paper about MBS

Its regulatory structure around these ratings

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Unformatted text preview: its regulatory structure around these ratings, investors like AIG, Citigroup, ABN Amro, UBS, Merrill Lynch, Lehman, and yes Fannie Mae and Freddie Mac, amongst others, got to engage in risky activities without having to hold nearly enough of a capital buffer due to the inflated ratings. Rating agencies acquiesced in this “unholy” alliance between investors and issuers. And the tax payers ultimately picked up the bill. While the Dodd-Frank Act makes significant headway on this issue, it is too early to determine whether the Act will successfully resolve the rating agency problem. Finally, private mortgage insurance (sold to guarantee some of the 20% junior tranches) would need to be much better capitalized than in the past. The regulation of these insurance companies should be strengthened and enforced better. There is even the issue of whether the insurance industry is equipped to offer insurance against such aggregate mortgage risk at all. It is strange to offer insurance on events that, if they occur, the insurance company cannot hope to payout. To better understand this argument, note that, traditionally, insurers pool and diversify idiosyncratic risks with potentially catastrophic consequences for individuals and businesses. In competitive markets, insurers price diversifiable risks on an actuarial basis, yielding tremendous utility gains to the previously exposed individuals and businesses. Mortgage insurance, however, protects against macroeconomic events such as a national house price decline or a rise in unemployment and other non-diversifiable risks such as a financial market meltdown. It is not a diversifiable risk and hence carries an extra charge – “risk premium” – over and above the actuarially fair price. At the same time, mortgage insurance is far more systemically risky than 115 are insurers’ traditional activities. This sets the stage for perverse incentives for the insurance provider: Sell a large amount of insurance to pocket the premium, but do not leave enough reserves (or capital) behind to honor the insurance payments. Since the payments will be due in a systemic crisis and the insurer is large, it is more likely than not that the insurer will be bailed out. At any rate, even if the insurer were not to be bailed out, it is hard to imagine that reserves will be adequately set aside for a systemic crisis as at least some costs of the insurer’s default are borne by the rest of the system. The tale of the financial crisis of 2007-2009 is that insurers provided excessive insurance on structured mortgage products that were tied to macroeconomic variables, and were undercapitalized and insufficiently liquid given the correlated risks of that insurance. For example, according to Inside Mortgage Finance, of the $960 billion of private mortgage insurance that was outstanding in 2007, 80% was held by just six companies: Mortgage Guaranty Insurance (21.8%), PMI Mortgage Insurance (18.8%), Radian Guaranty (14.9%), Genworth Financial (12.9%), United Guaranty (13.1%), and Republic Mortgage Insurance (11.5%). A substantial portion -- $173 billion -- was issued by these six insurers to satisfy the (11....
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its regulatory structure around these ratings investors...

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