Mortgage Backed Security

What Is A Mortgage-Backed Security (MBS)??

A Mortgage-Backed Security (MBS) is a type of financial instrument that is secured by a pool of mortgages. Investors in an MBS receive periodic payments derived from the principal and interest payments made by borrowers on the underlying mortgages. Here’s a detailed explanation:

Key Features of Mortgage-Backed Securities:

Structure:

• Pooling: Mortgages are pooled together to form a single security. This pooling reduces the risk for investors, as the risk is spread across many borrowers.
• Tranches: MBS can be divided into different tranches, or segments, each with varying levels of risk and return. Senior tranches have higher credit ratings and are paid first, while junior tranches offer higher yields but come with more risk.

Types of Mortgage-Backed Securities

In India, Mortgage Backed Securities (MBS) are financial instruments that allow investors to participate in the mortgage market. Here are some types of Mortgage Backed Securities found in India:

1. Pass-Through Certificates (PTCs): These are the most common type of MBS in India. PTCs represent ownership interests in a pool of mortgage loans. Cash flows from the underlying mortgages are passed through to the certificate holders.
2. Mortgage Participation Certificates (MPCs): MPCs are similar to PTCs but may offer different terms regarding the allocation of principal and interest payments among investors.
3. Collateralized Mortgage Obligations (CMOs): These are structured securities that offer different classes with varying maturities and risks. They are less common in India compared to PTCs and MPCs.
4. Securitized Mortgage Bonds (SMBs): These are bonds backed by a pool of mortgages, where the principal and interest payments from the mortgages are used to pay interest and principal on the bonds.
5. Residential Mortgage-Backed Securities (RMBS): These securities are backed by residential mortgages, providing investors with exposure to a pool of home loans.

These types of MBS help financial institutions in India to manage liquidity, reduce risk exposure, and provide alternative investment opportunities to investors in the mortgage market.

How Mortgage-Backed Securities Work

Mortgage-Backed Securities (MBS) in India operate similarly to those in other countries but with some unique features and regulatory frameworks specific to the Indian financial system. Here is a detailed explanation of how MBS work in India:

1. Mortgage Origination

• Borrowers: Individuals or businesses take out home loans from banks or Housing Finance Companies (HFCs) to purchase or refinance properties.
• Lenders: Commercial banks and HFCs like HDFC, LIC Housing Finance, and others originate these mortgage loans.

2. Pooling of Mortgages

• Pooling: Lenders sell individual mortgage loans to a special purpose vehicle (SPV) or trust, which pools these loans to create a mortgage pool. This pooling process is overseen by institutions such as the National Housing Bank (NHB) or private financial institutions.
• Creation of a Pool: The SPV combines multiple mortgage loans to form a diversified pool, reducing the risk associated with individual loan defaults.

3. Securitization and Issuance of MBS

• Securitization: The SPV issues MBS backed by the pool of mortgages. These securities are structured to provide claims on the cash flows generated by the underlying mortgages.
• Tranches: MBS can be structured into different tranches with varying levels of risk and return, similar to global practices. Senior tranches have lower risk and priority in payment, while junior tranches carry higher risk but offer higher potential returns.

4. Sale to Investors

• Distribution: The MBS are sold to various investors, including banks, mutual funds, insurance companies, pension funds, and individual investors.
• Investment: Investors purchase MBS to receive regular payments derived from the mortgage pool’s cash flows.

5. Cash Flows to Investors

• Monthly Payments: Borrowers make monthly mortgage payments to the lenders, which include both principal and interest components.
• Servicer Role: A mortgage servicer (often the original lender) collects these payments and passes them on to the SPV, after deducting servicing fees.
• Distribution of Payments: The SPV distributes the collected payments to MBS investors based on the terms of the MBS. Investors receive a share of the principal and interest payments.

6. Risks and Returns

• Interest Rate Risk: Changes in interest rates affect the value of MBS. Higher interest rates generally decrease the value of existing MBS.
• Prepayment Risk: If borrowers prepay their mortgages early, the expected cash flows to MBS investors decrease, impacting returns.
• Credit Risk: The risk that borrowers will default on their mortgage payments. The credit risk in India is influenced by the economic environment and regulatory measures.
• Market Risk: Broader economic conditions and the real estate market trends in India can impact MBS performance and value.

Regulatory and Market Framework

• National Housing Bank (NHB): The NHB, a subsidiary of the Reserve Bank of India (RBI), plays a key role in promoting housing finance and regulating HFCs. It also facilitates the securitization process.
• SEBI: The Securities and Exchange Board of India (SEBI) regulates the issuance and trading of MBS in the capital markets.
• SARFAESI Act: The Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act provides the legal framework for the securitization process and recovery of defaulted loans.

Detailed Example:

Let’s walk through a simplified example of how MBS work in India.

