When a bank provides loans to its customers, the bank also demands collateral from its customer. Mortgages backed securities are created by pooling of such collateralize loans and selling them in the secondary market as they provide income on a monthly basis which acts as cash flows to the investor and the collateral is used as security for an investor in case the customer defaults on the payment of interest, his collateral will be sold and the payments will be made to the investor. This process is called securitization. Pass through structures are created where interest and principal are collected from the borrower and passed through the banks and ultimately to the MBS investor.
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Suppose DHFL provides house loans to customers. There are two factors for this:
- The house and initial down payment act as collateral in case the customer defaults the house will be sold to recover the loss on the loan.
- The loan provides a monthly cash flow in the form of interest paid by the customer.
DHFL can pool these various loans and sell them as Mortgage-backed security.
Benefits of Mortgage-backed security:
- MBS helps banks to generate new loans, as the existing loans are pooled and sold to investors. This process is termed Securitization. The money received from these investors would be used to provide loans to other borrowers.
- MBS provides fixed income to the investor.
- MBS are generally guaranteed by the bank to provide security for default risk (Interest and principal) born by the borrower.
Risk related to Mortgage-backed security:
- MBS has prepayment risk. Prepayment risk is the customer makes the principal payment before the maturity date of the loan. The customer would make a prepayment when the interest rate in the market goes down the customer would borrow at a lower rate to make the prepayment of the loan.
- Prepayment acts as a loss to the lender as the monthly income generated from the security is lost. And they have reinvested the principal at a lower rate of interest.
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Financial Crisis of 2008:
MBS played a vital role in the financial crisis of 2008. In the USA the government promised homes to all the citizens with respect to this announcement it started infusing capital in banks to facilitate loans for homes.
Phase 1: Banks started to issue subprime loans to Home borrowers. Subprime loans are loans issued to borrowers with low credit (No collateral, No salary, etc.). Bank also provided teaser rates to the subprime borrower. Teaser rates are a low rate of interest charged to the borrower in the initial years of providing the loan as compared to the high rate of interest charged for the rest of the tenure of the loan.
Phase 2: Some borrowers started to refinance the loan from another bank to avail the facility of teaser rate of that bank. As they could not afford to pay the actual interest rate.
Phase 3: As the tenure of teaser rates ended many borrowers started to default as they did not have sufficient income to pay away their liabilities.
Phase 4: When the supply of housing loans increased and at the same time many borrowers started to default on the loan, property prices started declining.
Phase 5: The existing borrowers also started defaulting as they found that they paid more interest and principal than the price of the property.
Phase 6: When these subprime loans were issued they were pooled and sold to investors as MBS. As the borrowers defaulted and the property prices started to fall the issuer of MBS were not able to make the requisite payments to the investor and they started to default as well.
Phase 7: Many financial institutions financed their investment in MBS by issuing Commercial paper were not able to fulfill their liability. As they financed long term investment with short term liability.
Author: Divya Sankhla
About the Author: Divya has completed her graduation in Bachelors of Accounting and Finance. She has worked in Deloitte Touche Tohmatsu Services, Inc. as a Research Analyst for 1 year and at JM financial as a Credit Risk Analyst for 1.3 years. She is keen on learning about Financial Market. Well versed with Bloomberg, Capital Line, and Excel.