Introduction and Working Principles of MBS Bonds

MBS is an abbreviation for "Mortgage Backed Security", also known as "Mortgage Backed Bonds", and is the earliest asset securitization product produced in the United States in the 1960s. It is mainly an asset securitization commodity issued by professional housing banks and savings institutions in the United States using the housing mortgage loans they lend. Its basic structure is to gather the loans that meet certain conditions from the lent housing mortgage loans, forming a pool of mortgage loans. The cash inflows of principal and interest that occur regularly in the loan pool are used to issue Securities, and the securities are guaranteed by government agencies or financial institutions with government background.

The following is an introduction and working principle of MBS bonds:

1. Mortgage loan: The foundation of MBS is a mortgage loan.The borrower purchases real estate and then applies for a mortgage loan from a bank or lending institution to pay the purchase price of the house. These mortgage loans usually have different terms and interest rates.

2. Bundling and packaging: Financial institutions issuing MBS bundle a set of mortgage loans together to form an asset pool. These mortgage loans can come from different regions and borrowers, so there are various types of mortgage loans in the asset pool.

3. Securitization: Next, financial institutions convert this asset pool into securities, known as MBS. These MBS securities represent equity in mortgage loans in the asset pool.

4. Income and risk allocation: MBS holders purchase these securities and charge interest and principal payments on mortgage loans in the asset pool. These payments come from the repayments of mortgage borrowers. Therefore, MBS holders can obtain stable returns.

5. Risk diversification: Due to the asset pool containing multiple mortgage loans, MBS securities have the characteristic of risk diversification, as the default of a single mortgage loan will not have a catastrophic impact on the entire portfolio.

6. Market liquidity: MBS securities can be bought and sold in the secondary market, providing a liquidity channel that allows investors to flexibly buy and sell these securities.

What is the purpose of issuing MBS?

1. Due to the population expansion caused by the baby boom (1946–1964), there was a shortage of housing and deflation. In order to lower housing mortgage interest rates and achieve the American Dream of "homeownership".

2. Fannie Mae and Freddie Mac, among other mortgage companies, strictly review personal credit, which can transfer loan-related risks to numerous investors and diversify risks.

3. It is conducive to expanding the loan scale of banks.

MBS Bond Introduction and Working Principle Mode Types:

1. The off-balance sheet model, also known as the US model, refers to the original equity holder (such as a bank)'selling' assets to a special purpose vehicle (SPV), which then reconstructs an asset pool to support the issuance of securities;

2. The on-balance sheet model, also known as the European model, is where the original equity holder does not need to sell assets to the SPV and remains on their balance sheet, with the issuer issuing securities themselves.

3. The quasi-off balance sheet model, also known as the Australian model, is where the original equity holder establishes a wholly-owned or controlling subsidiary as an SPV and then "sells" the assets to the SPV. The subsidiary can not only purchase the assets of the parent company but also other assets. After the subsidiary acquires the assets, it forms an asset pool to issue securities.

Compared with US Treasury bond bonds, the yield of MBS is considerable, and some high-quality loans packaged into MBS are guaranteed by the US government. So MBS has become a hot topic pursued by funds in the market, especially pension funds, insurance, and sovereign funds.

MBS is not only sold domestically in the United States but also worldwide. Global funds flow into the US housing market through MBS, providing the funds needed for housing loans to US residents. At the same time, the risks of American people's home purchase loans are also passed on to the world through MBS.

Although the role of MBS bonds is known from the introduction and working principle above, the MBS market has also played a negative role in the financial crisis, as a large number of subprime mortgage defaults led to a sharp decline in the value of MBS, leading to a financial market crisis. This incident attracted widespread attention during the 2008 subprime mortgage crisis.

Disclaimer: This material is for general information purposes only and is not intended as (and should not be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by EBC or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.