Securitization is the issue of marketable securities backed by a pool of existing assets such as auto or home loans. After an asset is converted into a marketable security, it is sold. A securitization company or reconstruction company can raise funds from only the QIB (Qualified Institutional Buyers) by forming schemes for acquiring financial assets.
Mortgage Backed Securitization (MBS) is the securitization of mortgage loans against residential or commercial properties. The securitization of residential mortgage loans or mortgage-backed securitization (RMBS) includes traditional home loans and loans against property (LAP).
Mortgage pass-through securities were first created in the United States in 1970 by the Government National Mortgage Association (or Ginnie Mae, as it is more commonly known).
Financial institutions have realized that there is more profit to be made in issuing and servicing a mortgage, i.e., appraising credit, charging fees, advancing the funds, and collecting and processing monthly payments—than in tying up deposit capital in the loans. It is preferable to lend a billion rupees loan after the appraisal and collection of initial fees and then sell the mortgage to investors, using the guarantee by some central agency to get the loaned amount back. These financial institutions can lend the amount again and collect more fees, sell it again and continue in a never-ending process. The initial loaned amount can earn much more in initial fees and fees for processing each loan’s monthly payments.
This process adds a lot of liquidity to the market. Moreover, investors are happy to buy the MBSs because they can effectively place money in real estate without default risk—having the benefit of a guarantee by government-backed agencies like CHMC in Canada, Fannie Mae, Ginnie Mae & Freddie Mac in the USA or the problems of collections and credit appraisal.
The packaging of insured mortgages has the added benefit of creating tradable securities, the MBSs, which come from nationwide mortgages. The assets are safe and liquid for the investors, and funds become available for lending to any area without limiting local credit shortages.
Collateralized Mortgage Obligation
A further development from MBSs is the collateralized mortgage obligation (CMO), which exists primarily in the United States. In this instrument, the MBS pool is further divided into tranches that make payments based on different segments of the mortgage cash flows. For example, a fast pay tranche might receive all the principal payments from the MBS until its investment has been recouped; meanwhile, the other tranches receive only interest payments. Once the fast-pay tranche is satisfied, the second tranche receives principal payments until it is repaid, and so on, until all tranches have been repaid. Interest payments are based on the principal outstanding to each tranche. The ordering of the tranches results in an earlier to later recovery of capital for each investor class.
Mortgage Backed Securitization in India
The securitization of assets historically began with the securitization of residential mortgages. The receivables are generally secured by a mortgage over the financed property, thereby enhancing investors’ comfort. This is because the mortgaged property does not typically erode its value like other physical assets through depreciation. Instead, it is more likely that real estate appreciates over time. Further,
- The receivables are medium to long-term, thus catering to the needs of different categories of investors;
- The receivables consist of many individual homogenous loans that have been underwritten using standardized procedures. It is hence suitable for securitization;
- In the US, where it originated, these mortgages were also secured by guarantees from the Government;
- The receivables also satisfy investor preference for risk diversification, as the geographical spread and diversity of the receivable profile are huge.
Role of National Housing Bank in MBS in India
NHB has played a lead role in starting up Mortgage Backed Securitisation and developing a Secondary mortgage market in the country. NHB launched the pilot issues of Mortgage Backed Securities (MBS) in August 2000 in the Indian financial market.
In the field of Mortgage-backed securitization, NHB launched the pilot issues of RMBS in August 2000. Since then, there have been other issuances of RMBS by Banks and Financial Institutions. NHB has been working towards developing systems and building institutions to make the RMBS market sustainable in the long run. In this process, NHB’s efforts have been directed at equipping the market participants with an adequate understanding of the RMBS products and generating sufficient awareness about the issues, risks, and benefits associated with the RMBS instruments as also gradually widening the investor base, which is essential for a thriving secondary mortgage market in the country.
- First Stage: Transfer the mortgage debt from the primary lending institution (Originator) to a Special Purpose Vehicle (NHB SPV Trust set up by NHB through declaration) with or without the underlying security.
- Second Stage: The mortgage debt acquired will be converted into tradable debt instruments (say in the form of Pass-Through Certificates) without recourse to the originator or the SPV.
Securitization of Mortgage Debt
NHB SPV may purchase and convert the housing loans into securities/ PTCs concurrently and issue them in the capital market for investment by investing institutions.
Execution of Memorandum of Agreement with NHB
Based on the willingness to sell or securitize its portfolio of housing loans, the Primary Lending Institution is required to enter into an umbrella agreement (called Memorandum of Agreement) with NHB to sell/securitize its portfolio of housing loans. The Memorandum of Agreement encapsulates the entire MBS transaction. It entitles NHB to take necessary steps to purchase or securitize an identified pool of housing loans, including circulation of the Information Memorandum and collection of subscription amounts from investors, as the case may be.
Selection of Pool of Housing Loans
The Primary Lending Institution would select the pool of housing loans from its existing housing loans based upon a ‘pool selection criteria laid down by the NHB.
Bottomline: MBS an Innovative Financial Product for Sophisticated Investors
Mortgage-backed securities typically offer yields that are higher than government bonds. Securities with higher coupons offer the potential for greater returns but carry increased credit and prepayment risk, meaning the realized yield could be lower than initially expected. Investors may receive higher payments than the income generated by investment-grade corporate issues. A portion of these payments may represent the return of principal due to prepayments. MBOs also carry credit risk as it is affected by the number of homeowners or borrowers in the pool of mortgages who default on their loans. Credit risk is considered minimal for mortgages backed by government agencies or government-sponsored enterprises.
MBOs are complex financial instruments and require a good understanding of their structure, returns, and tax implications. Usually, institutional investors are allowed to participate in MBOs.