Mortgage-backed securities are one of the many financial innovations born in the US financial markets. The mortgage-backed securities provided a way for investors to get access to a new and untapped source of investment – mortgage loans.

In simple words, a mortgage-backed security (MBS) is a security sold to investors, whose cash flow is backed by a pool of mortgage loans. There are many types of MBS such as pay-through securities, pass-through securities, and collateralized mortgage obligations (CMOs).

In this article, we will look at what mortgage pass-through securities are and how they work.

Let’s first review what a mortgage loan is. A mortgage loan is a loan taken by a homeowner to buy the home or any other property. The loan is secured by the home for which the loan was taken. A mortgage loan will typically have a term within which the loan needs to be repaid, and it will have a monthly payment schedule. The borrower will have to make these monthly payments called Equal Monthly Instalments (EMI) to the lender. EMI consists of the interest payments and a portion of the principal payment calculated in such a way that at the end of the loan term, the entire principal has been paid. This is also called loan amortization. Apart from the interest and principal payment, the borrowers also have the option to make extra payments in order to help them pay off their loan early. These are called prepayment. Prepayments are a common phenomenon. So, a loan typically pays three kinds of cash flows, namely, net interest, scheduled principal payment and prepayment.

Now let’s move our attention to a mortgage pass-through security. In a mortgage-pass through security, thousands of mortgage loans are collected into a pool, known as mortgage pool. With this mortgage pool as a collateral securities are issued to the investors representing a share in the mortgage pool. As the name suggests, the cash flow from the mortgage pool is simply passed on to the investors on a prorate basis.

Since the total cash flow from the collateral pool is uncertain (due to prepayments), the payments to the security holders also are uncertain.

Let’s say the collateral pool contains 1,000 loans each amounting to $100,000. So, the total collateral pool has a value of $100 million. Assume that 100,000 pass-through certificates are issued, each worth $1,000. Each certificate or share represents 0.001% (1/100,000) of the cash flow.

Below are some of the important points about pass-through securities:

• The cash flows from the mortgage pool are passed-through to the investors on a pro-rata basis.
• The investors in pass-through MBS are exposed to prepayment risk.
• These securities are issued by government agencies such as Ginnie Mae, Fannie Mae, and Freddie Mac.
• Securities issued by these agencies are also called agency MBS, and are guaranteed for timely payment of principal and interest.
• The loans, to be included in the collateral pool, must satisfy certain criteria, and are called conforming loans.
• Loans not satisfying the criteria become nonconforming loans, and are used in collateral pools for MBS not issued by the agencies.
• The lender creating the loan is called the originator. The originator will generally sell the loan pool to a special purpose vehicle (SPV) who will then create and issue securities to investors.