What are mortgage-backed securities?

Securities play a crucial role in the housing finance market and broader financial systems, shaping investment opportunities and risk management strategies.
Loan Against Property
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5 min
25 May 2024

What is Mortgage Backed Securities?

Mortgage-backed securities (MBS) are investment products similar to bonds. Each MBS represents a portion of a pool of home loans and other real estate debts purchased from banks or government agencies. Investors in MBS receive regular payments, much like bond coupon payments.

In the context of a loan against property (LAP), similar securitisation practices can be applied where loans secured by properties are bundled together to create investment products. This helps financial institutions manage risk and provide additional liquidity for further lending activities.

Mortgage Backed Securities are created when banks and other mortgage lenders bundle together individual mortgage loans and sell them as a single security to investors. These securities are backed by the cash flows from the underlying mortgage loans, including both principal and interest payments made by homeowners.

How do mortgage-backed securities work?

To fully understand how mortgage-backed securities (MBS) work, it is helpful to see how they are created. Here is a breakdown of the process:

  • Origination: A financial institution, like a bank or an NBFC, offers mortgages to homebuyers, with the properties purchased serving as collateral.
  • Pooling: The financial institutions group many of these mortgages. These loans generally share common traits, such as interest rates and maturity dates.
  • Securitisation: The pooled mortgages are sold to a trust, which could be a government-sponsored enterprise or a private financial entity. The trust then packages these loans into MBS.
  • Issuance: MBS are issued and sold to investors, backed by the mortgages in the pool. Agency MBS are further guaranteed by government agencies, offering extra protection to investors.
  • Servicing: A mortgage servicer collects monthly payments from borrowers and distributes these to MBS investors.
  • Investment: Investors purchase MBS, effectively lending money to the homebuyers in the pool. In exchange, they receive periodic payments, including both interest and principal repayments from the underlying mortgages.

Types of mortgage backed securities

There are several types of mortgage-backed securities, including:

  1. Pass-through securities: These securities pass through the principal and interest payments from the underlying mortgage loans directly to the investors.
  2. Collateralised mortgage obligations (CMOs): CMOs divide the cash flows from the underlying mortgage loans into multiple tranches, each with different risk and return characteristics.
  3. Stripped mortgage-backed securities: These securities separate the principal and interest payments of the underlying mortgage loans into different securities, catering to investors with specific preferences for cash flow timing.

Advantages of investing in mortgage-backed securities

Investing in mortgage-backed securities (MBS) offers several advantages:

  • Stable cash flows: MBS provides a steady stream of income through the interest and principal payments from mortgage loans.
  • Diversification: MBS allows investors to diversify their portfolios by gaining exposure to the real estate market without directly owning property.
  • Relative safety: MBS issued by government-sponsored entities or reputable financial institutions are often considered relatively safe investments due to their backing.

Risks associated with mortgage-backed securities

Despite their advantages, mortgage-backed securities carry certain risks:

  1. Interest rate risk: Fluctuations in interest rates can affect the prepayment behaviour of homeowners, impacting the cash flows and returns of MBS.
  2. Credit risk: There is a risk of default on the underlying mortgage loans, especially in the case of subprime or non-conforming mortgages.
  3. Prepayment risk: Homeowners have the option to refinance their mortgages or pay them off early, which can disrupt the expected cash flows to MBS investors.

Key players in the mortgage-backed securities market

The mortgage-backed securities market involves various participants, including:

  1. Mortgage originators: These are financial institutions that originate and underwrite mortgage loans.
  2. Government-backed entities: In India, entities like the National Housing Bank (NHB) play a significant role in the MBS market by purchasing, guaranteeing, and securitising mortgage loans.
  3. Investors: Institutional investors, such as pension funds, mutual funds, and insurance companies, are major participants in the MBS market, seeking to earn returns on their investments.

How to invest in mortgage-backed securities?

