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The financial market has varied securities to cater to the diverse financial objectives of investors. Equities for those looking at growth, debt market for those looking at safety and stability, mutual funds for those looking for a mix of both – there is something for every investor.
Besides a variety of markets, each of them has different tools offering unique benefits to investors. One such distinctive instrument is the mortgage-backed security, part of the debt market. In today’s article, we will understand thoroughly the features of mortgage-backed securities.
What are mortgage-backed securities?
Mortgage-backed securities are debt instruments similar to bonds. The uniqueness of this instrument is the mortgage, which acts as the collateral. Before diving deeper, let’s understand what a mortgage means.
A mortgage is a debt that is usually connected with real estate to purchase land, house, etc. The asset hence purchased becomes the collateral, giving the lender the right to take over the asset if the borrower fails to clear the debt.
So, mortgage-backed securities are instruments where such loans are pooled by investment banks and made available to investors. The interest paid by borrowers of mortgage loans is paid to MBS investors in return for their investments. Such payments are a combination of principal and interest, so the value of the MBS keeps reducing with each payment. They work more like bank loans than bonds.
How do mortgage-backed securities work?
Commercial banks lend mortgage loans to borrowers. Investment banks purchase these loans from multiple banks and pool them together to create a special-purpose vehicle that holds such loans as securities. These securities are then open to mutual funds, hedge funds and other investors for investments.
While taking over the loans, investment banks also purchase the rights to receive interest and principal repayments from borrowers. Such receipts are forwarded as coupon payments to investors.
Types of MBS
Some common types of mortgage-backed securities are:
- Pass-through securities – This MBS is the most popular one, where mortgage loans are combined and given to investors. The interest and principal payments from borrowers are passed on to investors proportional to their investment amount.
- Collateralised mortgage obligations – Under this MBS, the overall cash flow from borrowers is divided into separate portions with different risks and rewards. Each portion caters to investors with varied risk and return goals.
- Stripped mortgage-backed securities – Here, interest and principal payments from borrowers are divided into two securities. Investors have the option to choose interest-only MBS or principal-only MBS.
- Commercial mortgage-backed securities – CMBS are regular MBS instruments, but the collateral is a commercial property like shops and complexes, office buildings, etc.
Mortgage-backed securities in India
Mortgage-backed securities are yet to gain popularity in India. Unlike the United States of America, where MBS is a well-known investment avenue, India has very few institutions providing this instrument to investors.
Recently, the National Housing Bank, with the Reserve Bank of India, has established RMBS Development Company Limited (RDCL) – A firm that aims to develop the residential MBS market in India. The top banking institutions in the country are investing in RDCL and are jointly working towards growing the Indian MBS market.
Pros and cons of mortgage-backed securities
Mortgage-backed securities offer both benefits and limitations to investors. Hence, it is essential to consider them thoroughly before investing.
Advantages of investing in MBS:
- Like all debt instruments, MBS pays periodic interest and provides a regular source of income to investors.
- Investing in MBS allows investors to hold a diverse investment portfolio. Since these are different from stocks and bonds, their risks and returns are different, too.
- Government-backed MBS offer high-quality securities to investors which are stable and less risky.
Disadvantages of investing in MBS:
- Interest rate risk is an inherent feature of all debt instruments. When the interest rate in the market increases, existing MBS become less attractive and lose value.
- Default risk, too, must be factored in while considering debt instruments for investments. Borrowers may default in paying interest and principal, which may lead to investors losing their money.
- Another unique risk which is not present in other debt instruments is the risk of early repayment. When borrowers repay loans ahead of their schedule, investors lose the opportunity to earn more money through interest payments.
Bottomline
Mortgage-backed securities are instruments where mortgage loans are combined to create a pool in which investors can invest. They are paid interest and principal periodically in return for their investments.
They are currently less popular in India. Hence, investors interested in MBS must research thoroughly and talk to their brokerage firms to understand whether such securities are available.
FAQs
Let’s say IDBI Bank (Industrial Development Bank of India) has 500 outstanding mortgage loans. The investment bank wing of HDFC takes over these 500 loans and pools them into one asset. The asset is then open for investment to investors, such as mutual funds, institutional investors, retail investors, etc.
Mortgage-backed securities pricing is quite complex as it considers various factors, like existing interest rates, credit risk, market demand, liquidity, possibility of defaults and prepayments, etc.
Since mortgage-backed securities are quite uncommon in India, investors must thoroughly research and reach out to different brokers to check the availability of this instrument. Even if they find something suitable, it is of paramount importance for investors to understand the features and terms of the instrument in detail before investing.
Mortgage-backed loans specifically involve real estate mortgages, while asset-backed securities are collateralised by other assets like credit card loans, vehicle loans, etc.
Subprime lending was one of the major contributors to the financial crisis in 2008. It was where home loans were lent to borrowers with low creditworthiness. Such subprime loans were pooled in and made available as mortgage-backed securities to investors. Since the borrowers were incapable of repayment, the defaults were high on these loans, leading to a decrease in the value of MBS.