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Mortgage Backed Securities: An introduction

Jul 27, 2002

With the meltdown in global stock markets, investors are wary of parking their funds into equities. Corporate accounting concerns are among the major worries for investors today. This has led to a sharp increase in volumes of debt markets, which are considered to be safe havens in such situation. Indian debt market has also seen a sea change over the last one year. One such change is the new crop of mortgage-backed securities issued by housing finance companies (HFCs). Housing finance sector has remained immune from the slowdown in industrial and economic activity, thanks to a steep decline in interest rates over the last one year. This coupled with tax benefits on a housing loans, boosted activity in the sector. In order to maintain strong business expansion, HFCs are required to offer housing loans at competitive rates. This is due to the fact that with the entry of banks into home loan market, rates have started sliding. Banks with the advantage of raising low cost funds through public deposits have virtually started a rate war. Consequently, it has become difficult for pure housing finance companies to raise funds at lower rates.

Mortgage backed securities (MBS) are instruments, which assist HFCs raise funds from the markets, at competitive rates, based on their credit rating. Several HFCs have already issued these securities. Let us understand the basic concept of MBS and how does it work.

Meaning and function of MBS
A mortgage loan is a loan with a physical asset such as real estate, provided as collateral or security. The most common form of mortgage loan is a residential mortgage. Mortgage gives the lender the right to foreclose and seize the property, if the borrower defaults on the loan. This is to ensure that the debt is paid off. MBS are backed/secured by a pool of traditional residential housing loans and are issued/originated by HFCs. They represent an individual ownership in an underlying pool of mortgage loans. Shares of such mortgage pools are then sold in the form of participation certificates. The interest, scheduled principal payments and prepayments that are collected from the underlying mortgages are passed through to investors after deducting servicing fees.

Unlike most fixed income products, MBS are sold and traded based on the average life of the security rather than the stated maturity. The average life is the average time it takes for mortgages in the underlying pool to be ‘paid off’, based on certain assumptions about mortgage prepayment speeds. If prepayment speeds are faster than expected (typical in declining interest rate environment), the average life of the security will be shorter than the original estimate. If prepayment speeds are slower (typical in rising interest rate environment), the security's average life will be extended.

For example, an HFC comes out with a MBS issue worth Rs 1,000 m at 9% coupon rate. Investors’ subscribe to this and are issued certificates based on their relative size of investments. In one year, the home loan size of the HFC gets reduced to Rs 900 m owing to prepayments by customers (home loan takers), then the investor will not only receive the 9% interest on their investment but will also be prepaid his principal in proportion to the investment.

Thus, prepayment risk is the significant risk for these securities, as cash flows from the investments cannot be ascertained. Prepayment risk gives these securities a character similar to that of callable securities (eg. bonds issued by IDBI and ICICI) since they can be retired before maturity with no penalty.

In India, HDFC has taken a lead in issuing these securities, followed by slew of HFCs including ICICI Home and Citibank. The following table gives a brief idea about the deals concluded in the past, interest rates at which funds were raised and tenure of the issue.

Selected MBS deals
Originator Amount (Rs m) Coupon rate Duration (months) Mortgage pool *
HDFC 1,560 9.1% 119 NA
ICICI Home Fin 511 8.8% 120 1,639
Citibank 509 NA 84 312
Canfin Homes 582 8.9% 42 4,526
* Number of housing loans
NA: Not available

The basic structure of the MBS programme this year has been facilitated by National Housing Bank’s (NHB) purchase of retail housing loans. NHB’s purchases of these loans are identical to the operations of the Federal Home Loan Mortgage Corporation (Freddie Mac) of the US.

The loans purchased by the NHB are issued to investors in the form of pass through securities, but without recourse to the HFCs. This would imply that the investors would have to assume the credit risk of the cash flow streams. The security that is available to the investors is the underlying physical assets against which the housing loans have been provided. All the issuers, have however, provided for additional collateralization of the receivables pool to enhance the comfort level of the investors.

Liquidity concern..
Currently, these securities are placed privately and are not traded in the markets. However, to provide liquidity and depth to these instruments, NHB plans to list these securities on the debt segment of the NSE.

Once the liquidity is ensured for the instruments, issue size could also be raised. Most of the issues that have hit the markets till now have all been small lots. The largest this year being the HDFC offering, which was in excess of Rs 1.5 bn. The larger issues would help HFCs bring down the weighted average cost of working funds. This in turn, would translate into lower lending rates for housing loan customers.

Other related instrument
Now lets get some basic idea on the derivative of MBS, which is known as collateralized mortgage obligation (CMO). Unlike MBS, CMO redistributes the prepayment risk among various investors.

Let’s see how does it function:
Different tranches of loans are created, which reprioritize principal and interest payments. For example, three classes of tranches may be created out of a pass through security. Lets call them Tranches I, II and III. They receive interest on the basis of their outstanding par values. Their payment structure may look like follows:

  • Tranche I receives net interest and all the principal payments until it is completely paid
    off.
  • Tranche II receives its share of net interest and starts receiving all the principal payments after Tranche I has been completely paid off. Prior to that, it only receives interest payments.
  • Tranche III receives monthly net interest and starts receiving all principal repayments after Tranche I and II have been completely paid off. Prior to that it only receives interest payments.

In this method, though the creation of a CMO has not altered the risk of prepayment, risk has been distributed across three classes of holders. Tranche I receives the prepayment first, followed by Tranche II and finally by Tranche III. The CMO’s major financial innovation is that the securities created more closely satisfy the asset/liability needs of institutional investors, thereby broadening the appeal of mortgage-backed products. Institutions prefer different tranches based on their liability structure and CMOs fill an important need in the market. Well, if you are wondering what happened to the underlying pool of mortgage loans, they are held in a trust and form the collateral for the CMO tranches.

To summarize:

  • The basic MBS is the mortgage pass through security created from a pool of mortgage loans.
  • Its cash flow includes net interest, scheduled repayments (that is amortization) and prepayments.
  • Cash flow of MBS is uncertain due to prepayment risk.
  • Collateralized mortgage obligation (CMO) redistributes prepayment risk to various classes of investors.

Due to its basic nature of amortization, whereby the overall principal size reduces with time, an investor should be clear on investment objectives before taking a plunge into MBS.

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