More concretely one of our novel proposals attempts

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More concretely, one of our novel proposals attempts to balance the short-term transition and long-term efficiency issues in moving away from the GSEs and is as follows: The GSEs’ investment function – which allowed them to invest in mortgage-backed securities as hedge funds or proprietary-trading desks – should be closed and wound down in an orderly, gradual fashion. Since the early 1990s, asset management firms have become an important part of capital markets and can pick up the slack in the secondary mortgage-backed security market. The government has no business running a gigantic hedge fund.
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8 Since mortgage default guarantees have been an essential element of the development and liquidity of the core of the mortgage markets in the United States, mortgage default insurance should be preserved in some form, but the role of the GSEs therein should be substantially reduced. Arguably, the private sector cannot be the sole provider as this insurance is systemic due to its dependence on macroeconomic events. When a private insurance firm fails to honor its insurance, other firms will likely be in the same situation and thus be unable to reinsure. Yet because of the lack of adequate governance, incentive structures, and accountability (let alone political considerations), the public sector alone cannot step into the breach either. We recommend a pragmatic middle-ground: a public-private partnership in which the private sector decides which mortgage guarantees to provide, prices the guarantees, but insures (say) only a 25% fraction of these mortgages, while the government is a silent partner, insuring the remaining 75% and receiving the corresponding insurance premiums. The private sector firms (which could even be a cooperative of several financial firms) would need to be well- regulated -- in particular, well-capitalized for the extent of systemic risk they take on, and subject to an irrefutable resolution authority. Further, the partnership model of guarantees should cover only the plain-vanilla “conforming” mortgages with strict underwriting criteria (such as maximum 80% loan-to-value ratios). The provision of default insurance to non-vanilla mortgages should be left entirely to well-capitalized private firms. Many other developed countries’ mortgage markets function without mortgage guarantees. Yet, their secondary mortgage markets tend to be less developed: banks hold on to a larger fraction of loans and long-term fixed-rate mortgage products are less prevalent than in the United States. Preserving the central role of the 30-year fixed-rate mortgage requires a well- functioning securitization channel. Moreover, these alternative mortgage market architectures proved just as fragile in the financial crisis, resulting in large-scale bank bailouts, not dissimilar to the GSE bailout.
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