Definition
A pass-through security is a type of financial instrument that channels income generated from a pool of underlying assets—such as loans, mortgages, or other debt pools—to investors through intermediaries. The most common type of pass-through security is a mortgage-backed security (MBS), where the principal and interest payments made by homeowners are collected by financial institutions (e.g., banks, mortgage bankers, or savings and loan associations) and then passed on to the investors who own the pass-through securities.
Examples
- Mortgage-Backed Securities (MBS): These are the most prevalent forms of pass-through securities, encompassing pools of residential (RMBS) or commercial (CMBS) mortgages. Payments from homeowners are aggregated and transferred to MBS holders.
- Asset-Backed Securities (ABS): These securities are backed by other types of loans, such as auto loans, credit card receivables, or student loans. The principal and interest payments from borrowers of these loans are passed through to ABS investors.
- Collateralized Mortgage Obligations (CMOs): Although more complex, CMOs are a type of pass-through security where cash flows from mortgage pass-through securities are divided into different tranches with varying maturities and risk levels.
Frequently Asked Questions (FAQs)
1. How are pass-through securities created?
Pass-through securities are created by pooling together a group of similar loans or assets and then issuing securities representing ownership in these pools. The cash flow from the borrowers of the underlying assets is passed through to the security holders.
2. What are the primary risks associated with pass-through securities?
The main risks include interest rate risk, prepayment risk (when borrowers repay the loan faster than expected), and credit risk (the risk that borrowers will default).
3. How do investors benefit from pass-through securities?
Investors benefit from earning a portion of the interest and principal payments made by borrowers of the underlying loans, usually offering a relatively steady income stream.
4. Are pass-through securities liquid investments?
The liquidity of pass-through securities can vary significantly. Generally, government-backed MBS (like those issued by Fannie Mae or Freddie Mac) are more liquid than private-labeled MBS.
5. What role do intermediaries play in pass-through securities?
Intermediaries, such as banks or mortgage bankers, collect the payments from the borrowers of the underlying assets and distribute them to the holders of the pass-through securities.
Related Terms
- Mortgage-Backed Security (MBS): A type of asset-backed security that is secured by a collection of mortgages.
- Asset-Backed Security (ABS): A type of financial security collateralized by a pool of assets such as loans, leases, credit card debt, royalties, or receivables.
- Collateralized Mortgage Obligation (CMO): A complex mortgage-backed security where the mortgage cash flows are divided into tranches.
- Interest Rate Risk: The potential risk to an investment’s value due to changes in the interest rates.
- Prepayment Risk: The risk associated with the early unscheduled return of principal on a fixed-income security.
Online References
- Investopedia - Pass-through Security
- Wikipedia - Mortgage-backed Security
- SEC.gov - Asset-Backed Securities
Suggested Books for Further Studies
- Handbook of Mortgage-Backed Securities by Frank J. Fabozzi
- Mortgage-Backed Securities: Products, Structuring, and Analytical Techniques by Laurie Goodman, Shumin Li, Douglas J. Lucas, Thomas A. Zimmerman
- Securitization: Structuring and Investment Analysis by Andrew Davidson, Anthony Sanders, Lan-Ling Wolff, Anne Ching
Fundamentals of Pass-Through Security: Finance Basics Quiz
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