China is trying to create a market to sell mortgage backed securities. These securities allows banks to repackage homeowner loans and sell them on capital markets. The attraction for banks is that it gets these loans off their books and allows the banks to sell more loans to other clients and earn more commissions without affecting the level of their capital reserves.

One reason why mortgage backed securities are popular with investors is safety. Residential real estate has historically been one of the safest collateral. The reason is simple. You can’t move real estate, so it is easy to find. In the US it is also easy to foreclose. So if there is a default, the lenders can quickly find and sell the collateral.

The problem in China is that it is illegal to foreclose on someone’s primary residence. As a result if the housing market, which has been undergoing a bout of speculation, collapses, it will be very difficult for lenders and holders of mortgage backed securities to retrieve their collateral. So instead of very safe investments, mortgage backed securities in China should actually be priced as loans without any collateral at all. Unfortunately, the illusion of low risk will most likely attach to these products, which will increase investor losses far beyond expectations in any down turn.

William Gamble

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