What Is a Pass-Through Rate?
The pass-through rate is the interest rate on a securitized asset, such as a mortgage-backed security (MBS), that is paid to investors once management fees, servicing fees, and guarantee fees have been deducted by the issuer of the securitized asset. It is often referred to as the net interest rate.
- The pass-through rate is the interest rate an investor receives on a securitized asset once the issuer deducts various fees.
- Often referred to as the net interest rate, the pass-through rate is always less than the interest rate quoted on the individual security when it is offered by the issuer.
- The largest issuers of securitized assets are Sallie Mae, Fannie Mae, and Freddie Mac.
- The fees deducted from the interest rate to arrive at the pass-through rate can either be as a percentage of total interest generated from the underlying mortgages or as a flat rate.
- The pass-through rate can fluctuate depending on if the interest rates of the underlying mortgages are fixed rates or variable rates.
Understanding a Pass-Through Rate
The pass-through rate (also known as the coupon rate for an MBS) is lower than the interest rate on the individual securities within the offering. The largest issuers of securitized assets are the Sallie Mae, Fannie Mae, and Freddie Mac corporations, whose guarantees on mortgages are backed by the U.S. government, giving the mortgages high credit ratings.
The pass-through rate is the net interest the issuer pays investors after all other costs and fees are settled. In a mortgage-backed security (MBS), for example, the amount forwarded to investors passes from the payments on the underlying mortgages that make up the securitized mortgage security, through the pay agent and ultimately to the investor.
The pass-through rate is always going to be less than the average interest rate paid by the borrower on the mortgages backing the security. This is so because various fees are deducted from the paid interest, including general management fees, for the overall management of the security, the conducting of transactions related to the security pool, and for guarantees associated with the securities involved. As defined in the terms and conditions governing the issuance of the securitized asset, fees are set up as percentages of the interest generated from the underlying mortgages or as flat rates.
Securitizing Mortgage-Backed Securities (MBS)
Many institutions, such as banks, underwrite numerous mortgages. They often then take these mortgages, repackage them into a bundle of mortgages, and sell them to investors as a mortgage-backed security (MBS). The investor that buys the MBS receives the interest payments on the individual mortgages that make up the securitized asset as interest payments/returns on the asset.
During times of economic stability, the risk associated with investing in mortgage-backed securities is low when compared to many other investment options, as there is diversity through the many mortgages that make up the securitized pool. The return realized as the pass-through rate is typically considered equitable for the degree of risk involved.
Projecting a Pass-Through Rate
When investing in a securitized asset, investors will project the pass-through rate as the return on their investment. Of course, unanticipated factors may arise and influence the amount of net interest generated.
For example, if the mortgages backing the security carry a variable or floating rate rather than a fixed rate, shifts in the average interest rate will impact the amount of the return. For this reason, investors may attempt to anticipate interest rate fluctuations over the life of the security and factor them into the projected pass-through rate. This process helps the investor decide whether the return is worth the degree of risk associated with the underlying mortgages.
Fannie Mae and Freddie Mac
Congress created Fannie Mae and Freddie Mac to provide liquidity, stability, and affordability in the mortgage market. The organizations provide liquidity for thousands of banks, savings and loans, and mortgage companies, making loans for financing homes.
Fannie Mae and Freddie Mac purchase mortgages from lenders and hold the mortgages in their portfolios or package the loans into mortgage-backed securities that may later be sold. Lenders use the cash raised by selling mortgages for engaging in additional lending. The organizations’ purchases help ensure that people buying homes and investors purchasing apartment buildings or other multifamily dwellings have a continuous supply of mortgage money.