Thursday, October 9, 2008

Mortgage Backed Securities

We would have heard of the term Mortgage Backed Securities being used in any article that talks about the US Subprime mortgage crisis. This article will be explaining what an MBS is and how it is created & used. Mortgage backed securities are very common & famous in the United States, hence this article would be covering about the MBS in the US Market.

Mortgage-backed securities (MBS) are debt obligations that represent claims to the cash flows from pools of mortgage loans, most commonly on residential property. Mortgage loans are purchased from banks, mortgage companies, and other originators and then assembled into pools by a governmental, quasi-governmental, or private entity. The entity then issues securities that represent claims on the principal and interest payments made by borrowers on the loans in the pool, a process known as securitization.

Most MBS are issued by the Government National Mortgage Association (Ginnie Mae), a U.S. government agency, or the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), U.S. government-sponsored enterprises. Ginnie Mae, backed by the full faith and credit of the U.S. government, guarantees that investors receive timely payments.

We saw the theoretical explanation of what an MBS is. Let me explain what and how a MBS is created in simpler terms:

Hope you know what a Mortgage loan is. If not Pls refer to this link on what a Mortgage loan is. Mortgage Loan

Let us take into consideration the following entities that would be used during the explanation.

Bank ‘B’ - The Bank that is issuing mortgage loans

Customer ‘C’ - The person who has taken the mortgage loan from the bank

Agency ‘A’ - The Agency that is going to create the MBS

Investor ‘I’ - The person who is going to purchase the MBS

Customer ‘C’ approaches Bank ‘B’ with the request to issue a mortgage loan of Rs. 1,00,000/-. After all the scrutinizing process ‘B’ decides to grant a loan of Rs. 1,00,000/- to ‘C’.

Agency ‘A’ buys the mortgage loan that was granted to ‘C’ at the rate of say Rs. 90,000/- and then packages it into a bunch of securities each with a face value of say Rs. 100/- each. Which means ‘A’ would be creating 1000 units of the MBS. These MBS units would be available for sale in the open securities market for investors to buy. Our Investor ‘I’ decides to buy these MBS units. He makes a payment of Rs. 1,00,000/- to ‘A’ and purchases the units. In many cases 'A' may opt to retain a portion of these units based on the loan mixture to generate revenue for itself.

‘B’ can now use this Rs. 90,000/- for granting fresh loans to other customers.

This is how a typical MBS gets created and sold in the open market.

There could be a lot of Questions on MBS that may arise after reading this article. I have tried to cover as many of them as possible. If you have any further doubts kindly leave a comment and I would try to post the answer to your question as well.

1. What is the use for Investor ‘I’ after purchasing these MBS Units?

As you know, each loan would have loan tenure and an EMI fixed while disbursement of the loan. Every month when the bank receives the EMI, it would deduct a small portion of the EMI as its margin and would be remitting the remaining to Investor ‘I’ through the Agency ‘A’. Because ‘I’ has invested the amount in purchasing the MBS, he would be getting a regular income as long as the Customer ‘C’ repays his EMI properly.

2. What is the Rate of returns on ‘I’s investment?

The Return on the investment made by ‘I’ would be dependent on the rate of interest charged by ‘B’ to the customer 'C'

3. Why are MBS so famous?

From the Bank perspective - When the loan amount disbursed to a customer is packaged into an MBS, the Bank gets almost all its amount back. This they can use to grant fresh loans.

From the Agent perspective - When the loan is packaged into an MBS the agency gets a commission based on the amount of loan packaged. Also it retains a portion of the MBS units, which would generate regular income for them.

From the Investor perspective - As long as the MBS units are held by the investor, he would be receiving regular payments from the bank. This is definitely better than the money being idle in the savings account.

4. What happens if the loan customer does not repay the EMI properly or forecloses the account?

The agency ‘A’ is responsible for taking care of this. Almost all agencies give a guarantee to its investors about protection of their funds that are invested in MBS. (This is the reason why the Investment banks & Brokerage firms that create and sell MBS were the most affected by the US Subprime Mortgage Crisis)

5. What kinds of MBS are famous?

The MBS that give maximum return on investment are famous. Examples are MBS created out of subprime loans.

6. What is a subprime MBS?

Pls Refer to this link for what a subprime loan is. Subprime Loan An MBS that is created out of a bunch of subprime loans is called a subprime MBS.

7. Why are subprime MBS famous?

The Rate of Interest charged for subprime customers is far higher than that charged to prime customers. As the ROI is higher on these loans, the subprime MBS generate a better return on investment when compared to the prime MBS.

Hope this article was able to give you an introduction of what an MBS is.

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