[sbinews] What is MBS? (Hindu Businessline)

  • From: Rajendra S Pai <rspai@xxxxxxxxxxxxxxx>
  • To: sbinews@xxxxxxxxxxxxx
  • Date: Wed, 9 Feb 2005 20:38:49 -0800 (PST)

What is MBS? 
B. Venkatesh 
(Hindu Businessline)
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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