mortgage lenders fool investors to not demand such high risk premiums so as to cover the likely loan losses? If investors had demanded sufficiently high risk premiums, then the initial loans wouldn’t have been profitable.
The most likely explanation for this is the moral hazard created by Greenspan’s previous bailouts, as well as the guarantees that Fannie Mae and Freddie Mac created for the various mortgages they bought and either kept or sold to others with that guarantee. Yet that moral hazard would have existed without securitization, so this is not an argument against mortgage backed bonds.
What, then, are the advantages of creating asset backed securities? The main advantage is that they make these loans tradable. By making them tradable investors can fairly quickly get out of their investments, but as it is a new investor instead of a bank that provide the original investor with money, no need exists to keep large reserves, as is the case with deposits. And as reserves are expensive to keep because of the opportunity cost from the interest it could have earned if invested, this enables investors in asset backed securities to earn a higher return than depositors, while it could at the same time lower borrowing costs for those who borrow.
4.5 The Importance of Free Derivatives Markets
Derivatives are securities whose value is derived from other securities, including stocks, bonds, commodities and currencies. They come in different forms: options, warrants, futures, forwards and swaps. These different forms of derivatives differ somewhat in their technical forms, but they have some common characteristics. Apart from all deriving their value from some other underlying security, they all consist of making a deal now about a future transaction under pre- determined conditions.
When derivatives are discussed in the public debate, it is often assumed that all parties that trade with derivatives are speculators. Yet a key function of the derivatives markets is hedging (elimination or reduction of risk), and that is a key reason why many enter the derivatives markets.