Modified Pass-Through Certificate

What Is a Modified Pass-Through Certificate?

A modified pass-through certificate is a type of fixed-income security that provides investors with income generated from a pool of underlying assets or loans. They are commonly issued by U.S. federal agencies such as the Government National Mortgage Association (GNMA).

How Modified Pass-Through Certificates Work

Modified pass-through certificates offer investors income through a pool of underlying securities, typically mortgages. The agencies that hold the loans guarantee interest payments to investors and make those payments regularly, whether the agency receives interest payments via the underlying note or not. The agencies pass principal payments along to investors as they come in, or by a specified date, whichever is sooner.

Under this arrangement, the agency issuing the modified pass-through certificate takes on the risk of defaults in the underlying portfolio. However, investors in modified pass-through certificates are not protected against prepayment risk, since any early payments of principal would be passed along to the certificates’ investors. Because prepayments reduce the amount of principal outstanding, they therefore also reduce the amount of interest received in the future.

From the perspective of investors, modified pass-through certificates can be an attractive way to reduce the risks associated with real estate lending. By receiving a government-backed guarantee of future interest and principal payments, investors in modified pass-through certificates can essentially eliminate the default risk associated with mortgage-backed securities. Moreover, since these securities group hundreds or even thousands of mortgages together in one instrument, they offer investors far greater diversification than would be possible if lending to individual homeowners.

Important

Investors who wish to further reduce their risks can invest in fully modified pass-through certificates, which mitigate prepayment risk by fully guaranteeing both the amount and timing of interest and principal payments.

Real-World Example of a Modified Pass-Through Certificate

To illustrate, suppose an investor purchases a modified pass-through certificate from the GNMA, known as Ginnie Mae, consisting of a pool of mortgages. If several homeowners default on their loans and fail to make interest payments in a given period, the investor still receives scheduled payments of mortgage and principal from Ginnie Mae.

On the other hand, if several homeowners pay off part or all of their mortgages, the investor will receive more in principal payments than scheduled for the month, but will also see a decrease in the value of planned interest payments for subsequent months. In other words, the modified pass-through certificate structure will protect this investor against default risk, but it will not protect them against prepayment risk.