Question 1
(A): Explain and analyse how commercial banks, and other mortgage lenders, create and issue mortgage backed securities. (500 words)
Guidance notes:
Explanation of asset backed securities and in particular mortgage backed securities.
Analysis of process of creation and issue of mortgage backed securities: mortgage origination; the role of SPV, structuring; credit enhancement – e.g. credit rating; tranching structures; issue and trading.
(B): Discuss the main advantages and risks of the process of mortgage securitisation for commercial banks, the financial system and its stakeholders. (500 words)
Guidance notes:
Using SPVs, rating agencies and the marketing power of investment banks, the usual lending process can be broken up so that organisations can focus on core competences such as mortgage broking, loan origination and loan servicing leaving the funding to the financial markets.
All parties involved earn fees!
Allows investors to diversify and invest in alternative assets to suit their needs – e.g. a UK bank can invest in US mortgages, using the credit ratings as a guide to risk and return.
Allows originators to sell loans to the special purpose vehicle at a profit and obtain liquidity (cash), which can be used to create more loans. They then avoid subsequent credit risk, which is borne instead by the bond holders / the bond insurers.
Allows borrowers to tap a wider range of lenders around the globe and this may result in lower funding costs.
Risks include:
Banks not maintaining credit quality – because they don’t keep the loans on their balance sheet.
Banks becoming too reliant on financial markets and securitisation for liquidity.
An over-reliance on credit ratings by investors.
Housing bubbles that subsequently burst leading to defaults and losses.
Although securitisation may diversify risk, it may also end up with risk being concentrated in the hands of particular investors.
Improved regulation should make ABS safer:
By forcing banks to retain a proportion of their ABSs (‘skin in the game’), it should ensure sound lending standards.
Forcing banks to hold more capital for more complex securitisations (under Basel 3) will lead to simple, transparent and comparable (STC) ABS being held on banks’ balance sheets.
Credit rating agencies will provide more information to justify their ratings of ABSs – increased transparency.
Question 2
(A) Explain and analyse how central banks attempt to maintain monetary stability with particular reference to the 2007 financial crisis and recent COVID19 crisis. (500 words)
Guidance notes:
Discussion of targeting inflation and wishing to avoid inflation that is too high or too low.
The particular danger of deflation following the financial crisis in 2008.
Extremely low interest rates set by central banks, including negative rates in some countries e.g. Japan, Switzerland, Sweden and Denmark.
Some emerging market countries have been forced to adopt higher interest rates due to inflation as their currencies have depreciated – e.g. Brazil.
Answers may discuss exchange rate stability and its links to monetary stability, linking this to central bank interventions – e.g. in China and Switzerland.
Definition of QE. An increase in the money supply as the central bank creates money and uses it to buy securities (mainly government bonds in the UK, and Japan but a wider range of securities in the eurozone and in the USA e.g. mortgage-backed securities) from companies and financial institutions.
Explanation of reasons for its introduction: limitation of conventional monetary policy when interest rates reduced to near zero; falling prices and deflation in relation to a positive target for inflation.
The need to offset a fall in bank lending and hence the money supply.
Discussion of different forms of QE in USA, Japan, UK and eurozone.
Answers may include a discussion of how central banks maintain the stability of physical currencies (notes and coins) – e.g. anti-forgery measures – e.g. new £5 note and planned £1 coin.
Evaluate the advantages and disadvantages of central banks operating ultra-loose monetary policies such as those seen in the USA, Japan, UK and the Eurozone, again referring to the above crises. (500 words)
Guidance notes:
Advantages may include:
Although it’s impossible to know what would have happened otherwise, the USA and the UK avoided deflation and loose policies elsewhere prevented things getting any worse. For example, in 2015, the introduction of quantitative easing by the ECB prevented the Greek crisis causing more damage to the eurozone.
QE in the USA and the UK is thought to have boosted growth and employment.
Borrowers – households, firms and governments, have all benefited from low funding costs.
Bank of England video on QE:
Disadvantages may include:
Increases in the money supply and bank lending have been weak – households and banks have been re-building their balance sheets, saving and paying down debts, and banks have been building up their capital reserves rather than lending more. Prospective borrowers therefore have generally not found it easier and cheaper to borrow.
Some companies have been borrowing at low rates of interest and buying their own shares. This boosts earnings-per-share and return-on-equity, and quite possibly executive bonuses. Critics argue that instead, such companies should use the cheap funding to invest in their business.
Carry trades using low cost funds to invest in higher returns in emerging markets. Dangers of reversal – now playing out as some emerging market currencies crash.
Mis-allocation of capital – bubbles in some bonds, equities and housing markets, which also increase wealth inequality.
The effectiveness of QE seems to diminish the longer it goes on and extending it may only worsen the mis-allocation of capital.
Some countries have accused other countries of deliberately weakening their currencies to help boost exports – ‘currency wars’.
Low funding costs allow inefficient ‘zombie’ companies to keep going, hindering the prospects of more efficient firms. Similarly, low funding costs for governments may discourage fiscal and structural reforms that would improve economies in the long-run.
Credit risk for banks will increase as interest rates eventually start to rise and some of their borrowers struggle to repay.
Savers have lost out – tiny rates of interest (negative real rates).
Insurance companies’ interest income has been reduced – hitting profits if they have promised higher returns to investors.
Low interest rates cause pension fund liabilities to increase.
Bank’s net income margins were reduced. They were reluctant to charge depositors for deposits but have limited ability to push up interest rates on lending because of competition.
The difficulty in enforcing negative nominal interest rates – e.g. people holding cash instead.