‘Mortgage Backed Securities’, some big words here. But we will get through this.
Let’s say:
HDFC Bank lends home loans for a tenure of 30 years. People take home loans by creating a charge on the house i.e. putting the house on mortgage – as a collateral (let’s understand it as a protection for the Bank, if the borrower is unable to repay the loan). And, as is generally the case for every loan, borrowers pay monthly installments for the entire duration of tenure, ergo EMIs (Equated Monthly Installments).
What components does EMI comprise of?
- Part of principal loan amount (Obviously)
- Interest on principal outstanding (Understandably)
- Pre-payment risk (Wait, what?)
What do you mean by pre-payment risk?
Pre-payment risk is the risk involved with the premature return of principal on a fixed-income security (home loan in our case).
So? Isn’t it advantageous for the banks to receive the principal loan amount earlier than the payment schedule?
Apparently not! Because, when principal is returned early, future interest payments will not be paid on that part of the principal. Now you know why.
Back to where we stopped –
HDFC Bank will receive part principal + interest + prepayment risk components over a period of 30 years. That’s a very long period of time.
How do banks account for this?
So, in a bank’s balance sheet, the loan is shown as accounts receivable (amount that will be received in the future) on the assets side.
But, what if the bank wants to realize this amount before the scheduled period of 30 years?
What if the bank wants the entire outstanding amount today? Can they get it?
YES, by a process called securitisation.
Banks can transfer the entire loan amount to an entity which is a special purpose vehicle (SPV). SPV is a legal entity used by banks to isolate them from the financial risk (risk that involves financial loss to the bank i.e. if the borrower doesn’t repay the loan).
Simply said, banks transfer the assets (accounts receivable in this case) to the SPV. In return, the SPV will give the present value of all the components to the bank on the day transfer of such assets. If the total of all components is US $1 billion, then the present value of US $1 billion [Present value = Future value/ (1+rate) ^ no. of periods] will be given to the bank as proceeds. The EMI which is due from the borrowers will now directly go to the SPV (and not to the bank anymore).
Have a look at the image attached below:
A mortgage pool is a group of mortgages held by a SPV. It is a heterogeneous pool of assets which has many mortgages (home loans) which have been taken by many people – See different ‘tranches’ in the image above. All home loans are pool together and then given to the SPV.
SPV on the other hand, issues bonds (securities) to investors against the mortgage pool. Thus investors invest in the bonds/ securities issued by the SPV. These investors are paid periodic returns by way of interest payments from the money that SPV collects from accounts receivables (i.e. EMIs from borrowers which are now receivable by SPV).
Wasn’t it easy to understand after all?
Still have questions? Leave them below in the comment section and I shall answer them for you!
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