MBS is not a threat

Recently, encouragement of mortgage backed security (MBS) from authorities as the central bank has raised concerns from the market.

The balance of China’s mortgage is around 20 trillion yuan, the term of 90% of which exceeding 3 years. Which means, if MBS starts, its issuance could reach up to a theoretically 10 trillion yuan. The industry is hailing for this while the public is still questioning: The MBS is just the chief blame for the 2008 American subprime mortgage crisis, isn’t it?  Then why should we repeat it? To this end, we need starting from the very basics of the MBS.

As a kind of commercial loans, the most distinctive trait of personal mortgage loans is its long cycle: the duration of mortgage lasts for more than 20 years--while most commercial loans have terms of 5 years or less. One consequence of the long cycle is that the mortgage loans takes up disproportional credit resources. Due to the constraints of reserves against deposit, the bank is disabled to lend more.

MBS, however, is one way to free up liquidity in the banking system. In simple terms, MBS selected out mortgage which meet certain conditions and form them into a pool of mortgage assets. It enables the cash of the principal and interests generated periodically by such asset pool to flow into issued securities and invites relevant institutes to provide guarantee on such securities. Through MBS, the issuer could transfer all principal and interests generated by the mortgage assets to the MBS investors. And in this way, banks take back their principal of loans and are guaranteed to be paid at a fixed interest spreads, which is the margin between the mortgage interest rate and the MBS interest rate.

Historically, the devising of MBS in the United States in 1968 also aimed to cope with fund shortage. However, MBS started accelerating after 1980 due to the higher financing cost led by the market-oriented interest rate reform. The depository financial institutions suffer from problems such as mismatching between the maturities of banks' deposits and loans while MBS provided a satisfying means to diversify risks. A retrievable figure is that the MBS scale of the United State in 2007 was 8.2 trillion dollars. Then, what about the MBS scale of China?

The market for securitised mortgage loans opened in 2005: China Development Bank and China Construction Bank both successfully issued their 1st MBS. As it was restarted this year after a six-year hiatus, the Postal Saving Bank of China issued 6.8 billion yuan in residential mortgage-backed securities in late July. However, there are only 3 MBS products so far in China with a total scale less than 14 billion yuan which is rather small comparing with US.

And what makes China’s MBS such small? One possible reason may be the overly prudent attitude of the regulatory institutes. For quite a long time, commercial banks have enough incentives to issue securitized debts for more profits. However, regulatory authorities do not hold positive attitude toward this. Because, once they allow commercial banks to pilot securitization of credit assets, commercial banks are enabled to lend freely without breaking the credit constraints which is precisely the primary methods for regulatory authorities in supervising the bank industry. If MBS issuance is encouraged, it will absolutely enlarge the total amount of social financing.

And back to this time, as to the regulatory authorities make the approval of MBS issuance again, the reason is presumably that the overly high cost for social financing has already affected the real economy and that the State Council kept reiterating the concept of revitalizing existing assets for the last year—mortgage loans are actually existing assets up to 20 trillion yuan.

In a word, MBS is not a threat, but a normal financial tool for a country of market economy. The absence of MBS for such a long time is just the evidence of China’s undeveloped finance industry. Of course, MBS may bring risks. But finance industry itself is actually an industry operating risks and risk control should be a liability for every financial institution. What is more important is that, the potential risks of MBS is quite negligible when compare with the financing cost it can relieve for banks and other financial institutions. And this is the very fundamental reason why we support MBS.

Published in the Oriental Morning Post | 2014-10-13