Mortgage-Backed Securities And Government Guarantees

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In a recent poll of the CFA Institute on the topic, the vast majority of the responders answered that explicit or implicit government guarantees on the mortgage based securities would do more harm than help the house market. The reason for this is that all kind of government guarantees by definition have the ability to distort the market and create corruption incentives, which on its turn, lead to decline in the trust in that market.

Among the most important reasons for the current financial and economic world crisis, is the inability to properly assess risk. Or, to officially include in the definition of risk the possibility of events which stand far away in the tail of a probability distribution. By entering the market as a “guarantor of last resort”, the government essentially takes away a portion of the risk inherent in the system. Such risk, however painful it may sometimes become, is needed for the system to function properly. It is like the death being the natural cleaner of the universe, if I am allowed to use a more common example. This risk is needed to properly judge between good and bad investments, and between good and bad debtors.

In May 2002 President Bush announced the start of multiple measures to facilitate the process of owning a home in the U.S. (source: Youtube video) – a program that without much doubt contributed a lot to the current state of affairs. Apart from resulting later in the need to massively capitalize the two guarantors in the case of a market collapse, that program twisted the thought process of debtors and creditors. The goal of creditors changed from making the proper investment, in means of return compared to risk, to entering the rapidly growing artificial market of MBS, even with the cost of lowering risk standards. The goal of debtors changed from improving their financial stability in order to become eligible to credit, to cherry picking the most attractive offer. Essentially, the policy of easy access to house ownership (Whether owning something on a credit terms is a real ownership is another very controversial question!) changed the market by a non-market shift of market power from suppliers of credit to the buyers. It created incentives for the one party to present itself as a more eligible one than it really was, and the other party to accept lower standards than it usually would.

It is true that in fact the U.S. government kept its promise and acted as a guarantor of last resort. This time. The question is: Will it be able to do it again? And again, if needed? And if I expand the field of thought, is it more worthy to “own” a house on credit than to have enough money to be financially free to chose your own time of buying it?

“Give a man a fish and you feed him for a day. Teach a man how to fish and you feed him for a lifetime.”
Chinese proverb

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