Legal Definitions - pass-through security

Pass-Through Security

A pass-through security is a type of investment where the income generated by a pool of underlying assets is collected and then "passed through" directly to the investors who own the security. Essentially, the issuer of the security acts as a middleman, collecting payments (like principal and interest) from the original borrowers and distributing them to the investors, usually after deducting a small service fee. The investors' returns are directly tied to the performance of these underlying assets.

Examples:

• Mortgage-Backed Securities (MBS): Imagine a bank originates thousands of home mortgages. Instead of holding all these loans on its books, the bank might sell them to a government-sponsored enterprise (like Ginnie Mae) or another financial institution. This institution then pools these mortgages together and issues pass-through securities to investors. As homeowners make their monthly mortgage payments, these funds are collected and, after a small administrative fee, are passed directly to the investors who own the MBS.
  This illustrates a pass-through security because the payments from the underlying mortgages are directly channeled through to the investors, who receive a share of the principal and interest collected from the homeowners.
• Auto Loan-Backed Securities: A large auto finance company provides loans to thousands of customers buying cars. To free up capital for more lending, the company might bundle these auto loans into a large pool. An investment bank then creates pass-through securities backed by this pool of loans and sells them to various investors. Each month, as car owners make their loan payments, these funds are collected and, after covering servicing costs, are distributed to the investors holding the auto loan-backed securities.
  Here, the security is "pass-through" because the cash flow generated by the individual auto loans is directly transferred to the investors, making their investment performance dependent on the repayment of those car loans.
• Student Loan-Backed Securities: A financial institution specializing in education loans might originate a vast number of student loans. To manage its balance sheet and raise more capital, it could package these loans into a portfolio. This portfolio then serves as collateral for pass-through securities sold to institutional investors. When students make their scheduled loan payments, these amounts are gathered and, after deducting administrative fees, are paid out to the investors who purchased the student loan-backed securities.
  This is a pass-through security because the income stream from the student loan repayments is directly passed on to the security holders, who bear the economic risk and reward associated with the underlying loan pool.