Therefore pools of mortgages as found in mbs are

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therefore pools of mortgages (as found in MBS) are nevertheless fairly opaque and
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109 heterogeneous by nature -- more so than corporate debt. Second, while some parts of the corporate debt market could falter, there is usually an alternative source of financing for corporations, such as commercial paper, bank loans, preferred stock, common stock, convertible bonds, and plain vanilla public debt issuance. There is no plan B for the mortgage market. Third, mortgage finance is at the center of economic household activity; without access to mortgage finance in difficult times, the economy would go into a tailspin. Because mortgages are opaque, underlying uncertainty about the credit risk of these underlying mortgages makes MBS less liquid than otherwise similar debt securities. Liquidity is the ability to convert securities immediately into cash, and becomes particularly valuable to investors in times of distress. As the current crisis – and even preceding ones such as the collapse of Long Term Capital Management – showed, the market for MBS without credible guarantees – even safe, so-called AAA-rated MBS – can freeze temporarily or even collapse altogether as the risk of financial firms rises, the investors’ risk appetite wanes, and the demand for cash soars. Investors demand a premium for bearing such illiquidity, and that translates to higher interest rate spreads. To the extent that guarantees enhance liquidity of the secondary mortgage market, the cost of financing mortgages will be lower. There is another reason why mortgage guarantees may be necessary at least in the short- to medium-term. Capital markets are not built overnight. It takes years to develop the expertise and investor base. From the investors’ side, one potential advantage of keeping all conforming mortgage-backed securities guaranteed (credit risk-free) is that an investment community with substantial human capital was built up around buying and selling default-free mortgage-backed securities. Of course, this does not mean that a similarly well-developed capital market and collection of investors cannot take root in the credit-based MBS market. However, if the past is a guide, then the experience of the recent crisis is that the investor base was not committed to the private-label credit-based MBS market. A case in point: After the MBS market developed in the 1980s, in order to further expand the market to investors, the collateralized mortgage obligations (CMOs) market was created. CMOs took GSE MBS and broke them into prioritized tranches of prepayment and interest rate risk. The CMO market expanded rapidly from non-existent in 1983 to less than $100 billion in 1989 to over $300 billion in 1993. With the rapid fall in interest rates in 1993, huge losses were distributed in CMOs across capital markets, causing the CMO market to literally disappear overnight. Similar to the current crisis, the CMO collapse can be attributed to: (i) a large shock to the market – in this case, prepayments on mortgages; and (ii) too much complexity, with some CMOs’ having 100 tranches or more. The happy ending, however, was that the CMO
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