So, what are Mortgage-Backed Securities?
In this article, I have tried to explain what Mortgage-Backed Securities are and how they work in providing a sound flow of capital into the market. It may be difficult to understand at first sight, but when you do, you must appreciate the ingenuity of the financial markets to have come up with such a hauntingly beautiful investment vehicle back in the1970s.
Let’s first understand the term securities. Securities are anything that holds some monetary value. It is a financial instrument that helps the holder of these securities to be the owner or the creditor of the issuing entities. These days everyone tries to hold some shares of a publicly traded company via Stock- a creditor relationship with a government or private entity via Bonds- or rights to ownership to an enterprise represented by Option. They all possess underlying values derived from their underlying parent assets.
What do Mortgage-Backed Securities mean? To oversimplify, these securities derive their worth from the underlying asset- that is Mortgages. In this unconventional and complicated process of securitization, where banks who issue loans to homebuyers, become the middleman. Lenders grant mortgages to the customers and sell to the investors at a discount and record the sale of MBS as an asset (in reality debts should be recorded as a liability) in their balance sheets. The lenders pool together a large number of often deemed illiquid debts and sell at a discount to the government or securities firm or big large investment banks like Goldman Sachs, JP Morgan, Merry Lynch, etc who will use it as collateral to create an entity whose shares would be backed by the inflow of mortgages via the mentioned process. The investor essentially lends money to the home buyers with banks just being the facilitatory institution. The investor gains a high return on these obligations as long as the customer pays his/ her EMIs in a regular manner.
Sounds a bit complicated, isn’t it? Let’s understand the concept through an example. Suppose you want to buy that beach-side dream home of yours on a sale. You go to your local commercial bank and take out a loan of, say Rs.1Cr. The concerned bank or lender credits money in your bank account and you are able to buy the home and promise to pay back the bank with a nice little interest over the principal amount in a matter of years. The lender then bundles similar mortgages like yours of many aspiring millennials and sells them in bulk to an investment bank at a discount. The investment bank in turn buys the rights to the monthly EMI payments from the lender at face value. The latter bank creates a separate entity and issues shares of the same to other investors, hedge funds, mutual funds, Pension Fund accounts, etc. And this complicated process of securitization of mortgages gives rise to new ingenious vehicle Mortgage-Backed Securities.
It’s a win-win situation for all. The homebuyers get cheap loans, lenders convert liability to an asset and investors take home a fat profit.
Well, there is a catch. What if you lose your job and default on your EMI? It will not affect much if you are the sole borrower. But if the majority keeps on defaulting all at once, the flow of funds to the market is disrupted, and once the darling MBSs are deemed worthless in a short span of time. As our markets are tightly integrated with the general economy, its shockwaves are felt all across the financial markets and lenders start filing for bankruptcy. This is the very reason behind the 2008 Housing Bubble Crisis when lenders and investors in a crazy run to amass profit started issuing subprime mortgages of astronomical amounts to individuals with weak credit ratings. This indiscriminate lending process and corporate greed gave birth to the ticking time bomb that finally exploded resulting in a global financial meltdown in September 2008 and wiped out trillions of dollars worth of wealth in a matter of months. Banks and big financial institutions went bust making the bubble the worst financial crisis since the Great Depression. The MBS were deemed worthless and the Central Banks across the largest financial markets had to buy those junks to inject much-needed liquidity and save the economy from going into a tailspin.
The Bottom Line:
This complex process is often out of bounds for the general public. It works smoothly if everyone does what they are supposed to do. Banks must ensure the quality of mortgages, rating agencies assess their investment-grade properly, and perform due diligence. Any of the institutions downplays the risk of default and over-leverages, the whole fragile system comes crashing down with the borrower being battered down badly.
- By Prajna Prayas