Mortgage Backed Securities: The Anatomy of the US Financial Crisis

The process of restructuring and re-packaging a pool of financial assets yielding future cash-flows is called securitisation. Such Financial instruments are called Securities, specifically Asset-Backed Securities and are sold to prospective investors who would be interested a piece of the future cash-flows. Any financial asset yielding future cash flows can be securitised by the above process.

Securitisation of assets which are essentially mortgages are called Mortgage Backed Securities.

MBS can be of various types depending on :

• type of Mortgagor (Borrower)

  Residential MBS - on residential Property,

  Commercial MBS - on commerical property

• type of Mortgaged Assets :

  Prime - Borrowers with good credit scores, reliable credit history, verifiable income / assets (Lower Default Risk Rating)

  Sub-Prime - weaker credit scores, no verification of income etc ... (Higher Default Risk Rating)

MBS's are floated because it helps Mortgagees [Lenders] in re-financing their current operations. In the absence of an MBS, the mortgagee would receive the cash-flow - as per the loan structure in the form of EMIs -equated monthly installments- through the tenure of the loan ranging between 10-25 years.

The advantage of an MBS to the Mortgagee is - By restructuring the pool of it's diverse loan portfolio as an MBS and selling these in the capital market, the Mortgagee forfeits it's future cash flow in exchange for a discounted present-value of the asset [decided by a pricing formula]. In addition, the Mortgagee [typically, banks] also does away with the default risk /credit risk by selling the asset and it's associated risk to a third-party thereby, securing & avoiding the risk on his balance-sheets. This also reduces the contingency capital which Banks are regulated to maintain as a function of the risk on their balance sheets as per new Basel Norms.

The advantage to the investors buying these MBS's is that they are able to get a piece of the future cash-flows at a discount. These MBS's are subsequently re-packaged and restructured and sold to other interested parties in exchange for Fees, as Bonds in many cases. The advantage of issuing Bonds backed by mortgages is that these third-parties are able to monetise the credit spread between an underlying mortgage and a market-driven yield decided by the Bond market (typically investors). Typically, the interest rate paid to investors os lower than the interest rate of the underlying loan to cover for Service Fees, Guarantee Fees and other expenses.

Parties in an MBS transaction:

Mortgage Issuer : Banks -also called the Mortgage Originator, who issue loans allow securitisation of their mortgage Portfolios to be sold in pools / packages by Special Purposes Entities like Fannie Mae (FNMA, Federal National Mortgage Association), Freddie Mac (FHLMC, Federal Home Loan Mortgage Corporation) or Ginne Mae (GNMA, Government National Mortgage Association), being government sponsored entities have become the biggest players in the market of MBS issuing, who buy the mortgages from banks [the original Lender] and re-package them into MBS's by providing financial guarantee to the payment of principal & interest to the registered owners of the MBS.

It is understood that the financial guarantee provided by Fannie Mae & Freddie Mac would play a significant role in the event that an adverse economic scenario hits the mortgage market, as they would pitch in to protect the interests of the investors as well as the general economic environment in the mortgage market.

Mortgage Buyer: Typically, investors who are interested in re-selling / re-packaging the MBS's.

Mortgage Guarantors: The presence of this party is not mandatory in all MBS transactions. Those transactions which take place without guanrators are called Pass-through MBSs. A large percentage of MBS's are backed [guaranteed] by Government-Sponsored Entities like Fannie Mae (FNMA), Freddie Mac (FHLMC) and a smaller percentage being backed by Ginnie Mae (GNMA, Government National Mortgage Assocaition). The role of guarantors is not issuance, but providing Federal Financial guarantee to investors on the principal and interest components of the MBS's.

Investment Banks play a variety of roles in the MBS ecosystem in exchange for spreads / commissions - sometimes, the role of an Arranger to setup the structure of the MBS transaction, sometimes, re-packaging and re-selling the MBS by re-structuring them into financial instruments such as Bonds backed by these MBS's and distributing them to investors across the globe.

MBS cash-flow:

When the mortgagors (Borrowers) make their monthly payments (EMIs) to their Bank [Lender], the cash if forwarded to the Guarantor who then forwards the same to the holders of the MBS,less the Service Fees.

Subprime Loans

As mentioned above, loans which are awarded to households / individuals who do not have high credit-scores or a verifiable income / asset source have typically, the highest risk rating owing to the possibility of default risk. This possibility multiplies manifold in an adverse economic scenario with rising domestic interest rates, credit-squeeze or a real-estate bubble in the making. In all such events, the subprime loans are the first ones to create havoc in the economic system.