Why MBS?
MBS is about transferring risk. Risk is transferred from the bank (or mortgage company) that made the loan to investors who have an appetite for risk and wish to profit from it.
The profit comes from the interest payments on the loan. The risk comes from the fact that the loan may not be repaid. Or, the loan may be repaid early (!) which is likely if it can be refinanced at a lower rate of interest. So, changes in interest rates also add to the risk for investors.
Also, banks love getting these housing loans off their balance sheet. Banks are required to hold a percentage of their loans as reserve and using MBS, they can comply with the reserve ratio requirements while freeing up the capital.
In addition, the investment banks issuing the mortgage-backed bonds profit from the difference in interest rates paid by individuals who take a housing loan and interest rates expected by investors who invest in mortgage-backed bonds.
Slicing and dicing
The pool of mortgage loans is split into slices (also called tranches) of varying levels of risk.
As shown is this diagram, the highest rated tranches offer the lowest risk and the lowest returns. On the other end of the spectrum the most risky tranche (which is usually unrated) offers the highest returns.
Investors can choose the tranche based upon their risk appetite. A pension fund might buy the “senior” conservative bond while a hedge fund might buy the “junior” speculative bond.
Risk protection
It is important to understand that the lowest tranches offer protection to the senior tranches.
Any losses will be absorbed by the investors of the most junior tranche until the value of their investment reaches zero. If this occurs, investors in the next junior most tranche absorb further losses, and so on until the senior most tranche is reached.
The lowest tranche contains loans made to subprime customers (i.e., who have a blemished credit history and have a high chance of defaulting on their mortgage payments).
The crucial lowest 10%
The lower tranches make up around 10% of the entire MBS. The catch is, the lower tranches have to be sold in the first place. If the lower tranches cannot be sold, the higher tranches cannot be sold either, and the entire deal is off!
Who buys the risky stuff?
CDOs (Collateralized Debt Obligation) buy the riskier parts of an MBS. The next post will discuss CDOs.
