What it means
A lender gathers a large number of similar loans, such as home mortgages, into a pool. It then places the pool into a trust and sells certificates to investors, each representing a proportional ownership of the pool.
The trust collects payments from the borrowers and passes them on to the certificate holders. For the lender, this converts illiquid loans into cash, which can be used to make new loans.
For the investor, it gives access to the income of many loans in a single security. The investor also takes on the risk of the loans, including borrowers who fail to repay.
A servicer collects payments and takes a fee before the rest is passed on. In some programmes, a government-backed agency guarantees timely payment of interest and principal to investors for another fee.
The guarantee changes the risk from the borrower's default to the credit of the guarantor. Cash flows are not fixed.
Borrowers can repay early, for instance when they sell a house or refinance, and the principal returns to investors sooner than expected. This prepayment risk means the investor cannot be sure how long the money will be invested or at what return.
The nuance for finance readers is that the certificate is an ownership interest and not a debt of the issuer. The investor's return depends on the pool's performance, and the issuer is not responsible for losses beyond any guarantee stated in the documents.
Investors typically look at the pool's characteristics before buying. Average loan size, borrowers' credit scores, loan-to-value ratios, location and the age of the loans all give clues about how the pool will behave.
A pool of older loans with a long record of on-time payments is usually viewed as more predictable than a pool of new loans to weaker borrowers.
In practice
Real-world examples.
Example
A community bank has originated $100,000,000 of home loans and wants to free up capital. It pools the loans and sells pass-through certificates to institutional investors. The cash received funds new lending. The bank keeps the servicing and earns a steady fee on the pool it has sold.
Example
A pension fund buys certificates backed by a pool of government-guaranteed mortgages. It receives monthly payments of interest and principal. When interest rates fall and homeowners refinance, the fund is repaid early and must reinvest at lower yields. The pension fund's analysts model several prepayment scenarios before agreeing the size of the purchase.
Example
An auto lender packages thousands of car loans into a trust and sells certificates. An analyst at an insurer studies the history of defaults in the pool before investing. She sets a limit on how much the insurer can hold. The insurer decides the yield on offer is acceptable for the level of risk.
Formula
Calculation
Holder's payment = holder's share of pool x (total collections - servicing fee)
In one month a pool of mortgages collects $400,000 of interest and $600,000 of principal, a total of $1,000,000. The servicer's fee is $20,000, so the amount passed through is 1,000,000 - 20,000 = $980,000. An investor who owns 5% of the pool receives 0.05 x 980,000 = $49,000 for the month.Case study
Seen in the real world.
Brackwater Savings is an illustrative, fictional lender that held $300,000,000 of fixed-rate mortgages and wanted to reduce its exposure to interest rate swings. It created a trust and issued pass-through certificates for the pool.
Investors bought the certificates and Brackwater kept the servicing role, earning a fee of 0.25% a year. In the first year, falling interest rates caused prepayments of about 18% of the pool, and the investors received principal back sooner than expected.
In the illustrative result, Brackwater's balance sheet became lighter and more flexible, while investors learned to price in prepayment risk. The lesson was that a pass-through certificate moves both income and risk from the lender to the buyers. Brackwater then reported the fee income and the lower balance sheet to its board in a short note each quarter.
Watch out
Common mistakes.
- Assuming the monthly payment is fixed, when it varies with early repayments and defaults in the pool.
- Believing the issuer guarantees the payments, when the investor usually bears the risk of the underlying loans unless a guarantee applies.
- Confusing a certificate with a bond, when a certificate is an ownership share in a pool and a bond is a debt of the issuer.
Questions
People also ask.
What is the role of the servicer?
The servicer collects payments from borrowers, deals with late payers and passes the money on, keeping a fee for the work. The servicer also advances missed payments in some programmes and recovers them later from the borrower or the sale of the property.
What is prepayment risk?
It is the risk that borrowers repay early, returning principal to investors sooner than expected, usually when rates are lower and reinvestment is less attractive. Prepayment risk is the main reason the cash flows from a pass-through certificate are hard to predict.
How is a pass-through different from a collateralised mortgage obligation?
A pass-through shares all cash flows proportionally, while a collateralised mortgage obligation splits them into tranches with different priority.
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