[sbinews] What is MBS (Market Backed Security)?

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What is MBS?
B. Venkatesh

THE National Housing Bank (NHB) proposes to act as a market maker for
mortgage-backed securities (MBS). Now, what is MBS?

These are securities created from a pool of home-loans. HDFC, for instance,
could bundle home-loans that possess similar risk characteristics and
maturity into securities and sell them to investors.

HDFC will collect the interest and the principal on these loans from its
borrowers and pass them to the investors of the MBS. A conventional MBS is,
hence, also called a pass-through security.

Assume HDFC pools home-loans with average maturity of 10 years with average
home-loan rate of 8 per cent. It may charge 0.5 per cent as commission to
collect cash flows from the home-loan borrowers. The MBS will, therefore,
carry an interest rate of 7.5 per cent with an average maturity of 10 years.

HDFC may also choose to get a credit guarantee for the MBS. This is referred
to as credit enhancing. Suppose HDFC pays NHB 0.50 per cent for credit
enhancing the MBS. This means that NHB will pay the investors of MBS, if
home-loan borrowers default in the payment of interest and principal to
HDFC. As credit enhancement lowers default risk, HDFC will be able to sell
MBS with a lower interest rate.

MBS helps a company like HDFC in converting the home-loan assets into cash.
The company can use this cash to offer more home-loans and expand the
business. Investors also benefit because the interest rate on MBS is higher
than that on government securities.

Of course, investors of MBS run a prepayment risk. This is the risk that the
borrowers will prepay their home-loans.
Typically, borrowers prepay when interest rates decline. In such times, the
home-loan company will collect the additional principal and pass on the cash
flows to the investors of the MBS. The investors will now be forced to
re-invest these cash flows at a lower rate.

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