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Definition: Pass-Through Security
It is a security which is backed by assets such as pool of mortgages and sold as shares or participation certificates to investors. The cash flows from the mortgage pool such as the interest and principal payments are collected by the intermediaries and ‘passed through’ to the security holder. Some of the pass through securities that were involved in the 2008 financial crisis were the Mortgage Backed Securities (MBS) and Asset Backed Securities (ABS).
Example: Mr. Jack wants to buy a house, so he goes to The American Bank to get a mortgage loan. The bank after verifying his credit worthiness, transfers the money to his account and Jack agrees to repay the amount on a monthly basis within a particular period of time. Now the bank may choose to hold the mortgage, i.e., just collect the interest and principal payment or sell it to someone else. The better option for the bank would be to sell the mortgage to a government or private entity (Freddie Mac, Fannie Mae, Ginnie Mae etc.) and get the cash so that it can give more such loans. So let’s assume that the bank sells the mortgage to Ginnie Mae, which in turn groups the mortgages having similar characteristics into pools and sells it to investors in the secondary market. With the funds that it receives from the sale of securities, it can create more such securities for mortgages.
So when Mr. Jack makes the monthly mortgage payment which includes the principal and interest payment, The American bank keeps a fee for itself and ‘passes’ the rest to Ginnie Mae, which in turn keeps a fee for itself and ‘passes-through’ the rest to the investor who holds the Mortgage Backed Securities.
So in a pass-through security the principal value of the investment is paid back to the investor during the life of the security and not as one large payment at the end of the security period. So there is unpredictability in the cash flow, since with each outstanding principal there is a corresponding decrease in the value of the interest that accrues. For e.g. If Jill had bought $10,000 MBS with 10% coupon, it would pay $1000 towards interest at the end of first year. So if we assume $1000 goes towards principal repayment, then for the next year, interest would be calculated on $9000 which comes out to $900. Also the return of principal is dependent on how quickly the underlying mortgages are repaid.
Above is the process flow of Mortgage Backed Securities.