What Degree of Securitization Suits Emerging Market Mortgage Markets?

In the Czech Republic, a sophisticated central European nation that emerged from Communism in 1991, approximately forty percent of the households own their own homes. Would the Czech Republic benefit from American Style securitization of its mortgage markets?


The answer would be a very qualified yes. The decision and the design depend on a series of questions: How desirable is home ownership as a social goal? Will securitization increase hoem ownership? How will securitization affect the banking system? Will it strengthen it or make the banking system riskier? Will it facilitate the creation of asset bubbles? Will a heavily securitized market shift resources from productive activities to transactions costs and mortgage churning? A careful reading of financial history and a subtle insight into the working of financial markets and institutions are the prerequisites to answering these questions properly.

The importance of these issues has been made manifest by the crisis that has enveloped world financial markets. This was caused by large international banks creating very sophisticated instruments based on securitized mortgages and then selling them to each other and investors. When the U.S. housing bubble burst, and defaults started rising, these securities created large losses which froze liquidity.

However there are key lessons to be learned from the current subprime mortgage crisis that has world financial markets in turmoil:

1) The lender closest to the borrower must maintain a stake in the home owner's loan. Security markets can not judge the situation on the ground. Central planners learned that the hard way.

2) Flexibility must be maintained. This is the historical function of banks. Historically security markets are inflexible.

3) Institutions and instruments must be designed that spread systematic risk such as interest rate risk to those who can bear them.

4) Transforming interest risk into default risk only creates new problems. Moving interest rate risk to homeowners through adjustable rate maortgages without proper protections is simply replacing one problem with another.

5) Creating overly sophisticated financial instruments that mislead ordinary people is a recipe for disaster. Disclosure does not mean pages of fine print written by lawyers but providing homeowners with plain explanations of the risks and financial implications of the contracts they sign.