Mortgage-backs are the root of all evil

Cat Fight

Mortgage-backs are the root of all evil – Yes!

Mortgage-backs securities (hereafter MBSs) could be seen of the root of all evil. To understand this statement it is important to define “evil” related to MBSs as well as the use of MBSs.

“Evil” refers to the results of the financial crises that were strongly related to MBSs. Especially this incorporates the money losses of investors, the diminishing trust in rating agencies as well as banks and the overall downtown of the economy.

MBSs are financial securities that are created out of a pool of prime mortgages.^[1] This process is called securitization and banks establish special-purpose-vehicles (SPV) to collect payments from the mortgage holders and then pay fractional streams of interest to the investors, i.e. the holders of the MBSs.^[2] In general, MBSs provide banks with the ability to get loans off their balance sheet, i.e. to diversify the default risk to a higher number of investors. In the years before the burst of the housing bubble this regular use of MBSs has changed. However, it can be shown, that the characteristics of MBSs supported an industry environment, which led to the creation of a housing bubble and its burst.

To understand the reason why MBSs have become “the root of evil”, one has to understand the strong relation of the market for MBSs between rating agencies, investors and banks/financial institutions.^[3]

Rating agencies are related to create this dangerous environment for two main reasons. First, they did not have or they did not want to spend enough time to evaluate most MBSs. This happened due to conflicts of interest, created by making profit for each finalized rating and at the same time providing credible ratings to the public. However, the rating agencies are paid by the banks, therefore making profit can be seen as the more favorable goal. Second, the rating agencies did not have accurate rating tools to evaluate MBSs or simply used definitions of AAA-ratings that lead to misunderstandings for the investors. From this follows that the expected risk exposures have been systematically underestimated.^[4] For instance, rating agencies gave an AAA-rating for the senior tranches within a securitization bundle, due to the fact that those will be paid first, not taking into account that the overall risk of the securitized assets could be high.^[5] These reasons increased the risk connected to MBSs because the public information in the markets has been wrong.

Solely relying on evaluations from rating agencies, which have been a reliable indicator in the past, investors have been convinced that MBSs are close to the risk of highly rated corporate bonds or even government bonds.^[6] This behavior can be seen as rational from investors’ perspective, because of two reasons. First, banks “created” so many different types of MBSs that investors put their trust in “experienced” evaluators, i.e. the rating agencies, and second, products became so complicated that sometime it would take a mathematician to explain them.^[7] The following high investments in these assets lead to unexpected portfolio risks (investors, like money-market funds or pension funds have been attracted by MBSs because they need to follow restrictions that only allow them to invest in AAA-rated assets).

However, researchers argue that bad investment choices within an asset group would not harm the total financial sector. Given the very high losses in the MBS-market, it still seemed manageable, given the overall size of U.S. and world debt markets.^[8] The financial and economic crisis, beginning with the burst of the housing bubble, was more a result of the behavior of banks/financial institutions, which ignored their original business model.

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^[1] Acharya and Richardson, 2009, p. 199.

^[2] Dennis Vink; André E Thibeault, 2008, p. 27.

^[3] Most of these arguments could also be applied to asset-backed securities and collateralized debt obligations, but I will focus on MBSs, to stay in line with the topic of this Cat Fight.

^[4] Acharya and Richardson, 2009, p. 196.

^[5] Alessandri and Haldane, 11/2009, p. 10.

^[6] W.W. Lang, J.A. Jagtiani, 2010, p. 309.

^[7] Jereski, Laura, 1993, p. 46.

^[8] W.W. Lang, J.A. Jagtiani, 2010, p. 296.