This discussion paper was written for a "cat fight", i.e. class discussions. During this "fight" the author argued that mortgage-backs are the root of all evil.
The paper includes three main reasons to support this opinion: The behavior of rating agencies, the behavior of banks and the housing bubble.
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.
[...]
[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.
Frequently Asked Questions About "Cat Fight"
What is the central argument of the "Cat Fight" text regarding Mortgage-Backed Securities (MBSs)?
The text argues that Mortgage-Backed Securities (MBSs) can be seen as "the root of all evil" due to their strong relation to the financial crises. This "evil" refers to the money losses of investors, the diminishing trust in rating agencies and banks, and the overall downturn of the economy.
How are MBSs defined in the text?
MBSs are defined as financial securities created from a pool of prime mortgages. Banks use special-purpose vehicles (SPVs) to collect payments from mortgage holders and distribute interest streams to MBS holders. This process, called securitization, allows banks to remove loans from their balance sheets and diversify default risk.
What role did rating agencies play in the problems associated with MBSs, according to the text?
The text suggests rating agencies contributed to a dangerous environment in two key ways: (1) They may not have dedicated enough time or resources to accurately evaluate MBSs, potentially due to conflicts of interest from being paid for each rating. (2) They may have used inaccurate rating tools or misleading definitions of AAA-ratings, leading to an underestimation of risk exposure by investors.
How did investors perceive MBSs, and why?
Investors often perceived MBSs as being close in risk to highly-rated corporate bonds or even government bonds, largely due to the reliance on rating agencies' evaluations and the increasing complexity of MBS products. This led to significant investments in MBSs, attracting investors like money-market funds and pension funds which were restricted to AAA-rated assets.
How did the behavior of banks and financial institutions contribute to the crisis, according to the text?
The text suggests that the financial and economic crisis, triggered by the housing bubble burst, was partly a result of banks and financial institutions deviating from their original business models. While bad investment choices within an asset group alone might not harm the entire financial sector, the behavior of banks in the MBS market exacerbated the problem.
What is the significance of AAA ratings in relation to MBSs?
AAA ratings were important because many investors, such as money-market funds and pension funds, are restricted to investing only in assets with these top-tier ratings. Rating agencies' decisions to assign AAA ratings to senior tranches of securitized assets, without fully accounting for the overall risk, attracted significant investment and potentially masked the underlying dangers.
- Quote paper
- Mario Pesch (Author), 2010, Mortgage-backs are the root of all evil, Munich, GRIN Verlag, https://www.grin.com/document/164363