Question

"Mortgage Securitization" Please respond to the following: Critics have suggested that the complexity inherent in securitization can limit investors' ability to monitor risk. Evaluate the merits of this criticism, indicating your agreement or disagreement with the criticism. Provide support for your position. Mortgage-backed securities are believed to have contributed to the recent subprime mortgage crisis. Assess the fairness of this statement, providing a rationale for your reasoning and a recommendation for future use of this type of investment.

Answer 1

Securitization is a way in which assets are pooled and sold to investors who get paid from the cash flows of the pooled assets.

The pooled investment has various tranches and the investor can decide which tranche to purchase depending on his/her risk appetite and return expectations. Each tranche has a separate credit rating. Also, the underlying pool of assets is fully disclosed to the investors so that they can make a choice. The junior tranche pays higher interest as there is higher default risk associated with it. Conversely, senior tranche is considered safest with lowest default risk and lower interest rate.

Thus, even though the securitized products are complex, it does not hamper the investor's ability to monitor risk of her portfolio.

So, I disagree with the criticism.

Mortgage backed securities were responsible for the recent subprime mortgage crisis.

The reason being that sub prime mortgages increased considerably during that period. Also, the housing prices were declining. As a result, the borrowers could not re-finance their loans. They defaulted on their loans. There were many mortgage backed securities with underlying pool of these sub prime mortgages on which the borrowers defaulted They also collapsed as a result leading in the collapse of entire credit market leading to financial crisis.

The recommendation for future use of such investment is subjective and depends on risk preferences of individual investors. In good times, these investments offer higher returns as compared to alternatives but one has to assess the quality based on the market conditions and current portfolio requirements.