What Mortgage Pass-Throughs Are
A mortgage pass-through is a type of mortgage-backed security where a pool of home loans serves as the underlying collateral. A special purpose vehicle, often a trust, buys the loans and issues certificates to investors. Homeowners make monthly payments of principal and interest to the loan servicer, which then passes the cash flow through to certificate holders after deducting a small servicing fee. The investor receives a pro-rata share of the payments based on the certificate ownership.
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This structure is most commonly associated with government agency securities issued by Fannie Mae, Freddie Mac, and Ginnie Mae. Because the issuer guarantees timely payment of principal and interest, these pass-throughs are among the most widely held mortgage-backed instruments in the world.
How the Cash Flow Works
Each month, homeowners in the pool make their mortgage payments. The servicer collects the funds and sends the investor their proportional share of principal and interest. The investor pays tax on the interest income and may also face phantom income when scheduled principal payments are made but not yet received in cash because the loans are amortizing.
The pace of cash flow depends on how fast borrowers prepay their loans, which is measured by the conditional prepayment rate. A CPR of 10% means that in a given year, 10% of the remaining balance is expected to be prepaid. Faster prepayments return principal to the investor sooner, forcing reinvestment at potentially lower rates.
Types of Mortgage Pass-Through Securities
The three main types are agency pass-throughs, non-agency pass-throughs, and stripped mortgage-backed securities.
- Agency pass-throughs are issued or guaranteed by Fannie Mae, Freddie Mac, or Ginnie Mae and carry high credit quality.
- Non-agency pass-throughs are issued by private entities and carry credit risk tied to the performance of the underlying loans.
- Strips separate interest and principal into distinct securities, such as IO (interest-only) and PO (principal-only) strips, which trade at deep discounts.
Key Risks for Investors
The most prominent risk is prepayment risk. When interest rates fall, homeowners refinance and pay off their loans early, shortening the life of the security and reducing the total interest earned. When rates rise, prepayments slow, and the security behaves more like a long-duration bond, increasing price sensitivity.
Extension risk is the mirror image: when prepayment slows, the security lasts longer than expected, exposing the investor to more interest-rate volatility. There is also credit risk in non-agency securities, where defaults in the loan pool reduce cash flow. Liquidity can be a concern in stressed markets, and servicing risk arises if the servicer fails to collect or remit payments properly.
Who Invests in Mortgage Pass-Throughs
Pension funds, insurance companies, mutual funds, and central banks are the primary investors. The predictable income stream, federal agency backing, and diversification benefits make these securities attractive for liability-driven investment strategies. Individual investors can access pass-throughs through mutual funds or exchange-traded funds that hold pools of agency mortgage-backed securities.
Pass-Throughs Versus Other MBS Structures
Unlike collateralized mortgage obligations, which slice the cash flow into tranches with different risk and maturity profiles, a plain vanilla pass-through gives every investor the same claim on the pool. There is no senior-subordinate structure and no credit enhancement beyond the agency guarantee. This simplicity is a major reason agency pass-throughs trade in deep, liquid markets.
Why Mortgage Pass-Throughs Matter
Mortgage pass-throughs are a core building block of the housing finance system. They channel capital from investors into home loans, allowing lenders to free up balance sheet capacity and originate more mortgages. For investors, they offer a blend of government-like credit quality, monthly income, and sensitivity to interest-rate and prepayment dynamics that few other fixed-income instruments provide.