What it means
When a pool of loans is packaged into securities, the borrowers pay interest at their own loan rates. Before the money reaches investors, the servicer takes a fee for collecting payments and a guarantor may take another for insuring them.
What is left is passed through to investors. Because loans in the pool carry different rates, the starting point is the weighted average coupon, which is the average of the borrowers' rates weighted by the size of each loan.
The pass-through rate is that average minus the fees. A pool of 6.00% mortgages with fees of 0.45% would pass through 5.55%.
Investors use the rate to compare the security with other investments and to estimate monthly income. A higher rate means more income but often signals higher risk or longer maturity.
It is also the basis for pricing the security in the market. The pass-through rate differs from the rate borrowers pay and from the yield the investor earns.
The yield depends on the price paid and on how fast the loans prepay, so an investor who pays above face value earns less than the stated rate if borrowers repay early. For lenders and servicers, the fees are a source of income.
A servicer collecting 0.25% on a large pool earns a steady stream, which is one reason servicing rights are traded as assets. The rate is typically quoted as an annual figure, but payments are made monthly, so the monthly interest is one twelfth of the annual amount applied to the remaining balance.
As the balance falls through repayments, the interest paid falls too. Investors therefore see a gradually declining stream of interest even though the rate stays the same.
In practice
Real-world examples.
Example
A mortgage servicer reports that a pool of loans pays borrowers an average of 5.50%. After a 0.25% servicing fee and a 0.15% guarantee fee, the investor rate is 5.10%. The servicer books its fee as income. The servicer reports the figures to investors each month in a standard statement.
Example
A fund manager compares two pass-through securities, one with a 4.50% rate and one with a 5.25% rate. She finds that the higher-rate pool contains loans to riskier borrowers. She decides to hold a smaller amount of it. Her team also checks whether the pool contains any loans with unusual rates.
Example
An analyst at an insurance company projects monthly cash flow for a $50,000,000 holding at a pass-through rate of 5%. Interest is 50,000,000 x 0.05 / 12 = $208,333 a month. She uses it to plan the insurer's liabilities. She adds the figure to the insurer's cash flow model as a monthly inflow.
Formula
Calculation
Pass-through rate = weighted average coupon - servicing fee - guarantee fee
A pool of mortgages has a weighted average coupon of 6.00%. The servicing fee is 0.25% and the guarantee fee is 0.20%. Pass-through rate = 6.00% - 0.25% - 0.20% = 5.55%. On a pool balance of $200,000,000, monthly interest to investors = 200,000,000 x 0.0555 / 12 = 11,100,000 / 12 = $925,000.Case study
Seen in the real world.
Ironwood Home Finance is an illustrative, fictional lender that pooled $120,000,000 of mortgages with a weighted average coupon of 6.40%. After a servicing fee of 0.30% and a guarantee fee of 0.25%, the pass-through rate was 5.85%.
An investor asked why the rate was lower than what the borrowers paid. The finance director showed the breakdown, and explained that the fees covered collection, handling of late payments and a guarantee of timely payment.
In the illustrative outcome, the investor bought a large position and priced it by comparing the 5.85% rate with government bonds of similar length. The lesson was that the pass-through rate is the number that matters to investors, and the gap to the loan rate is the cost of the service. The servicer later sent a plain one-page summary of the pool to each investor, showing the rate, the balance and the fees taken.
Watch out
Common mistakes.
- Assuming investors receive the same rate that borrowers pay, when fees are taken out first.
- Treating the pass-through rate as the investor's yield, when the price paid and the speed of prepayments also matter.
- Forgetting that the weighted average coupon changes as loans are repaid, so the rate on the remaining pool can drift.
Questions
People also ask.
Who sets the pass-through rate?
It follows from the pool's loan rates and the fees set in the documents, and it is stated when the securities are issued. Investors can find the figure in the offering documents.
Why is the servicing fee deducted?
It pays the servicer to collect payments, keep records and deal with borrowers who fall behind. Without it, nobody would have an incentive to run the collection process.
Can the rate change over time?
For fixed-rate pools it usually stays steady, but the average can shift as loans leave the pool, and rates on floating pools reset.
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