Investors can access the mortgage-backed securities market through various channels, including:

  1. Direct purchase: Investors can buy MBS directly from issuers or through brokerage firms.
  2. Exchange-traded funds (ETFs): ETFs provide a convenient way to invest in a diversified portfolio of MBS, offering liquidity and transparency.
  3. Mutual funds: Mutual funds specialising in MBS offer investors professional management and diversification across a range of mortgage-backed securities.

Consider Bajaj Finserv Loan Against Property

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In conclusion, mortgage-backed securities (MBS) serve as a vital link between real estate and financial markets, facilitating efficient capital allocation and risk management. Through the securitisation of mortgage loans, MBS offers investors opportunities for income and portfolio diversification while providing borrowers with access to capital. Despite the benefits, it is crucial to acknowledge the associated risks such as interest rate fluctuations and credit risks. However, with careful consideration, investors can navigate these complexities and capitalise on MBS investments.

Moreover, with products like Bajaj Finserv Loan Against Property, borrowers can leverage their property assets efficiently. With streamlined processes, tailored solutions, competitive interest rates, and convenient top-up loan facilities, Bajaj Finance enhances the accessibility and appeal of mortgage-backed securities.

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Frequently asked questions

What is an example of a mortgage-backed security?
An example of a mortgage-backed security is a pass-through security, where investors receive payments consisting of principal and interest from a pool of underlying mortgage loans.
What are securities backed by mortgages?
Securities backed by mortgages are financial instruments representing ownership interests in pools of mortgage loans. These securities derive their value and cash flows from the payments made by homeowners on their mortgages.
What is the difference between bonds and mortgage-backed securities?
While bonds represent debt obligations issued by corporations or governments, mortgage-backed securities are backed by pools of mortgage loans. Bonds typically offer fixed interest payments, while MBS offer variable payments based on the underlying mortgage cash flows.
What are mortgage-backed securities in India?
In India, mortgage-backed securities (MBS) represent securities backed by pools of mortgage loans. These instruments allow investors to participate in the real estate market by receiving cash flows from the underlying mortgage payments made by homeowners.
What are the risks associated with investing in mortgage-backed securities?

Investing in mortgage-backed securities involves multiple risks. The primary risk is prepayment risk, where borrowers may repay their mortgage early, affecting the overall return on investment. Extension risk is another risk factor where if interest rates rise, homeowners could delay refinancing, extending the duration of the mortgage-backed security. Other risks include market risk, where the value of the mortgage-backed security could fluctuate due to changes in the financial market, and credit risk, where borrowers could default on their mortgage, impacting your investment.

How do interest rate changes affect mortgage-backed securities?

Changes in interest rates considerably impact mortgage-backed securities. If interest rates fall, the likelihood of homeowners refinancing their mortgages to receive a lower rate increases, leading to an acceleration in the rate of repayment - this is known as prepayment risk. On the other hand, if interest rates rise, the refinancing rates decrease, extending the duration of the mortgage and leading to extension risk. Thus, the investment return could vary depending on the interest rate environment.

How is the performance of a mortgage-backed security evaluated?

The performance of a mortgage-backed security is evaluated through various methods. The yield or return on investment is a primary metric, but it is more complex due to factors like homeowner's prepayments. Analysts also consider the average life of the security, which represents the average time it takes for principal payments to be received. Additionally, the security's price sensitivity to changes in interest rates, also known as its duration, is assessed. All these factors collectively help in evaluating the performance of a mortgage-backed security.

What is extension risk in mortgage-backed securities?

Extension risk in mortgage-backed securities is a situation that occurs when interest rates rise. As rates rise, homeowners are less likely to refinance their mortgages, meaning the investors receive their principal back more slowly than anticipated. This extends the average life of the security, exposing investors to a longer period of risk. The result is that the security's sensitivity to further interest changes increases, often causing the value of the mortgage-backed security to decline. It is therefore crucial for an investor to gauge the extension risk before investing.

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