The advantage of establishing a market price cannot

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The advantage of establishing a market price cannot be underestimated. While the public-private guarantee will ensure sufficient liquidity in the secondary market and lower mortgage rates, these rates will now reflect the true market and credit risk of the underlying mortgages. Investors will purchase MBS that reflect these rates and thus the price of the underlying mortgage insurance. Most important, because market prices will no longer be distorted, competing private markets will no longer be crowded out. Therefore, markets for MBS without guarantees will be free to develop. If enough liquidity can be sustained in these markets, investors will be able to move along the risk-return tradeoff curve, private capital markets will grow, and the government will become less involved in mortgage finance. While combining some of the advantages of the nationalization and privatization options above, the hybrid option avoids the undesirable aspects of the pre-2008 public/private system. As in the privatization option, regulation would still need to be imposed to prevent securitizers from bulking into large systemic entities that would pose the same risks as did Fannie Mae and Freddie Mac, and to ensure that insurance companies that provide private insurance are well- capitalized. The transitional issues would be handled the same way as in the private solution described above. Here, we present some more specific details about how this private-public partnership would work: 1. The fraction of insurance that needs to be purchased from monoline insurance companies or mortgage insurance subsidiary units of larger financial institutions needs to be sufficient for the insurance companies to have enough of a stake to provide a liquid market and an efficient pricing mechanism -- say, 25% for the purposes of this discussion. This 25% stake, however, needs to be sufficiently small so as not to create systemic risk externalities in the private sector. 2. The government would be a silent partner in this effort, simply providing capital for the remaining 75% of the mortgage insurance and collecting fees on the 75%, albeit using a price determined from the mortgage insurance company’s 25%
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118 stake. This government percentage could decline over time if it appeared that the private sector was capable of absorbing an increasing fraction of the guarantee activity. 3. A key feature of the private-public partnership structure is a credible resolution authority for the private mortgage insurance companies. The companies would be required to hold enough capital to weather a large, but not any, macroeconomic shock. Upon failure, the mortgage guarantees would be pari passu with the unsecured debt of the private companies. If MBS suffered losses and the companies failed, investors would receive the 75% coverage from the GMRIC and would be creditors of the private insurance companies for the remaining 25%.
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