Agency Mortgage Pass-Through Securities

An agency mortgage pass-through pools hundreds or thousands of individual mortgage loans and issues a single security: investors receive a pro-rata share of all principal and interest payments from the pool, after deduction of servicing and guarantee fees. The agency (FNMA, FHLMC, or GNMA) guarantees timely payment of principal and interest — eliminating credit risk. What remains is prepayment risk: the uncertainty over when principal will be returned. Because borrowers prepay more when rates fall (refinancing) and less when rates rise (extension), pass-throughs exhibit negative convexity — their price-yield relationship bends the wrong way relative to a bullet bond. Pricing a pass-through requires assumptions about future prepayment speeds; the resulting cash flows, when discounted at the market yield, give the pass-through price.