Pass-through security

Definition

A pass-through security is a type of investment instrument that represents a claim on the cash flows generated from a pool of underlying assets, such as mortgage loans. Investors receive payments based on the actual cash flows from the assets, which can vary depending on borrower behavior and prepayment rates. This structure allows investors to gain exposure to the performance of the underlying mortgages while distributing the risks associated with them.

5 Must Know Facts For Your Next Test

1. Pass-through securities are commonly used in the context of mortgage-backed securities (MBS), where they provide investors with direct access to mortgage loan cash flows.
2. Investors in pass-through securities face prepayment risk, as higher prepayment rates can reduce the expected return on investment by shortening the duration of cash flows.
3. These securities are typically issued by government agencies or private institutions and are an important part of the secondary mortgage market.
4. Pass-through securities offer varying levels of risk and return based on the quality of the underlying mortgage loans and borrower creditworthiness.
5. They are often considered more liquid compared to individual mortgages, allowing investors to buy and sell them in secondary markets more easily.

Review Questions

• How do pass-through securities function in relation to the cash flows from mortgage loans?
  • Pass-through securities work by pooling together a group of mortgage loans and issuing shares that represent a claim on the cash flows generated from those loans. As borrowers make their monthly mortgage payments, those payments are passed through to the investors in proportion to their holdings. This structure allows investors to receive regular income based on actual cash flows rather than fixed payments, making it essential to understand how borrower behaviors impact returns.
• Discuss the impact of prepayment risk on pass-through securities and how it affects investor returns.
  • Prepayment risk significantly impacts pass-through securities because when borrowers pay off their mortgages early, it reduces the amount of interest income that investors would typically receive over time. This can lead to reinvestment risk, where investors must reinvest the returned principal at potentially lower interest rates. Consequently, understanding prepayment behavior is crucial for evaluating the expected returns and overall risk associated with these securities.
• Evaluate how pass-through securities contribute to the broader financial market landscape, particularly regarding liquidity and risk distribution.
  • Pass-through securities play a vital role in enhancing liquidity within the financial markets by allowing investors to easily trade these instruments in secondary markets. By pooling individual mortgage loans into a single security, risks are spread out among multiple investors, reducing the potential impact of defaults on any single loan. Additionally, these securities provide a mechanism for funding home purchases while helping lenders manage their risk exposure, thus contributing to overall market stability and efficiency.

Related terms

Mortgage-backed security (MBS): A type of asset-backed security that is secured by a mortgage or a collection of mortgages, providing investors with regular income from mortgage payments.

Prepayment risk: The risk that borrowers will pay off their mortgage loans earlier than expected, which can affect the cash flows received by investors in pass-through securities.

Securitization: The process of pooling various types of financial assets, like mortgages, and converting them into securities that can be sold to investors.