7.4Permitting and encouraging banks to invest in Mortgage-backed securities:
Much of the efforts at developing a securitisation market could be nothingness, if there is not sufficient investor appetite. In order to develop the securitisation market, we need to develop strong investor demand, which has to come from two broad classes – institutional investors and retail investors.
Among institutional investors, banks, insurance companies, mutual funds, employee benefit funds, etc are major investors in senior classes of RMBS, and hedge funds, private equity funds, ABCP conduits, structured finance CDOs etc are investors in junior classes of RMBS.
Currently in India, major buyers of securitisation paper are insurance companies and banks.
Banks have a huge treasury position. The current investments by banks in RMBS paper are driven by an RBI circular being DBOD No. BP. BC. 106/21.01.002/2001- 02, dated 24th May 2002. The language of this circular is far from clear. It does nothing by way of incentivising banks to invest in RMBS paper, nor does it provide any guidance on how to assess the risks of RMBS investing. On the other hand, by laying down several conditions that banks must monitor, some of which are impractical, it only creates the impression of being a piece that regulates banks’ investments in RMBS.
Though the circular aforesaid does provide a 50% risk weight for investments in RMBS, what is required is a comprehensive guidance to banks wanting to invest in RMBS. Not necessary that the RBI should do it – even some industry association, for example, FIMDA, can do it. Bond Market Association in the USA has easily-understandable guidance on investing in MBS paper. In absence of a guide, it is quite easy for banks to either over-estimate or under-estimate the risks of MBS investing. In practice, in a situation of ignorance, over-estimation of the risks is more common. We spend below a few paras on the risks of RMBS-investing.
The other significant investor class is mutual funds. So far, there were several apprehensions as to whether mutual funds could invest in MBS, as the same was not apparently defined as “securities” under sec. 2 (h) of the Securities Contracts (Regulation) Act, and under SEBI’s current scheme, mutual funds might invest only in “securities”. A major step in this direction has already been taken - the Union Budget 2005 proposes an amendment of the definition of ‘securities’ in sec. 2 (h) of the aforesaid law, so as to clearly include asset-backed and mortgage-backed securities. This will open the avenues for mutual funds and foreign institutional investors to invest in MBS paper.
Employee benefit funds may also find investing in senior tranches of MBS paper interesting. The government’s interference here is very helpful – it might recommend/permit limited MBS investment by provident funds and pension funds.
7.5RISK ASSESSMENT OF INVESTING IN MORTGAGE-BACKED SECURITIES:
In any market, to encourage investors to invest in securitisation transactions, an easy-to-understand guide from a body who carries reliability and faith would be highly helpful. We are of the view that in absence of such guide, the risks of investing in MBS have generally not been understood, or have been over-blown.
Essentially, there are two primary risks in MBS investing:
Prepayment risk, which is essentially Interest rate Risk
Essentially, in MBS, like in any other defaultable mode of investment, the basic risk is risk of default, or credit risk. Mortgage-backed securities are not guaranteed by either the originator or the trustees – the credit support has to come from the credit enhancements which are put in place at the inception of the transaction. There is no continuing credit support, and it would be foolhardy to think that any of the parties would do anything to bail out a transaction potentially into a default.
This risk, analytically, is no different from risk of plain corporate bonds. In case of plain corporate bonds, the bond-holders’ primary source of comfort is the existence of equity in the corporation. To the extent the equity is not wiped out due to losses, the bond holder is protected. As equity is wiped out, the bonds will get into a default.
What equity does to corporate finance, credit enhancements do to a securitisation. Credit enhancement is the economic equity of a securitisation.
Investors need to understand that in structured finance transactions, the computation of the size of the credit enhancement is based on the rating agencies’ stressed default scenarios. Each an every factor that contributes to the credit of the portfolio – excess spreads, prepayment rates, contraction of the excess spread over time, delinquencies, are stressed, stretched, and the ability of the transaction to withstand the stress is analyzed. The size of the credit enhancement itself is a function of the desired rating.
Investors need to look at the following factors to understand the inherent credit risk:
The rating of the tranche that they are buying
The rating rationale and the factors that the rating agency has/has not considered in giving its rating;
Was excess spread a major factor in determination of the credit enhancements? Excess spread itself is a function of the weighted average rates of return from the pool over time, and rising prepayment rates might compress the excess spread.
Assumptions of recovery rates, delays in case of foreclosure
Other assumptions made by the rating agencies.
One of the most commonly misunderstood risks in MBS investing is the risk of prepayment. Since mortgages tend to prepay (obligors exercise a prepayment option), the prepayments are passed over to investors. Thus, investors get a part of the principal before scheduled maturity, and hence, lose their coupon to the extent they are prepaid.
A degree of prepayment speed is always estimated in any MBS investing, and hence, the expected maturity is computed, but if the actual prepayment speed is higher than that estimated, it introduces a maturity contraction risk to the investment; if the actual prepayment speed is slower than that projected, it introduces maturity extension risk. In general, neither of the two risks affect the yield of the investors from the given investment – but they have a bearing on the reinvestment returns. Therefore, in a falling interest rate scenario, a contraction risk results into reinvestment risk. In a rising interest rate scenario, extension risk becomes a loss of opportunity. Ironically, in a portfolio of fixed rate mortgages, falling interest rates will be generally associated with increasing prepayment speed, and rising interest rates will slow down prepayment speeds.
Much of the literature on prepayment risks comes from the USA - where mortgages carry a contractual prepayment option. In India, as in most other markets, there are prepayment penalties – which serves as a demotivator to prepayments. If the prepayment penalties are worked out as a mark-to-market differential23, the prepayment penalties may be sizeable for a mortgage which is not significantly burnt-out (that is, substantially amortized). Those are the mortgages where there is a stronger urge to prepay based on interest rate changes.
Besides the above difference, there is yet another significant difference between the US market and the Indian market – the predominant share of floating rate mortgages in India. If the mortgage lending rates are periodically reset based on interest-rate changes, interest rates cease to be a motivation for prepayments to happen.
These risks have not properly been communicated to investors. Being unaware, investors demand too high risk premiums for investing in MBS, which implicitly includes a fat premium for their own lack of understanding.