What it means
A bank or other lender gathers loans of a similar type, puts them in a pool and sells shares in that pool to investors. As borrowers make payments, a servicer collects them and sends the money to the investors, less its fee.
The investors are therefore paid from the cash flows of the underlying loans. The structure helps lenders because they receive cash immediately instead of waiting for loans to be repaid.
That cash lets them make new loans and spreads risk across the market. For investors, the securities offer regular income and diversification across many borrowers.
The payments are not level. Each month brings interest on the remaining balance, a scheduled repayment of principal and any extra principal from borrowers who repay early.
Because early repayment is more likely when interest rates fall, investors face a risk that their money comes back just when reinvestment rates are lower. Credit risk depends on the type of pool and any guarantee.
Some pools carry a government-related guarantee of timely payments, while others leave the investors to bear the losses from borrowers who default. The price investors accept reflects this difference.
The 2008 financial crisis showed the danger of weak lending standards inside pools, as poorly checked loans were bundled and sold widely. Since then, buyers and regulators have paid more attention to the quality of the loans behind the securities.
Prices of pass-through securities move with interest rates, but in a more complicated way than ordinary bonds. When rates rise, prepayments slow and the security lasts longer than expected, which means its price falls more.
When rates fall, prepayments speed up and the price gains less than a normal bond would, a feature known as negative convexity.
In practice
Real-world examples.
Example
A retirement fund buys a pass-through security backed by home loans to gain steady monthly income. It receives a payment every month, part interest and part principal. The fund's manager reinvests the principal in other bonds. The manager reviews the monthly statement to check the split between interest and principal.
Example
A credit union sells a pool of car loans to free up cash. The buyers receive the payments as drivers repay. The credit union keeps the servicing role and earns a fee. The deal frees capital that the credit union uses for new member loans.
Example
A corporate treasurer is offered a pass-through security as a place to park spare cash. She declines because the cash flows are uncertain and her company needs to know exactly when money will be returned. The pool's pattern of early repayments would make the timing impossible to forecast precisely.
Formula
Calculation
Monthly cash flow = interest + scheduled principal + prepaid principal
A pool has a balance of $50,000,000 and a pass-through rate of 5%. Monthly interest = 50,000,000 x 0.05 / 12 = $208,333.33. Scheduled principal is $60,000 and borrowers prepay a further $240,000. Total cash flow = 208,333.33 + 60,000 + 240,000 = $508,333.33. The pool balance after the month is 50,000,000 - 60,000 - 240,000 = $49,700,000.Case study
Seen in the real world.
Meridian Trust Bank is an illustrative, fictional institution that wished to reduce its holding of long-term home loans. It created a pool of $250,000,000 and sold pass-through securities to insurers and pension funds.
Over the next year, interest rates fell and borrowers refinanced, causing the pool to shrink by 22%. Investors received more principal than expected and had to reinvest at lower rates.
In the illustrative lesson, the bank used the proceeds to make new loans and earned servicing fees, while investors adjusted their expectations of prepayment. The case shows that these securities move cash and risk from the lender to the market. Meridian also began to report the pool's prepayment speed each quarter so that its board could see how the market was reacting.
Watch out
Common mistakes.
- Treating a pass-through security as a normal bond with a fixed repayment date, when the cash flows depend on borrowers.
- Ignoring prepayment risk, which can shorten the life of the investment when rates fall.
- Assuming all pass-through securities are guaranteed, when only some pools carry a guarantee.
Questions
People also ask.
What assets can back a pass-through security?
Common examples include home mortgages, car loans and credit card balances, as long as the payments can be pooled and passed on. Other assets, such as student loans and equipment leases, can be pooled in a similar way if the payments are predictable enough.
How are investors paid?
They receive a monthly share of the interest and principal collected by the servicer, minus fees. A bond promises fixed payments on fixed dates, whereas a pass-through security delivers whatever the borrowers actually pay.
Is a pass-through security the same as a bond?
No, it represents ownership of loan cash flows rather than a fixed promise from the issuer.
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