paper about MBS

It may be however that simpler more standardized

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Unformatted text preview: It may be, however, that simpler, more standardized structured finance products develop and at least some of these loans would therefore be packaged and sold off as MBS to the capital markets at large. In any event, if financial firms hold onto these loans, or purchase the MBS in the secondary market, these firms will need to be well-capitalized and systemically less risky than other firms. It is pie in the sky, however, to believe that systemic risk will not exist in the mortgage finance market and that financial institutions will not gradually build up this risk on their 122 balance sheets. It is unavoidable. As a result, it is crucial that the external costs of systemic risk are internalized by each financial institution; otherwise, these institutions will have the incentive to take risks that are not borne just by the institution but instead by society as a whole. This means that systemically important financial firms that are active in holding nonconforming mortgages as whole loans or as MBS should be charged either higher capital requirements, concentration limits, or a systemic risk “tax” in order to prevent them from accumulating too much systemic risk. 60 Consider the most likely remedy: higher capital requirements. Whatever capital requirements are placed on one set of financial institutions – say banks and bank holding companies - it is important that the financing of riskier mortgages does not just move elsewhere in the shadow banking system. 61 Yale economist John Geanakoplos has argued that it is not possible to solve this problem at the institutional level – measuring leverage and then implementing capital requirements fairly across financial firms. He argues instead that leverage should be legislated at the security level. This idea is tantamount to requiring a significant down payment or even banning nonconforming mortgages. We believe that an innovative way around this problem is that systemically risky firms could hold nonconforming mortgages but simultaneously would have to hold a position offsetting this risk -- a so called “macro hedge”. It would work as follows: For each dollar of nonconforming mortgage on the balance sheet, the firm would have a short position in an index of similarly risky MBS. In other words, the whole financial system must be looked at and treated in unison. In addition, without concentration limits or a systemic risk tax, it is highly likely that nonconforming mortgage finance would just end up with financial firms that have government guarantees, such as FDIC-insured banks and too-big-to-fail institutions. As we have argued in the earlier chapters, the more guarantees that a firm receives, the lower are its costs of debt funding, which could lead to an alternative group of private GSE firms in the mortgage finance area....
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It may be however that simpler more standardized structured...

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