Why Are Mortgage Securities Important?

Mortgage securities can perform a number of valuable functions in emerging economies. Their introduction and use can improve housing affordability, increase the flow of funds to the housing sector and better allocate the risks inherent in housing finance.

In economies with pools of contractual savings funds, mortgage securities can tap new funds for housing. Institutional investors (pension, insurance funds) with long term liabilities are potentially important sources of funds for housing as they can manage the liquidity risk of housing loans more effectively than short-funded depository institutions. Although in some countries, these investors are also involved in loan origination and servicing, it is not their core mission or competency. Efficiencies can be gained through passive investment in mortgage securities by institutional investors, allowing depositories and specialist mortgage companies perform the other functions. An increase in the supply of funds can, all other things equal, reduce the relative cost of mortgage finance and improve accessibility to finance by the population.

Funding through the capital markets through issuance of mortgage securities can increase the liquidity of mortgages, thereby reducing the risk for originators and the risk premium charged by lenders. The ability to dispose of an asset within a reasonable time and value, a crucial factor to mobilize long term resources, is a service that capital markets, as opposed to banking systems, can provide. A frequently expressed reluctance of primary market financial institutions to offer housing loans is a lack of long term funds.[1] Access to the long term funds mobilized by institutional investors can reduce the liquidity risk of making long term housing loans, increasing their affordability and improving the access to funds for home buyers.

A third rationale for introducing mortgage securities is to increase competition in primary markets. The development of capital market funding sources frees lenders from having to develop expensive retail funding sources (e.g., branch networks) to mobilize funds. Securitization for example can allow small, thinly capitalized lenders who specialize in mortgage origination and servicing to enter the market. These lenders can increase competition in the market and can lower margins and introduce product and technology innovation into the market. The experience of Australia in the 1990s provides dramatic evidence of the power of capital-market funded lenders to change a market. The market entry of wholesale funded specialist lenders led to a reduction of 200 basis points in mortgage spreads during the 1994-1996 time period [Gill, 1997].

Increasing competition and specialization can in turn increase efficiency in the housing finance system. Greater specialization can lead to cost-savings and reduce spreads. The phenomenon of unbundling (Figure 1) has been associated with development of secondary mortgage markets. As the functional components of the mortgage process are unbundled, specialists emerge and obtain market share through scale economies in processing, access to information and technology and risk management.
[1] There is a degree of speciousness to this argument, however. In most countries, depository institutions have a core of long term deposits. Although the contracts may be short term, they are typically rolled over and can fund long term housing loans. An institution can provide a significant percentage of its loans for housing while accepting only a modest amount of liquidity risk. This statement frequently masks other reasons for not providing housing loans including high transactions costs, high perceived credit risk etc.).