Why Do MBS (Mortgage-Backed Securities) Still Exist?

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Why Do MBS (Mortgage-Backed Securities) Still Exist?

There are several arguments in favor of enabling market participants to trade and possess mortgage-backed securities despite their bad reputation and alleged participation in the financial crisis of 2007-2008. (MBS).

An MBS is essentially any investment strategy that leverages a pool of commercial, residential, or both mortgages as the underlying asset. The goal of an MBS, like other financial innovations, is to boost return and diversify risk. Investors may absorb the statistical chance of non-payment by securitizing pools of comparable mortgages.

An MBS, however, is a sophisticated tool that may take many various shapes. Similar to how it would be difficult to evaluate the risk of a general bond or stock, it would be challenging to evaluate the overall risk of an MBS. Risk is mostly determined by the characteristics of the underlying asset and the investment contract.

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Improved Liquidity and Risk Argument

Financial institutions sell mortgage debt and mortgage pooling to private investors, other financial institutions, and governments. With the money acquired, loans are provided to additional borrowers, including subsidized loans for borrowers with low incomes or who are at danger of default. An MBS is a liquid product in this sense.

Mortgage-backed securities lower the bank’s risk as well. Every time a bank extends a mortgage loan, it runs the risk of not being paid back (default).It may shift risk to the buyer, who is often an investment bank, if it sells the loan. The investment bank pools similar mortgages together since it knows that some of them will fail. This is comparable to the way mutual funds work. Investors get interest payments on the mortgage loan in return for taking on this risk.

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One might argue that any sort of securitization, including bonds and mutual funds, is too hazardous if they claim that certain kinds of MBS are.

Aggregate Arguments: Consumption Smoothing and More Homes

Economic studies from 2009 indicated that the securitization of the mortgage market has resulted in the pooling of consumer risk on both local and foreign markets. This smoothes the business cycle and aids in the normalization of interest rates across various demographics and risk profiles while enabling financial institutions to provide lending even during economic downturns. Theoretically, as a consequence of higher securitization, the level of consumer spending in the market is smoother and less susceptible to recession/expansion oscillations.

Mortgage securitization has undoubtedly led to a rise in house ownership and a decrease in interest rates. Banks are better equipped to provide house loans to borrowers who would not otherwise be able to get them thanks to MBS and its derivative, the collateralized mortgage obligation.

Federal Reserve Involvement

The MBS market has a bad reputation, but from the perspective of an individual investor, it is safer now than it was before 2008. Following the collapse of the housing market, banks raised their underwriting criteria, which has strengthened and enhanced their transparency.

In the MBS market, the Federal Reserve is still a significant participant. According to the Fed’s quarterly report, MBS accounted for $2.72 trillion of the $8.9 trillion balance sheet as of March 2022. The central bank has recovered much of its credibility now that it is a big participant in the market.

Free to Contract Argument

Another justification for permitting MBS has more to do with the essence of capitalism than it does with financial considerations: A profit-and-loss system, capitalism is based on the justification that free enterprise and individual initiative are ultimately better to governmental controls. No one is legally required to compel a financial institution to create new loans, no investor is required to buy an MBS, and no borrower is forced to take out a home loan.

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The MBS provides borrowers the opportunity to purchase houses via free contracts, enables banks to lower risk, and allows investors to seek a return.

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