Mortgage Securitization: Innovation or Instability?
Securitization is the process of converting various types of assets into tradable securities. The most common method involves pooling large assets together and issuing a larger number of small securities linked to this pool. Financial innovation, and particularly securitization, are often cited as key drivers behind the U.S. housing boom of the early 2000s and the subsequent financial crisis. By the end of 2022, the U.S. securitization market exceeded $12.5 trillion, which is about half of the U.S. GDP. In this question, you'll explore the advantages and disadvantages of securitization and its impact on the housing and mortgage markets. Consider a simple example. A bank issues 100 mortgage loans, each worth $1 million. The bank then creates 10,000 securities, each promising investors a 1/10,000th share of the total payments from the pool.
(a) (9 rp) A bank wants to sell all 100 mortgage loans to investors. There are two ways to do this:
1. Each loan is individually auctioned to the highest bidder.
2. The loans are pooled together, and securities are issued as described above, then auctioned.
Which method is more profitable, and why? Provide three reasons.
Profitability of auction methods (9 points)
Pooling mortgages and issuing securities is more profitable than auctioning individual loans for the following reasons:
1. Affordability:
- Securities (may) cost less than individual mortgage loans, making them accessible to a larger pool of investors.
- More investors can participate, increasing demand and potentially driving up the price of the securities.
2. Diversification:
- Each security is backed by a fraction of the entire pool of mortgages, spreading the risk associated with any single mortgage.
- This reduces the risk for investors, making the securities more attractive.
3. Liquidity:
- Securities are easier to trade in the market compared to individual mortgages. (each security is backed by the same pool, while each mortgage is backed by a different house)
- The high number of securities (10,000) compared to the number of mortgages (100) means there is a larger market, enhancing liquidity and making them more appealing to investors.
(b) (5 rp) Explain how securitization can lead to house price appreciation.
Securitization leading to house price appreciation (5 points)
Securitization leads to house price appreciation through the following mechanism:
1. Increased profitability for banks:
- Securitization enhances the profitability of mortgage lending for banks.
2. Higher supply of mortgages:
- Increased profitability leads banks to issue more mortgages.
3. Lower interest rates and easier access:
- An increased supply of mortgages lowers interest rates and makes mortgages more accessible to a wider range of borrowers.
4. Increased demand for housing:
- With more affordable and accessible mortgages, more people can afford to buy homes, increasing the demand for housing.
5. Higher house prices:
- The increased demand for housing drives up house prices.
(c) (8 rp) Provide two reasons why securitization may cause more risks for investors.
(c) Risks of securitization for investors (8 points)
1. "Investors don't know": It is more challenging for investors to thoroughly analyze a pool of 100 mortgages compared to a single mortgage, resulting in less informed investment decisions and higher risk.
2. Moral hazard: Banks may retain higher-quality loans and securitize riskier ones, knowing that investors cannot scrutinize each loan in detail.
3. "Investors don't care": If house prices are expected to rise, investors might ignore the default risk, assuming the collateral will cover the loan. If prices fall, the risk of large losses increases.
4. Reduced screening incentives: Banks have less incentive to thoroughly screen borrowers when they can offload the risk to investors, increasing the likelihood of defaults.
(d) (8 rp) Credit Score is the most common indicator of a borrower's creditworthiness, calculated using the borrower's credit history (i.e., how the borrower was making loan payments in the past). To improve housing affordability, the government considers offering subsidized mortgage insurance on mortgages with low risk of default, that is, with the borrower's credit score of 620 and above. Surprisingly, in the years after the policy was implemented, mortgages with a credit score of 620 defaulted more frequently than those with a credit score of 619. Why did this happen?
(d) Credit score threshold (8 points)
1. Information beyond credit score:
- Banks have more information about borrowers than just the credit score, such as income, employment status, and other nancial behaviors.
- Under the new policy, banks could securitize mortgages with a score of 620, potentially ignoring additional risk factors they would consider if they retained the loans.
2. Behavioral changes and manipulation:
- Borrowers with a credit score just above 620 might have manipulated their scores to meet the threshold, thereby increasing their actual default risk.
- These borrowers applied more frequently, knowing they had a better chance of approval and insurance, even if they were less condent in their repayment ability.