Insure all of the mortgage credit risk in the us or

Info icon This preview shows pages 123–125. Sign up to view the full content.

View Full Document Right Arrow Icon
insure all of the mortgage credit risk in the US, or even all of the tail risk, would lead to an even bigger catastrophe than the one we just had. The only option appears to be the development, and most likely a slow one, of a private sector mortgage lending market for nonconforming mortgages. This market in theory would consider and price in the loan’s LTV, FICO score, the borrower’s income to mortgage interest ratio, as well as intangible information. Like other countries, it may well be that this market is not securitized, and loans would be held on the balance sheet of financial institutions as whole loans. It may be, however, that simpler, more standardized structured finance products develop and at least some of these loans would therefore be packaged and sold off as MBS to the capital markets at large. In any event, if financial firms hold onto these loans, or purchase the MBS in the secondary market, these firms will need to be well-capitalized and systemically less risky than other firms. It is pie in the sky, however, to believe that systemic risk will not exist in the mortgage finance market and that financial institutions will not gradually build up this risk on their
Image of page 123

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
122 balance sheets. It is unavoidable. As a result, it is crucial that the external costs of systemic risk are internalized by each financial institution; otherwise, these institutions will have the incentive to take risks that are not borne just by the institution but instead by society as a whole. This means that systemically important financial firms that are active in holding nonconforming mortgages as whole loans or as MBS should be charged either higher capital requirements, concentration limits, or a systemic risk “tax” in order to prevent them from accumulating too much systemic risk. 60 Consider the most likely remedy: higher capital requirements. Whatever capital requirements are placed on one set of financial institutions – say banks and bank holding companies - it is important that the financing of riskier mortgages does not just move elsewhere in the shadow banking system. 61 Yale economist John Geanakoplos has argued that it is not possible to solve this problem at the institutional level – measuring leverage and then implementing capital requirements fairly across financial firms. He argues instead that leverage should be legislated at the security level. This idea is tantamount to requiring a significant down payment or even banning nonconforming mortgages. We believe that an innovative way around this problem is that systemically risky firms could hold nonconforming mortgages but simultaneously would have to hold a position offsetting this risk -- a so called “macro hedge”. It would work as follows: For each dollar of nonconforming mortgage on the balance sheet, the firm would have a short position in an index of similarly risky MBS.
Image of page 124
Image of page 125
This is the end of the preview. Sign up to access the rest of the document.

{[ snackBarMessage ]}

What students are saying

  • Left Quote Icon

    As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

    Student Picture

    Kiran Temple University Fox School of Business ‘17, Course Hero Intern

  • Left Quote Icon

    I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

    Student Picture

    Dana University of Pennsylvania ‘17, Course Hero Intern

  • Left Quote Icon

    The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

    Student Picture

    Jill Tulane University ‘16, Course Hero Intern