Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Pass-Through Security

What it is:

Pass-through securities receive payments from an intermediary that collects payments from a pool of assets.

How it works (Example):

Mortgage-backed securities (MBS) are some of the most common pass-through securities. To get a feel for how the "pass-through" in Pass-Through Securities works, let's take a closer look at MBS.

Step 1: Pool Some Assets

Let's assume you want to buy a house, and so you get a mortgage from XYZ Bank. XYZ Bank transfers money into your account, and you agree to repay the money according to a set schedule. XYZ Bank (which could also be a thrift, credit union, or other originator) may then choose to hold the mortgage in its portfolio (i.e., simply collect the interest and principal payments over the next several years) or sell it.

If XYZ Bank sells the mortgage, it gets cash to make other loans. So let's assume that XYZ Bank sells your mortgage to ABC Company, which could be a governmental, quasi-governmental, or private entity. ABC Company groups your mortgage with similar mortgages it has already purchased (referred to as "pooling" the mortgages). The mortgages in the pool have common characteristics (i.e., similar interest rates, maturities, etc.).

Step 2: Securitize the Pool
ABC Company then sells securities that represent an interest in the pool of mortgages, of which your mortgage is a small part (called securitizing the pool). It sells these securities to investors in the open market. With the funds from the sale of the securities, ABC Company can purchase more mortgages and create more mortgage-backed securities.

Step 3: Pass the Payments from the Borrowers to the Investors (the "pass-through")
Here is how XYZ Bank and ABC Company make money by buying and selling mortgages: When you make your monthly mortgage payment to XYZ Bank, XYZ Bank keeps a fee or spread and sends the rest of the payment to ABC Company. ABC Company in turn takes a fee and passes what's left of your principal and interest payment along to the investors who hold the mortgage-backed securities (ABC Company hires a central paying agent to accomplish this administratively).

Why it Matters:

Pass-through securities are much like bonds. Most offer semi-annual or monthly income, and this payment frequency enhances the compounding effects of reinvestment. However, it is important to note that payments that are part interest and part principal could be unfavorable to some investors, because with each increase in outstanding principal there is a corresponding decrease in the amount of interest that accrues.

For example, if a $50,000 Ginnie Mae loan with a 5% coupon would pay $208.35 ($50,000 x .05/12) in interest every month, but it might also pay $100 in principal. This means that only $49,900 is earning interest next month, and by the end of the year there may only be $48,800 earning interest. The return of principal could also vary depending on how quickly the underlying mortgages are repaid.

Although the diversification offered by investing in a pool of mortgages considerably mitigates the risk that an MBS issuer will default, some MBS have additional layers of default protection. For example, consider a GNMA MBS. Its first protection against default is the creditworthiness of the original borrower (that is, the borrower's ability to repay XYZ Bank). Second is the mortgage insurance or guarantee provided by a government-sponsored enterprise (for example, if the borrower has qualified for a VA loan, whereby the Veterans Administration promises to repay XYZ Bank if the borrower cannot). Third is the creditworthiness of the MBS issuer (in our example, ABC Company's ability to pass on interest and principal payments to the MBS investors). Fourth is GNMA's financial strength (that is, GNMA's ability to pay the MBS investors if ABC Company does not). Fifth is the full faith and credit of the U.S. government (that is, the government's ability to print currency to make interest and principal payments on GNMA-guaranteed MBS if GNMA cannot fulfill its obligations).

Prepayment risk can also be a concern. When people move, for example, they sell their houses, pay off their mortgages with the proceeds, and buy new houses with new mortgages. When interest rates fall, many homeowners refinance their mortgages, meaning they obtain new, lower-rate mortgages and pay off their higher-rate mortgages with the proceeds.