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Second the other major disadvantage of

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Second, the other major disadvantage of nationalization approach is that the government would be stuck with a huge on-balance sheet liability at a time of large fiscal deficits and ballooning debt. Most economists would argue that the government has no comparative advantage in providing mortgage credit to most U.S. households and that it currently crowds out the private provision of mortgage credit. The discussion above suggests that there may be some value to allowing a credit-risky (non-guaranteed) MBS market to develop and compete openly with a guaranteed MBS market. Nationalization pretty much rules out this possibility. Finally, government institutions tend to be poorly governed and subject to political capture. Like the GSEs, they have a tendency to morph and to be reoriented away from their intended mission towards new political goals over the course of their life. They are easy to create, but hard to manage and to abolish. 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
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113 subordinated tranches, private insurance companies -- such as monolines -- could sell default insurance.
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