What Is a Pass-Through Certificate?

A pass-through certificate is a form of a fixed income security that allows the certificate holder to receive money. In most cases, this type of fixed income security comes in the form or mortgages placed together in one securitized loan package. For example, banks and other financial institutions provide mortgages to borrowers; the institutions then place a group of these mortgages in a large investment and sell it to another financial institution. The interest from all of these mortgages represents the pass-through certificate as the holder of the note receives the money. This process scan be quite complex and creates some difficulty for the financial institutions involved.

Mortgages and similar loans fall into a class of investment commonly called asset-backed securities. For example, when a bank or other financial institutions presents money to borrowers for a physical item, the loan centers on this item. Default or failure to pay for the loan associated with the item means the lender has a right to take this item in lieu of nonpayment. If a bank or other financial institution packages these loans into a securitized investment, potential investors may see them — such as a pass-through certificate — as more stable than other investment types. Other types of securitized options may also work for these investment types.

In some economies, there may be a company or government-sponsored entity that purchases securitized mortgage investments or pass-through certificates frequently. The purpose of this entity is to provide liquidity to banks and financial institutions that can continue to make loans and issue mortgages to new borrowers. In short, this process continues in perpetuity so long as borrowers need money for large items they cannot purchase through normal cash flow. The interest from the payments made on mortgages in the securitized instrument goes to the purchase of the investment.

Investors who purchase a pass-through certificate may think that this investment is more secure or less risky than others. The problem is that mortgages in the securitized instrument may not actually be entirely risk free, however. For example, when a mortgage goes into default, the holder of the securitized instrument loses money. This can result in the holder — such as a major government-sponsored entity — not being able to cover its payments or costs associated with business. This creates a downward cycle of money in the process of buying and selling a pass-through certificate.