Question

5. Mortgage-Backed Securities and Risk Taking by Financial Institutions:

Do you think that institutional investors that purchased mortgage backed securities containing subprime mortgages were following reasonable investment guidelines? Address this issue for various types of financial institutions such as pension funds, commercial banks, insurance companies, and mutual funds (your answer might differ with the type of institutional investor). If Financial Institution are taking on too much risk, how should regulations be changed to limit such excessive risk taking?

Answer 1

Institutional investors usually pool the funds on behalf of others that is to be invested in various type of asset class and financial instruments. Institutional investors involved in these types of activities can be mutual fund companies, insurance companies, penson fund, commercial banks etc. These instituional investors influence the market to a great extent as they own a major percentage of equity market.

Pension fund: Pension fund receive payment largely from individuals and guarantees to pay them retirement benefits. Penson fund uaually invest in private equity and hedge fund.

Commercial Banks: These banks accepts deposits from customer and provide loans in the form of mortgages, line of credit, personal loan etc. to individuals and businesses. These banks follow the guidlines of the Central Bank to protect the interest of customer by maintaining adequate capital reserve. These banks usually invest in marketable securities and treasury bonds.

Mutual Funds: Mutual Funds usaually provide open-ended funds and close-ended funds. Open-ended fund means that new shares are issued to investors as it recieves the amount. Close-ended fund includes the fixed number of shares. As it includes more of the ETFs and involvement of high risk, now a days it is less attractive to investors.

Insurance Companies: Insurance companies uaually take amount from policyholders in the form of premiums and invest these money in low-risk income securities and bonds.

Majority of the investment in Mortgage backed securities are done by the investment institutions like mutual fund companies and pension fund. Sub prime crisis involve many parties to blame. Lenders are selling these mortgages to investment institutions and these institutions issue similar type if securities to be invested by the other investors. Here, institutional investors must gather information about the lenders before investments as investment is done at a market risk. And lender must gather adequate information about their customer's creditworthiness. Institutional investors are less following the investment guidlines by not gathering the adequate information about the lenders which results in sub prime crisis. Sub prime mortgages are indicated to the borrower of the loan that are likey to get default due to low creditworthiness. Thus, sub prime mortgage securities effects the whole parties involved in buying and selling of these securities.

As financial instiutions are taking more risk by buying the mortgage backed securities. There must be a limit set for their investments in these type of securities so that it won't effect the whole economy. And fed must strictly issue the gulidlines to the lenders regarding the gathering of customer's information and creditworthiness of each before lending loans to them.