1. Mortgage Origination:
   • HDFC originates 500 home loans, each worth ₹2,000,000, totalling ₹1,000,000,000 in mortgages.
2. Pooling:
   • HDFC sells these 500 mortgages to an SPV created by the National Housing Bank.
   • The SPV pools these mortgages into a single MBS pool worth ₹1,000,000,000.
3. Issuance of MBS:
   • The SPV issues MBS from the pool and divides them into 10,000 units, each worth ₹100,000.
   • Each unit represents a share of the total cash flows from the pool of mortgages.
4. Sale to Investors:
   • Investors, including banks, mutual funds, and insurance companies, buy these MBS units.
   • Each investor owns a portion of the pool and is entitled to a share of the cash flows.
5. Monthly Payments:
   • Homeowners make monthly mortgage payments, say ₹20,000 each.
   • The servicer (HDFC) collects ₹20,000 from each of the 500 mortgages, totaling ₹10,000,000 per month.
6. Distribution of Payments:
   • The servicer deducts its fee, e.g., ₹100,000.
   • The remaining ₹9,900,000 is distributed to MBS investors.
   • Each unit of MBS receives a share of the ₹9,900,000 based on its proportion of the pool.

Factors Affecting Mortgage Backed Security Pricing

The pricing of Mortgage-Backed Securities (MBS) is influenced by a variety of factors, each of which can impact the expected returns, risks, and overall value of these securities. Here are the key factors:

1. Interest Rates

• Market Interest Rates: The level of prevailing market interest rates has a significant impact on MBS prices. When market interest rates rise, the price of existing MBS typically falls because new issues will offer higher returns. Conversely, when interest rates fall, the price of existing MBS tends to rise.
• Yield Spread: The difference between the yield on MBS and the yield on comparable risk-free securities (like government bonds) also affects pricing. Wider spreads typically indicate higher perceived risk and lower prices for MBS.

2. Prepayment Rates

• Prepayment Risk: The risk that borrowers will repay their mortgages early, which affects the cash flows received by MBS investors. High prepayment rates can reduce the amount of interest income investors receive, leading to lower MBS prices.
• Prepayment Models: Financial models are used to estimate prepayment rates based on factors such as interest rate changes, housing market conditions, and borrower behavior.

3. Credit Risk

• Default Risk: The risk that borrowers will default on their mortgage payments. Higher default rates increase the risk for MBS investors, leading to lower prices.
• Credit Enhancements: Features like insurance, guarantees  and over-collateralization can reduce credit risk and support higher MBS prices.

4. Housing Market Conditions

• Home Prices: Changes in home prices can impact the value of the underlying collateral for MBS. Rising home prices typically reduce default risk, supporting higher MBS prices, while falling home prices can increase default risk and lower MBS prices.
• Economic Conditions: Broader economic conditions, such as employment rates and income levels, also affect borrowers’ ability to make mortgage payments, influencing MBS pricing.

5. MBS Structure

• Tranching: The structure of MBS into different tranches affects pricing. Senior tranches, which have priority in payment and lower risk, are priced higher than junior tranches, which carry higher risk but offer higher potential returns.
• Type of MBS: The specific type of MBS (e.g., pass-through MBS, CMOs, SMBS) and their respective payment structures and risk profiles also influence pricing.

6. Liquidity

• Market Liquidity: The ease with which MBS can be bought and sold in the secondary market affects pricing. Higher liquidity generally supports higher prices, while lower liquidity can lead to discounted prices.
• Trading Volume: Higher trading volumes typically indicate better liquidity and more stable pricing.

7. Regulatory and Policy Environment

• Government Policies: Changes in government policies, such as tax incentives, housing subsidies, or changes in regulations affecting the mortgage market, can impact MBS pricing.
• Monetary Policy: Central bank actions, such as changes in interest rates or quantitative easing programs involving the purchase of MBS, can significantly influence MBS prices.

8. Macroeconomic Factors

• Inflation: Higher inflation can lead to higher interest rates, which typically reduce MBS prices. Conversely, low inflation can support lower interest rates and higher MBS prices.
• GDP Growth: Strong economic growth can lead to improved borrower creditworthiness and lower default rates, supporting higher MBS prices.

Summary:

Risks Associated With MBS

Investing in Mortgage Backed Securities (MBS) carries several risks, which investors should carefully consider:

1. Credit Risk: This is the risk that borrowers may default on their mortgage payments, leading to losses for investors holding MBS. Economic downturns or changes in interest rates can affect borrowers’ ability to make payments.
2. Interest Rate Risk: MBS are sensitive to changes in interest rates. When interest rates rise, prepayment rates on mortgages tend to slow down, increasing the duration of the MBS and potentially reducing their market value. Conversely, falling interest rates can increase prepayment rates, shortening the MBS duration and potentially affecting their value as well.
3. Prepayment Risk: Borrowers can repay their mortgages early (prepay) due to refinancing or other reasons. This can affect the expected cash flows from MBS, as investors may receive their principal sooner than anticipated, potentially at a time when reinvestment opportunities are less attractive.
4. Extension Risk: Conversely to prepayment risk, when interest rates rise, borrowers may be less likely to refinance, leading to slower prepayment speeds. This can extend the duration of the MBS and expose investors to higher interest rate risk.
5. Liquidity Risk: MBS can be less liquid than other fixed-income securities, especially during periods of market stress. This lack of liquidity can make it difficult for investors to sell their holdings at fair prices.
6. Structural Risk: Some MBS structures, such as collateralized mortgage obligations (CMOs), have complex cash flow structures with different tranches that prioritize payments differently. Understanding these structures is crucial to assessing the risks and potential returns associated with each tranche.
7. Market Risk: MBS prices can be affected by broader market conditions, investor sentiment, and regulatory changes impacting the mortgage market.
8. Legal and Regulatory Risk: Changes in laws and regulations governing mortgages and MBS can affect their value and performance.

