Another issue is that the market for structured

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Another issue is that the market for structured mortgage finance will have to develop more transparency and standardization to regain the confidence of its investors, but this is likely a problem that can be solved. And then the elephant in the room – the credit rating agencies – will have to be dealt with in some way for structured mortgage finance to be credible. In the typical view of the role of ratings in the financial crisis, MBS investors were asleep at the wheel due to the government’s “seal of approval” of rating agencies. But ratings were used by financial institutions to exploit capital requirements in order to hold risky MBS with little or no capital, so it wasn’t investors who got duped here but taxpayers. This is how it worked: Because the issuer pays the agency that rates the issuer’s bonds, there is a huge conflict of interest to shop the MBS tranches around until the issuer gets the desired rating, leading to inflated ratings. Because the government sets 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
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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
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