James Chen, CMT is an expert trader, investment adviser, and global market strategist.
Updated May 22, 2022 Reviewed by Reviewed by Doretha ClemonDoretha Clemons, Ph.D., MBA, PMP, has been a corporate IT executive and professor for 34 years. She is an adjunct professor at Connecticut State Colleges & Universities, Maryville University, and Indiana Wesleyan University. She is a Real Estate Investor and principal at Bruised Reed Housing Real Estate Trust, and a State of Connecticut Home Improvement License holder.
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 (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.
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.
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.
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.