The happy ending however was that the cmo 110 market

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some CMOs’ having 100 tranches or more. The happy ending, however, was that the CMO
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110 market gradually recovered, reaching issuance of $300 billion some five years later, and, five years after that in 2003, coming close to $1 trillion. The important lesson is that it takes time for financial innovation to reach its full potential. The necessary requirement is that an investment community, through experience and expertise, needs to understand the market. No one should think that an appropriately designed MBS market that is focused on mortgage credit risk is not viable. However, even if guarantees are correctly priced on an actuarial basis, these guarantees still come at a cost. While the moral hazard problem is mitigated once guarantees are priced, it does not disappear. This is because the actions of the mortgage lender are not fully observable, so once the premiums for the guarantees of conforming mortgages are set, the lender will be tempted to originate riskier mortgages. And the government’s experience with FDIC’s deposit insurance also indicates moral hazard problems in spite of charging banks with insurance premiums. 53 An additional concern is that government guarantees might have less to do with creating liquid, efficient capital markets, but more with regulatory arbitrage by financial institutions that exploit the favorable capital requirements that are associated with mortgage guarantees. A reasonable question to ask is: If the purpose of the securitization of mortgages was to take advantage of the growth and efficiency of capital markets, why were so many of the MBS held within the banking sector? Chapter 1 described how the financial system – GSEs and banks together – exploited loopholes in capital regulation essentially to rearrange the deck chairs on the Titanic. Whatever structure is established going forward, it is essential that different approaches to financing identical mortgages be treated equally in terms of capital requirements. This crisis has taught us that the same way that water flows downhill, mortgage assets flow to whoever can leverage them the highest. It is very difficult for the insurer to not be one step behind the insured. In the rest of this chapter, we take the pragmatic stand that at least some mortgage guarantees must be taken as given, and discuss three potential routes towards reform of the guarantee business: (i) nationalization, (ii) privatization, and (iii) a hybrid model of public and private capital. No matter which route is chosen, we believe that it is important that the concept of a conforming mortgage be tightened again. At the heart of the problem of the current crisis, and especially the GSEs, were sliding underwriting standards. As we described in earlier chapters, the GSEs were stretching the notion of a conforming mortgage during the housing boom. For example, they often bought mortgages with loan-to-value rations that exceeded 90%. We envision that conforming loans’ LTV ratios should never exceed 80%. We also recommend that
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