- 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.
- 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 Rate = Mortgage Rate – Service Fee
- 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.