Mortgage Pass-through Securities: Characteristics and Risks

  • 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.

  • A mortgage pass-through security is a type of MBS.

  • Following issuance, pass-throughs can be resold by investors on the secondary market.

Pass-through Rate = Mortgage Rate - Service Fee

  • 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").

  • WAC = weighted average coupon rate of the mortgages in the security pool

  • WAM = weighted average of maturity of the mortgage in the security pool

Pass-through Types

  • Agency Pass-throughs: Guaranteed by U.S. government agencies (Fannie Mae, Freddie Mac, and Ginnie Mae).

  • 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.

  • Mortgage Pass-throughs: Issued by Ginnie Mae and Fannie Mae

  • Participation Certificates: Issued by Freddie Mac

  • Conforming Mortgages: Meet standards to obtain agency backing

  • Jumbo Mortgages: Mortgages that do not qualify for agency backing because of their size (too large)

  • 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

  • Interest Rate Risk: As rates rise, the security's value will fall.

  • 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.

  • Prepayments are unpredictable, but directionally they increase as interest rates fall and decrease as interest rates rise.

  • Prepayment risk is form of reinvestment risk, as the investor will be forced to re-invest at lower interest rates.

  • MBS securities exhibit negative convexity as a result of the ability to prepay.

  • Credit Risk: Agency securities tend to have low credit risk.

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