Tuesday, September 28, 2010

An Analysis of Government Guarantees and the Functioning of Asset-Backed Securities Markets

By Diana Hancock and Wayne Passmore (Federal Reserve Board)

Abstract: Mortgage securitization has been tried several times in the United States and each time it has failed amid a credit bust. In what is now a familiar recurring history, during the credit boom, underwriting standards are violated and guarantees are inadequately funded; subsequently, defaults increase and investors in mortgage-backed securities attempt to dump their investments.

We focus on a specific market failure associated with asset-backed securitization and propose a tailored government remedy. Our analysis of loan market equilibriums shows that the additional liquidity provided by securitization may (or may not) lower primary loan rates, but such liquidity comes at a cost. More specifically, if guarantee-sensitive investors doubt the credit quality of asset-backed bonds, significant risk premiums can develop. If a financial crisis ensues, securitization can disappear from the market entirely, leaving banks that originate just the highest quality loans as the only source of credit. This abrupt increase in lending standards can tighten credit, exacerbate asset price declines, and impinge on economic growth.

We argue that an institutional structure for stemming "runs," analogous to the current set up for the Federal Deposit Insurance Corporation, could be deployed to insure pre-specified asset-backed instruments. Such an insurer would likely benefit from the accumulated information and infrastructure that is embodied in Fannie Mae and Freddie Mac. Hence, the provision of federally-backed catastrophic insurance could provide a rationale for restructuring the housing-related GSEs towards a public purpose. Regardless of its institutional structure, a federally-backed catastrophic bond insurer would provide greater financial stability and ensure credit is provided at reasonable cost both in times of prosperity and during downturns. Moreover, the explicit pricing of the government-backed guarantee would mitigate the market distortions that have been created by implicit government guarantees during prosperity.

Download here: www.federalreserve.gov/pubs/feds/2010/201046/201046abs.html

See critical comment from Seeking Alpha:

Now, I know what you are probably thinking--this sounds pretty good, but what happens when if this bond insurer gets into financial problems (like what happened to Fannie Mae). Won't the market panic when they see that the bond insurer cannot fulfill all of its obligations? Don't worry; the sagacious PhDs at the Fed have a plan for this eventuality: an explicit government guarantee for the bond insurer and all of its obligations. That's right; taxpayers are on the hook for all losses suffered the bond insurer. The authors argue that an implicit guarantee is not enough to prevent a "run" on the securitization market because it still leaves doubt in the market.

But you should not concern yourself too much, because the bond insurer would apply prudent risk management to its portfolio and charge market rate premiums. The paper acknowledges that "in essence the government provides the risk management and market discipline that retail investors cannot provide." For those of you who question the premise that government knows best the authors are quick to counter that:

Moreover, such an insurer would likely benefit from the accumulated information on mortgage default, credit risk modeling expertise, and the securitization know how and infrastructure (e.g., work-out processes and other real estate owned management) that is embodied in the Fannie Mae and Freddie Mac organizations.

If you are not laughing on the floor out loud after reading this, then you are good little government trusting slaves. Fannie and Freddie (FMCC.OB) dramatically under priced risk despite their insider knowledge of the mortgage market. Furthermore, the two government wards failed to see the folly in using 100-1 leverage. And to top it off, these two institutions were routinely audited and supervised by the Office of Federal Housing Enterprise Oversight (OFHEO). These clowns signed off on Fannie Mae's books and missed a large accounting fraud, estimated at over $9 billion.

If the authors have their way. this new entity will not have to put up with very much congressional oversight. The legal status of this new, bond insurer would be structured as an independent agency within government and would have a line of credit with the Treasury (similar to the FDIC) to cover catastrophic losses. Coincidentally, this is the same legal status as the Federal Reserve.

The paper goes on to mention the benefit of a new bond insurer for financial institutions (I love how the government is always looking out for the banks) because it would allow them to adequately hedge their risk by purchasing insurance on their asset backed securities. Another advantage is that the bond insurer would guarantee debt issued by financial institutions as long as the debt was backed by an ABS. The idea is that as long as the government is explicitly guaranteeing these assets, banks should not have a problem issuing ABS or bank debt during financial panics. After all, you are backed by the full faith and credit of the American tax slave taxpayer. Another benefit of this new scheme is that it gives the Federal Reserve another potential asset to buy during liquidity crises.

I don't know about you, but after hearing this preposterous idea, my head is hurting. It could be that since I am not a classically trained PhD in Economics. I simply cannot understand the inherent rationale of this proposal. To me, this paper is suggesting that the US taxpayer provide a complete guarantee to the entire asset backed security market. This scares the living daylights out of me because we just witnessed the collapse of Fannie Mae and Freddie Mac, which has cost the US taxpayer hundreds of billions of dollars.

I realize that we should not be too concerned about the cost of these bailouts because we print money, but this idea sets up a large future liability to taxpayers when the ABS market blows up again. Another problem I have with this idea is that it amounts to another bailout for the financial industry and will create an unimaginable amount of moral hazard. Banks will quickly get the idea that they can originate almost any asset, regardless of its credit quality because the government will always guarantee it. Fraud will be rampant as institutions lie about asset quality in order to be eligible for government insurance.

I know the authors would counter that the bond insurer would have high credit standards and would not insure risky collateral. To answer this I submit to you Fannie Mae and Freddie Mac. These two institutions said the same thing about the credit quality of their portfolios, and look what happened.

As it turned out, Fannie Mae and Freddie Mac had dramatically underestimated the real risks contained in their portfolios. Risk management is very imprecise and subject to large errors, depending on economic conditions. I have no faith that this new bond insurer would be any better at managing risk in the ABS market than Fannie Mae did in the mortgage market. While I do not like the idea of a taxpayer backed bond insurer with an explicit government guarantee, the concept would make an interesting economic experiment.

Can there be a financial panic if the government guarantees all financial assets and prints money to fulfill its obligations?

1 comment:

  1. We are going to be in the market for a new mortgage in 2012, and we are strongly in favor of a 15-year. After losing an estimated 28% and counting on our current place (according to zillow estimates, we are currently ‘underwater’ by $1600 after a little over 5 years) we’d much rather be in a position where we are rapidly paying down principle – and since it’s a new mortgage the closing costs are going to be the same whether we get a 15-year or a 30-year, so we’d rather take the lower interest rate. We are saving up cash for the 20% down payment and hoping our neighborhood recovers enough by 2012 to cover our closing costs for selling it (we’d need the value to increase roughly 3%).

    Given that our down payment is going to dictate our purchase price rather than our monthly payment, we will be able to comfortably afford a 15-year with plenty of room left over.


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