Question

What are the three sources of cash flow of a pass-through MBS?

Answer 1

Let's first understand the term "Pass - through MBS"

MBS stands for Mortgage- Backed Securities. It provides investors with a monthly pro-rata distribution of any principal and interest payments made.

In a pass-through MBS, the issuer collects monthly payments from a pool of mortgages and then passes on a proportionate share of the collected principal and interest to bondholders.

A pass-through MBS generate cash flow through three sources:

• Scheduled principal
• Scheduled interest
• Prepaid principal (usually variable depending on the actions, as governed by prevailing interest rates)

Of these three components, the first two together are designed by the traditional mortgage contract to sum to the same amount from month-to-month. Together, these two parts are designed to provide a predictable payment stream to the mortgage investor.

The third component is more unpredictable and depends on the pre-payment behavior of the mortgage borrowers. Borrowers may choose to only make regular scheduled
payments over the life of the mortgage or they may pre-pay some or all of the principal on an accelerated schedule. Because of the unpredictability of these pre-payments, the cash flow from the pass-through can vary each month. Investors accept the possibility of irregular monthly payments when investing in pass-throughs.