cash flows to investors, primarily to manage prepayment risk.

A pass-through security pools mortgages, and the monthly principal and interest payments from these mortgages are "passed through" on a pro-rata basis to all investors. This means all investors in a pass-through pool share the prepayment risk equally. If borrowers prepay their mortgages, all investors in that specific pass-through security receive a portion of those early principal payments.

In contrast, a collateralized mortgage obligation (CMO) is a more complex structure that divides the cash flows from a pool of mortgages into multiple tranches or classes of bonds. Each tranche has a different priority for receiving principal and interest payments, effectively reallocating prepayment risk among investors. For example, some tranches might receive all principal payments first (short-term tranches), while others only begin receiving principal after earlier tranches are paid off (long-term tranches). This tranching allows CMOs to cater to investors with different risk appetites and investment horizons, offering greater customization than the simpler pass-through structure.

FAQs

What assets typically back a pass-through security?

Pass-through securities are most commonly backed by residential mortgages, forming mortgage-backed securities (MBS). However, they can also be backed by other financial assets like auto loans, student loans, or credit card receivables, which are categorized as asset-backed security (ABS).

Are pass-through securities considered safe investments?

The safety of a pass-through security largely depends on the credit quality of the underlying assets and whether the security carries a guarantee. For example, pass-through securities guaranteed by government agencies like Ginnie Mae are considered very safe because they are backed by the full faith and credit of the U.S. government, mitigating credit risk. Privately issued pass-throughs, however, carry higher credit risk and their safety depends on the quality of the collateral and any credit enhancements.

How do interest rates affect pass-through securities?

Interest rates significantly affect pass-through securities due to prepayment risk. When interest rates fall, borrowers are more likely to refinance their loans, leading to increased prepayments and a faster return of principal to investors. This can force investors to reinvest funds at lower rates. Conversely, when rates rise, prepayments slow down, extending the life of the security and potentially locking investors into lower-yielding assets.

Do pass-through securities pay monthly?

Yes, most pass-through securities, especially mortgage-backed ones, are designed to make monthly payments to investors. This aligns with the monthly nature of the underlying mortgage or loan payments from which the cash flows are derived. These payments consist of both principal and interest payments.