Mortgage Pass-through Securities: Characteristics and Risks
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Mortgage Pass-through Security: shares in a pool of mortgages sold by a financial institution or government agency, where mortgage payments less fees are passed through to the security investors.
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A mortgage pass-through security is a type of MBS.
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Following issuance, pass-throughs can be resold by investors on the secondary market.
Pass-through Rate = Mortgage Rate - Service Fee
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Note that while mortgage payments are due on the first of the month, investors do not receive the pass-through payment for several days thereafter, enabling the servicing institution to collect several days worth of interest (which is called the "float").
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WAC = weighted average coupon rate of the mortgages in the security pool
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WAM = weighted average of maturity of the mortgage in the security pool
Pass-through Types
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Agency Pass-throughs: Guaranteed by U.S. government agencies (Fannie Mae, Freddie Mac, and Ginnie Mae).
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Technically, Fannie Mae and Freddie Mac pass-throughs are corporate and do not carry the full faith and credit of the U.S. government, but there has been considerable debate over the "implied backing" of these securities.
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Mortgage Pass-throughs: Issued by Ginnie Mae and Fannie Mae
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Participation Certificates: Issued by Freddie Mac
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Conforming Mortgages: Meet standards to obtain agency backing
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Jumbo Mortgages: Mortgages that do not qualify for agency backing because of their size (too large)
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Non-agency Pass-throughs: Are issued by private financial institutions and do not have the backing of a government agency; the mortgages in a non-agency pass-through are usually non-conforming.
Risks of Mortgage Pass-through Securities
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Interest Rate Risk: As rates rise, the security's value will fall.
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Prepayment Risk: Because mortgages can usually be prepaid at any time without penalty, mortgages essentially take the form of a callable bond that has a strike price at par.
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Prepayments are unpredictable, but directionally they increase as interest rates fall and decrease as interest rates rise.
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Prepayment risk is form of reinvestment risk, as the investor will be forced to re-invest at lower interest rates.
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MBS securities exhibit negative convexity as a result of the ability to prepay.
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Credit Risk: Agency securities tend to have low credit risk.