What Is a Pass-Through Certificate?

What Is a Pass-Through Certificate?

Pass-through certificates are fixed-income securities that represent an undivided interest in a pool of federally insured mortgages put together by a government-sponsored agency, such as the Government National Mortgage Association (Ginnie Mae).

How a Pass-Through Certificate Works

A large percentage of mortgages that have been issued to borrowers are sold in the secondary mortgage markets to institutional investors or government agencies that buy and package these loans into investable securities. These securities are then offered for sale to investors who expect to receive periodic interest payments and a principal repayment upon maturity of the securities.

The regular payments of interest and return of principal that mortgagors make on the original loan repayments are funneled or passed through to investors of these securities; hence, the name “pass-through securities.”

An investor that invests in asset-backed security (ABS), such as a mortgage-backed security (MBS) is given a pass-through certificate. The pass-through certificate is the evidence of interest or participation in a pool of assets and signifies the transfer of interest payments in receivables in favor of the holders of the pass-through certificate.

Pass-through certificates are issued by banks in order to protect themselves and their clients.

A pass-through certificate does not mean that the holder owns the securities; it only means that the holder is entitled to any income earned from the securitized finance product. Mortgage-backed certificates are the most common types of pass-through certificates, in which homeowners' payments pass from the original bank through a government agency or investment bank to investors.

Special Considerations

Banks issue pass-through certificates as a safeguard against risks. Through these certificates, banks can transfer their receivables, that is, their long term mortgaged assets to governments and institutional investors that purchase these debt securities.

This way, the bank can release some of these assets off its books to release more capital funds to issue more loans to borrowers. In effect, pass-through certificates ensure that banks can maintain their liquidity requirements as stipulated by the Federal Reserve Bank and still lend money continuously.

The most common type of pass-through security is the Ginnie Mae pass-through, which has interest and principal payments guaranteed by Ginnie Mae to reduce the default risk inherent in these securities.

The issuers of the securities service the mortgages and pass-through interest and principal payments to the pass-through certificate holders. During periods of declining interest rates, holders of Ginnie Mae pass-throughs are likely to receive extra principal payments as mortgages are refinanced and paid off early.