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Somewhat perversely the problem is all the more

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financing of financial firms and the loss of market discipline. Somewhat perversely, the problem is all the more worsened by the financial firms’ becoming systemically important and thus too- big-to-fail: The implicit government guarantee gets more ingrained, and the negative impact is that much more. And rather than the regulatory system’s discouraging this behavior, it is actually encouraged. The combination of GSEs and commercial banks or thrifts in a securitized mortgage finance system has less than 30% of the capital requirements of traditional banking. No wonder we are where we are. It should be clear then that mortgage markets operate in the broader context of the financial system and its existing infrastructure and regulation. The Dodd-Frank Act of 2010 is likely to affect this broader context in non-trivial ways by regulating origination, securitization,
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103 and rating aspects of mortgage finance. Given the undesirable state of mortgage finance in the U.S. at the present moment, transition issues must be addressed on the road towards the desired long-term reform. How much – and in what form – should government involvement persist in the long- term reform of mortgage finance? As a fundamental principle, government involvement should only be present to the extent that it improves the efficiency of the reformed housing finance system, as outlined above. This is the best way to minimize costs to taxpayers, in sharp contrast with the seemingly endless losses that we witnessed with Fannie and Freddie. Such an efficient system can restore liquidity in the moribund markets for mortgage-backed securities (MBS), facilitate efficient risk-sharing across different institutions and households, and support a wider availability of fairly-priced mortgages. Recall that the GSEs currently perform two functions: (1) Portfolio or investment function , in which they buy and retain mortgages and mortgage-backed securities; and (2) Guarantee function , in which they underwrite the credit risk of mortgages to facilitate the pass- through of their interest and principal payments to capital market participants and financial firms. Also, the GSEs operate in two markets: (1) Conforming mortgages (subject to size limits, low LTVs, high credit scores, good income coverage ratios, etc.); and (2) Nonconforming mortgages (the rest). We will explain below that these two functions and the two markets require slightly different reforms to ensure that our efficiency criteria are met. Our preferred reform proposal involves the following steps: First, the proprietary trading function of the GSEs needs to be discontinued entirely. Second, we discuss how to structure the guarantee function of the GSEs. It should be reworked to better balance systemic risk, efficient pricing, and market discipline. One of the conclusions is that public guarantees should be restricted to conforming mortgages. Therefore, the final set of recommendations discusses how to deal with non-conforming mortgages and, in particular, where these mortgages fit into the
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