The most common type of mortgage-backed security is Pass-Throughs.
Understanding Pass-Through Securities
Pass-through securities are a fundamental form of mortgage-backed securities (MBS). They represent an investment in a pool of mortgage loans. In this structure, payments from individual mortgages—including both principal and interest—are collected by a trust or issuing entity. These collected payments are then passed along to investors who hold shares in the security, typically on a monthly basis.
This direct flow of payments from borrowers to investors, minus administrative fees, is what gives pass-throughs their name. They offer investors a way to gain exposure to the housing market and receive a steady income stream derived from mortgage payments.
How Pass-Throughs Work
The process of a pass-through security involves several key steps:
- Mortgage Origination: Lenders issue individual mortgage loans to homeowners.
- Pooling of Mortgages: A financial institution or government-sponsored enterprise (GSE) purchases many of these individual mortgages and groups them into a large pool.
- Securitization: This pool of mortgages is then used as collateral to issue a new security, the pass-through certificate.
- Investor Payments: Investors purchase shares of these pass-through certificates. As homeowners make their monthly mortgage payments, these funds are collected by the trust and distributed to the investors based on their proportional ownership.
Key Characteristics of Pass-Throughs
Pass-through securities are valued for their simplicity relative to other MBS structures, but they do come with specific considerations for investors:
- Regular Income: They provide a consistent stream of income, making them attractive to investors seeking yield.
- Exposure to Mortgage Market: Investors gain direct exposure to the performance of the underlying mortgages.
- Prepayment Risk: A significant risk associated with pass-throughs is prepayment risk. This occurs when homeowners pay off their mortgages early (e.g., by refinancing at lower interest rates or selling their home). When prepayments happen, investors receive their principal back sooner than expected, which can reduce the total interest earned over the life of the security, especially in declining interest rate environments.
Common Types of Mortgage-Backed Securities
While Pass-Throughs are the most prevalent, other types of MBS exist, each with unique structures and risk profiles.
| MBS Type | Description | Commonality |
|---|---|---|
| Pass-Throughs | Represents direct ownership in a pool of mortgages; principal and interest payments are collected by a trust and then passed along to investors. | Most Common |
| CMOs | Collateralized Mortgage Obligations: More complex MBS structured into different "tranches" with varying maturities, interest rates, and risk levels, redirecting cash flows. | Common |
| Stripped MBS | Created by separating the principal and interest components of a mortgage pool into two distinct securities (Principal-Only or Interest-Only strips). | Less Common |
The straightforward nature of pass-throughs, directly linking investor returns to the underlying mortgage payments, contributes to their widespread use and makes them a cornerstone of the mortgage-backed securities market. For more detailed information, you can explore resources on Pass-Through Securities.
