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paper about MBS

For all of these reasons we do not favor the

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Unformatted text preview: For all of these reasons, we do not favor the nationalization option. 8.2.2. Privatization The second option is to fully privatize the guarantee business. In this scenario, the GSEs would be completely dismantled. Existing banks and mortgage lenders, as well as new lenders, would step into the breach and conduct all conforming (core) mortgage originations. What facilitates the privatization solution is that conforming mortgages are loans that are conservatively underwritten: For example, all the loans in a pool would have loan-to-value ratios of 80% or less and have documented mortgage-payment-to-income ratios of 35% or less. Therefore, these loans would have low credit risk to begin with. Strengthening the criteria for what constitutes a conforming (core) mortgage loan would be important. The techniques of structured finance could be applied to reallocate further the credit risk: The idea is to structure these loans into “tranches”. The most senior tranche would effectively have no credit risk, and therefore would not need any credit guarantees. This tranche could be as large as 80% of a pool that is composed of only conforming loans: The default rate on the pool would need to exceed 40% with only a 50% recovery rate before the senior tranche would take its first dollar loss. Even in the current bust with the worst housing market for at least seven decades, the default rate on conforming mortgages has stayed well below 10%, and recovery rates are around 60%. Under this scenario, the remaining 20% of the value in a pool would be securitized as higher risk (subordinated) tranche(s) that would explicitly contain credit risk, and trade as such in private markets. To further facilitate the liquidity of these 113 subordinated tranches, private insurance companies -- such as monolines -- could sell default insurance. The rationalization for the privatization approach is that the banking sector is quite capable of doing mortgage lending to households, just as it is for providing lending to corporations and credit card lending to households. It is quite capable of pricing risky corporate loans and junk bonds, so why would it not be able to price and trade risky mortgage bonds (the junior tranches of the MBS)? The private market may currently well be crowded out of the mortgage lending market by the extensive activity of the GSEs. The advantage of this approach is that it would eliminate the distortions that arise because of government guarantees, such as artificially low financing costs enjoyed by GSEs (or their nationalized equivalents) and the resulting low mortgage rates. The pure privatization option, however, has several risks that would have to be managed carefully by the government or the mortgage market regulator. First, the government would have to make explicit that there will be no future bailouts of the new private mortgage players....
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