Mortgage Backed Security

Mortgage backed securities are bonds developed by collating multiple home loans issued by a
banking institution. A mortgage-backed security is a culmination of a bunch of mortgages & real
estate loans of similar characteristics pooled together and administered by an authorised
financial institution & sold as an asset-backed security.

What is a Mortgage-Backed Security (MBS)?

Mortgage-backed securities are debt instruments that allow investors to lay a claim to cash
flows originating from a collection of mortgage loans. Loans given out by issuing financial
institutions act as the assets securing these bonds and the investors buying these bonds actually
lend money to loan takers.

A mortgage backed security is backed by mortgaged properties such as homes and/or real
estate. Mortgage backed securities thus created are traded in the secondary market. MBS
investors have their investments secured by mortgage loans and can get a fixed income from
mortgages without any direct involvement.

How do Mortgage-backed Securities work?

 Traded as asset-backed securities, MBSs are vehicles for individuals and non banking financial
institutions to engage in the mortgage business. The bank is the mortgage lender and acts as
the bridge between mortgage borrowers and investors. The investors essentially lend money to
the borrower and obtain the mortgage rights, including all interest and principal payments.

A mortgage backed security comes into being when a lender sells loans to issuers such
as investment banks or a government certified financial institution. Home and mortgage
loans of similar characteristics are then bundled together by the issuer to create an MBS. MBS
issuers generally trade them via special investment vehicles for added security.

Smaller banks generally sell mortgages to central banks and government certified institutions to
acquire funds. The large banks then pool similar loans to create MBSs to be sold on the
secondary market. As a result, they offer investors attractive returns and risk assurance from
a financial industry regulatory authority.

MBS investors get timely payments as borrowers make their monthly mortgage payments. In
addition, banks get to sell off the loans at discounts without worrying about any default risk.
However, risks remain under control as long as all parties operate optimally, fulfil their duties &
obligations, and the market remain stable.

How do Mortgage-backed Securities affect mortgage rates?

Market conditions, real estate prices, and residential market rates affect the prices of mortgage
backed securities directly. When MBS prices drop, banks and mortgage loan providers increase
interest rates. This helps them attract investors for the MBSs.

Conversely, mortgage rates go down when prices go up.

Mortgage-backed Securities and the housing market

Mortgage backed securities offer significant benefits to all parties involved in the housing & real
estate industry. Each party gets the best out of the housing & mortgage market.

 MBS allows lenders ( central banks, private banks, and mortgage loan providers) to sell off potentially
bad loans to government certified aggregators and use their capital much more wisely.
 Aggregators merge similar-conforming loans into MBS and add features to make them attractive to
investors.
 The need for similar loans pushes lenders to offer more loans to borrowers. As more loans become
available, interest rates decrease, making loans more accessible to the commoner.
 Under favourable conditions, MBSs are attractive investment opportunities for investors. In theory, they
get monthly payments and become the owners of the mortgaged properties.
 Residential MBSs exhibit prepayment risk. They occur when rates fall and borrowers return the entire
principal to investors least interested in reinvesting. In addition, MBS may carry substantial liquidity and
market risks. All such risks pass on to the investors as well. So, in addition to principal payments and
interests, investors must be ready to cope with the risks associated with MBS as well.
 Types of Mortgage-backed Securities
1. Pass-through Securities:

These are the most basic mortgage backed securities with maturities ranging from 5 to 30
years. Pass through MBS are generally backed by fixed interest, variable interest, and other
bond types. All mortgage payments are passed through to the MBS investors.

2. Collateralised Mortgage Obligation (CMO):

More complicated than pass through MBS, collateralised mortgage obligations are made up
of pools of securitised mortgage bonds, each with its own set of rules & nuances.

CMOS are somewhat similar to collateralised debt obligations. However, CMOS have pools of
securities bundled together called tranches. Each has different credit ratings, maturity periods,
and interest rates.

3. Stripped Mortgage-backed Securities (SMBS):

These MBSs split principal and interest payments down the middle. As a result, investors can
either opt for principal or interest payments.

History of Mortgage-backed Securities

Mortgage backed securities have a very controversial history.
MBSs were an exceedingly popular investment venture in the United States of America.
However, subprime mortgages and bad MBSs played a central role in the 2008 Global Financial
Crisis.
The Reserve Bank of India released maser directions with regards securitisation of assets
including mortgage backed securities. The master directions of RBI simplified guidelines and
relaxed restrictions on mortgage backed securities. The differential guidelines released sets the
stage for mortgage backed securities listed on the stock market for trading. The relaxed
minimum holding requirements and all-inclusive norms set by the central financial authority of
India will to boost MBS trading & let the 2.1 lakh crore industry take wings. The relaxed norms
are an attempt by the RBI to develop a stable and robust securitisation market.
Mortgage-backed Securities Today
Despite their bad reputation, MBSs are still a key cog in the housing and mortgage industry.
When everything works as planned, mortgage securitisation makes housing industries more
resilient, boosts cash flows, and increases liquidity.

The Role of RBI in MBS

MBSs are not a popular investment vehicle in India, primarily due to a lack of directives &
restrictions imposed on the securitisation of home & real-estate loans.

However, recent developments have been really exciting. The Reserve Bank of India’s master
directions with regards to said securitisation and relaxed limits on mortgage securities. RBI
highlights the large number of collateralised mortgage obligations in the Indian finance sector.
 The focus has been particularly on residential mortgage backed securities, and the directives
cite the following for RMBS.

 They need to have a minimum holding period of six months

 Must possess a minimum 5% retention rate of the book value of the debt instrument to be securitised
 Compulsory listing mortgage backed security such as loans with homes or real estates as collateral,
when the total pooled value of all assets is more 500 crore
In its directions and draft framework, the Reserve Bank of India also declared special purpose
vehicles as the only legal aggregators of securities. These organisations will monitor and
supervise all repayments and dividends in connection with securities.

What’s the Relationship Between MBS and a Bank?

The bank is the lender and a bridge between investors & borrowers. It offers mortgages to the
general public and then sells conforming mortgage loans at discounts to a central investment
bank or a government agency. The agency pools similar mortgages into MBSs and offers them
up for trade.

The bank is the lender which sells multiple mortgage loans to an aggregator or special purpose
vehicle at a certain price. The special purpose vehicle collates similar loans and turn them
into mortgage backed securities for trading.

What Is an Asset-Backed Security (ABS)?

Asset-backed securities are debt-based securities formed by aggregating different kinds of loans.
For example, asset-backed security may have mortgages, student loans, auto loans, credit card
loans, etc., as the pool of underlying assets.
Assets such as auto & credit card loans are generally too small to be sold individually. Banks and
NBFCs thus aggregate them together for securitisation and trading. As a result, asset-backed
securities have a diverse risk profile, and investors bear the risk while availing of cash flow from
principal and interest payments.