The Hidden Risks of Mortgage Backed Securities

Mortgages function like a bank account did in the previous century. Features including the ability to draw out liquidity, perception of continual appreciation-compounding, an implied federal guarantee for MBS securities, and the role as the primary savings instrument for the majority of people in the nation speak to that point.

Safeguards present to protect against bank failures and loss of savings are entirely lacking in the highly leveraged real estate market. Therefore, the real estate market has the potential energy to destroy wealth on an unprecedented scale not seen since to the bank failures of the great depression.

Real Estate can fail catastrophically without a safety net while in contrast bank deposits are insured as a response to a prior collapse. The market may be so big that intervention could at best delay a crash or preserve just a small fractional of stored wealth.

Counter intuitive action between central bank lending and mortgage related interest rates suggest that Mortgage Backed Securities (MBS), which are aggregated mortgages offset by derivatives, do not conform to the neutral risk model envisioned when they were created. The bond market may be saying that the artificial corollary between US Treasury instruments and Mortgage Backed Securities (MBS) has been forever broken and that all risks are not created equally.

Given the shear scope and size of the mortgage market, participants will be unable to absorb the difference in risk between US Treasuries and MBS. Not to say that US treasuries which are denominated in USD are as risk free as they are perceived to be, US Treasuries are only secure as long as other currencies are cross-collateralized to USD, simply that MBS are inherently more risky.

In the near term the government can intervene with a reduction in lending rates, they can allow the holders of MBS to fail, or they can enter the market and purchase the risk. The system could fail of its own volition.

A reduction of rates will prove ineffective because the corollary between rate structure has been irrevocably broken. Reducing the overnight rates will not ameliorate risk inherent in MBS securities. Such action would cause housing values to rise temporarily but would only prove helpful to a minority of people equipped to interpret such a move as a sell signal. The associated rise in housing prices would form the apex of a downward curve.

The government could allow the holders of MBS to incur the damage of these under-funded instruments failing. Foreign holders that use MBS as a replacement for treasury instruments are anticipating this occurrence thus some central banks are positioning away from these instruments.

As MBS securities become unpalatable credit will become tighter the housing market will collapse because real estate holdings will become solidified or trapped. The value of homes will not be sufficient to offset associated debt thus they will be abandoned or become distressed. In this scenario, the global economy will become zero bound because it presently derives the majority of its global momentum from US consumer spending which has been funded by credit against future income streams.

The US government could purchase the risk built into the system and subsidize future mortgage underwriting. However, the risk reward curve of highly leveraged aggregate mortgages cannot truly be assessed. In this scenario the government absorbs the uncertainty by fixing rates artificially to fulfill the social objective of stability.

Essentially the government would bail out holders of MBS and become the direct market maker and guarantor of mortgages to consumers. Based on the current balance sheet of the nation, no assurance exists that foreign holders would want long-term (thirty-year) treasury instruments at an acceptably low rate of interest. The abysmal condition of the US balance sheet and dollar speak more directly to currency devaluation and/or hyperinflation.

Government intervention would be an artificial socialistic construct of political necessity. Such constructs are untenable. They may however be a political necessity.

The most likely outcome may be a interest rate reduction which will induce a short term appreciation of real-estate valuations. Thereafter declines in foreign exchange and equity markets will cause the value of MBS and US debt instruments to erode. Real estate prices will collapse in the context of a zero bound economy or depression.

Any kind of Intervention may delay the inevitable but ultimately it will fail, as all artificial economic constructs tend to do. The best case for individuals will be to identify this potentiality in an investment class erroneously perceived as sanctified ground and plan accordingly.

3A%2F%2F0.gravatar.com%2Favatar%2Fad516503a11cd5ca435acc9bb6523536%3Fs%3D60&r=G /%

About wpollock

Warren Pollock has written 6 post in this blog.