Role of MBS in the Financial Crisis of 2007-2008

Mortgage Backed Securities (MBS) played a significant role in the 2007-2008 financial crisis, primarily through their association with subprime mortgages. Here are the key ways MBS contributed to the crisis:

1. Subprime Mortgage Market Expansion: MBS enabled financial institutions to bundle and securitize subprime mortgages (mortgages issued to borrowers with weaker credit histories). These securities were often marketed as higher-yielding investments despite their higher risk profiles.
2. Securitization and Risk Transfer: The securitization of mortgages allowed originators (lenders) to transfer the credit risk associated with these mortgages to investors who purchased MBS. This led to a disconnect between the originators, who were no longer as concerned about the creditworthiness of borrowers, and the ultimate investors in MBS, who were exposed to the underlying credit risk.
3. Credit Rating Agencies: Credit rating agencies assigned high ratings to many MBS, particularly those that were structured into different tranches (like CDOs – Collateralized Debt Obligations), based on flawed assumptions about the underlying mortgage risk and diversification. This mispricing of risk misled investors about the true creditworthiness of MBS.
4. Rapid Decline in Housing Prices: As housing prices began to decline from their peak in 2006, many borrowers with subprime mortgages found themselves owing more than their homes were worth (underwater mortgages). This triggered a wave of defaults and foreclosures, particularly among subprime borrowers who had taken out adjustable-rate mortgages with initially low teaser rates that reset to higher levels.
5. Widespread Financial Institution Exposure: Many financial institutions held significant quantities of MBS, either directly or indirectly through complex financial products like CDOs. As the value of MBS declined due to rising defaults and falling housing prices, these institutions faced substantial losses and liquidity problems.
6. Systemic Impact: The interconnectedness of financial institutions and the global financial system meant that losses in MBS and related securities spread rapidly, leading to a broader financial crisis. Banks and financial institutions that were heavily exposed to MBS suffered from reduced capital levels, increased funding costs, and in some cases, failures or government bailouts.

Investment Strategies Involving MBS

Investment strategies involving Mortgage Backed Securities (MBS) vary depending on investors’ risk tolerance, investment objectives, and market conditions. Here are some common strategies:

1. Yield Enhancement: Investors seeking higher yields may invest in MBS, especially those backed by mortgages with higher interest rates or those with lower credit quality (such as subprime mortgages). These securities typically offer higher yields compared to government bonds or investment-grade corporate bonds.
2. Interest Rate Risk Management: MBS are sensitive to changes in interest rates. Investors can use MBS to manage interest rate risk in their portfolios. For example, when interest rates are expected to decline, investors may prefer MBS with shorter durations or those with adjustable-rate mortgages (ARMs) that reset periodically based on prevailing interest rates.
3. Sector Rotation: Investors may rotate into MBS sectors based on relative value assessments. For instance, they may switch between agency-backed MBS and non-agency MBS, depending on their assessment of credit risk and yield spreads.
4. Risk Management through Diversification: MBS offer opportunities for diversification within fixed-income portfolios. By investing in a range of MBS with varying credit qualities, prepayment characteristics, and maturities, investors can spread risk and potentially enhance overall portfolio stability.
5. Sector-Specific Strategies: Investors may focus on specific sectors within the MBS market, such as residential MBS (RMBS) or commercial mortgage-backed securities (CMBS), depending on their outlook for the residential or commercial real estate markets.
6. Structured Products: Some investors may engage in more complex strategies involving structured products like Collateralized Mortgage Obligations (CMOs) or Mortgage-Backed Securities Tranches (MSTs). These products offer different risk profiles and cash flow structures, allowing investors to tailor their exposure to specific risk-return preferences.
7. Income Generation: MBS can be used to generate regular income streams through the receipt of interest and principal payments from the underlying mortgages. This income can be attractive for income-oriented investors, such as retirees or those seeking stable cash flows.
8. Tactical Allocation: Investors may adjust their allocations to MBS based on macroeconomic factors, interest rate expectations, and market conditions. For example, during periods of economic uncertainty or rising interest rates, investors may reduce exposure to MBS perceived to have higher credit risk.

 Conclusion

Thus Investors in MBS should conduct thorough due diligence and consider their risk tolerance, investment horizon, and market conditions before investing, as these securities can exhibit different risk profiles compared to traditional bonds or equities.