Thursday, November 20, 2008
In defense of mortgage backed securities
Some time ago, Susan Wachter and I wrote an article about (among other things) the history of the US mortgage market. One of the points of the piece was that depositories are not capable of holding long-term fixed-rate mortgages, because it subjects them to too much duration risk: mortgages are assets with long duration (i.e., have values that are sensitive to changes in interest rates), while deposits are liabilities with short duration. Hence, when short-term interest rates fall, depositories make large profits, but when they rise, depositories invested in mortgages can quickly become insolvent. This is exactly what happened to Savings and Loans in the 1970s and 1980s.
Life-insurance companies and pension funds have long liabilities, and are therefore better candidates to hold mortgages, but they can be harmed by negative duration. When interest rates fall, homeowners refinance their loans. This means that insurance companies and pensions funds see the income they were going to use to meet their long-term obligations fall, and so must raise capital or premiums lest they become insolvent.
In light of this, there is a role for un-leveraged investors to hold mortgages. But these investors may not wish to hold individual mortgages, because individual mortgages carry idiosyncratic risk. A mortgage backed security stitches together the cash-flows of multiple mortgages, and as such diversifies risk: an investor should prefer owning 1/30 of 30 mortgages to owning a single mortgage.
At the same time, Fannie Mae and Freddie Mac, because of their (perhaps unfair) market advantage, could impose common underwriting standards on all the mortgages they purchased and placed into securities. This turned the securities into commodities, and so they traded in deeply liquid markets. Even now, Fannie-Freddie MBS are performing reasonably well under very difficult market conditions.
Problems arose when Wall Street became overly enthusiastic about developing derivative products based on MBS. I will post more on these at another time (I actually think the CMO structure is basically fine; it is the CDO structure that reflected hubris). But the basic MBS was and remains an ingenious product, and will continue to be an important instrument of housing finance in the years to come.