An Analysis of Government Guarantees and the Functioning of Asset-Backed Securities Markets

46 Pages Posted: 27 Jul 2011

See all articles by Diana Hancock

Diana Hancock

Federal Reserve Board - Division of Research and Statistics

S. Wayne Passmore

Board of Governors of the Federal Reserve - Household and Real Estate Finance Section

Date Written: September 1, 2010

Abstract

Mortgage securitization has been tried several times in the United States and each time it has failed amid a credit bust. In what is now a familiar recurring history, during the credit boom, underwriting standards are violated and guarantees are inadequately funded; subsequently, defaults increase and investors in mortgage-backed securities attempt to dump their investments.

We focus on a specific market failure associated with asset-backed securitization and propose a tailored government remedy. Our analysis of loan market equilibriums shows that the additional liquidity provided by securitization may (or may not) lower primary loan rates, but such liquidity comes at a cost. More specifically, if guarantee-sensitive investors doubt the credit quality of asset-backed bonds, significant risk premiums can develop. If a financial crisis ensues, securitization can disappear from the market entirely, leaving banks that originate just the highest quality loans as the only source of credit. This abrupt increase in lending standards can tighten credit, exacerbate asset price declines, and impinge on economic growth.

We argue that an institutional structure for stemming "runs," analogous to the current set up for the Federal Deposit Insurance Corporation, could be deployed to insure pre-specified asset-backed instruments. Such an insurer would likely benefit from the accumulated information and infrastructure that is embodied in Fannie Mae and Freddie Mac. Hence, the provision of federally-backed catastrophic insurance could provide a rationale for restructuring the housing-related GSEs towards a public purpose. Regardless of its institutional structure, a federally-backed catastrophic bond insurer would provide greater financial stability and ensure credit is provided at reasonable cost both in times of prosperity and during downturns. Moreover, the explicit pricing of the government-backed guarantee would mitigate the market distortions that have been created by implicit government guarantees during prosperity.

Keywords: Fannie Mae (FNM), Freddie Mac (FRE), Mortgage-Backed Securities (MBS), Government-Sponsored Enterprises (GSE), Asset-Backed Securities (ABS), financial crisis, catastrophic risk

Suggested Citation

Hancock, Diana and Passmore, Stuart Wayne, An Analysis of Government Guarantees and the Functioning of Asset-Backed Securities Markets (September 1, 2010). FEDS Working Paper No. 2010-46, Available at SSRN: https://ssrn.com/abstract=1895534 or http://dx.doi.org/10.2139/ssrn.1895534

Diana Hancock (Contact Author)

Federal Reserve Board - Division of Research and Statistics ( email )

20th & C. St., N.W.
Washington, DC 20551
United States
202-452-3019 (Phone)
202-452-5295 (Fax)

Stuart Wayne Passmore

Board of Governors of the Federal Reserve - Household and Real Estate Finance Section ( email )

Washington, DC 20551
United States
202-452-6432 (Phone)
202-452-3819 (Fax)

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