Mortgage-backed or Pass-through Securities

The mortgage pass-through securities are much more complex than regular fixed-income securities. The mortgage pass-through securities are created from the mortgage transactions. The majority of purchases of houses are financed with borrowed funds from financial institutions such as banks and mortgage companies that issue mortgages.

The borrowers promise to pay off the amount lent in monthly payments during all the mortgage loans life. However, most banks and mortgage companies do not keep these mortgages until maturity. On the contrary, they sell the mortgages to others (government and private) institutions that pool the mortgages in pass-through securities and later sell them to investors. House owners continue making their monthly payments to the newly assigned financial institutions.

These financial institutions pool their mortgages and sell shares in those pools to investors. The mortgage pools are a collection of similar mortgages. Mortgage pass-through securities are shares in pools or collections of similar mortgages. Then, the investor receives monthly the interest and principal payments (minus a modest fee, normally about ? of 1%), form there comes the term pass-through securities. The size of mortgage pools vary, consisting some of thousands of mortgages and others having only a few mortgages. Normally, these pools are issued with a minimum of $1 million.

You may get to understand better the pass-through securities by examining how do mortgages work. Let’s suppose that a $1 million mortgage pool consists of only a 30-year conventional mortgage at 9%. The monthly payment that the house owner has to pay the mortgage lender is $8046.23. This payment consists of interests and a portion that goes to the reduction of the principal’s balance. The monthly payments are designed so that at the end of the mortgage term (30 years, or 360 payments) the mortgage is reduced to zero.

As you may infer the amounts of interest expense declines each month, which means that more of the monthly payment is applied to reducing the outstanding loan (mortgage) balance. In other words, the fixed-payable amounts  are all equal, but the proportional amount of interests received decline and the proportional amount of repayment of the principal is increased. In this case, the investor of this pass-through security receives a share of the pass-through interest and principal minus servicing fees and any other charges by the servicing institution, you cannot always count on the monthly amounts to be the same because mortgages borrowers have the option to prepay their mortgages. The payment could be done by the total amount of the mortgage or only part of it.

For example, if the borrower of the mortgage makes an additional prepayment of $1000 per month, the mortgage pass-through security investor receives a proportionate share of this additional payment, which in essence is the return of the principal or an investment capital of the pass-through investor.

For many reasons, the mortgage borrowers prepay the whole amount of their mortgages before time to maturity. House owners sell their homes or refinance their mortgages when rates of interests decline, or in case of fire or any other casualties in which the property is destroyed, insurance proceeds are used to cancel mortgages.

Consequently, a mortgage pool, if many mortgages are prepaid, the amounts of cash flow to the investors will not be that regular (they may fluctuate from month to month), and there is no security either over the period of time that will take the pool maturity. Investors do not any security over the timing of monthly cash flows.

Let’s suppose that payments of a mortgage are due on the first day of the month. If borrowers delay their payments and the process of these payments are also delayed, payments to investors will also be affected.

The time of the delay can vary accordingly to the type of pass-through security. Besides, the level-payment conventional mortgage described, which is the most common type of pass-through security, other types of mortgages (adjustable-rate mortgages and graduated-payment mortgages) re available to be used fro pass-through securities.

There are many types of mortgages pass-through securities at your disposition each one with its own hue.

Despite differences, investors in all mortgage pass-through securities are concerned with the following criteria:

  • Safety in issues
  • Liquidity and negotiability of the issue
  • The overall rate of return of the issue
  • The expected maturity of the issue