What Should Mortgage Finance Look Like?

Financial innovation is good. Financial innovations might or might not be. The great thing is to allow innovations to arise without institutionalizing them the way we did with MBS.

Arnold, any "innovation" created to bypass a regulation will hardly survive the removal of the regulation. This is true for all economic activities. The long history of black and informal markets support this view.

I think there is room for securitization in a market without stupid regulations. If it were empirically to turn out to be incorrect, I'm perfectly happy to live in a world without securitized mortgage products. I do have a preference that they not be encouraged by stupid regulations either way.

To say: "safety in mortgage finance . . . consists of lenders figuring out that a mortgage with a down payment of less than 10 percent has a significant probability of going into default," is a gratuitous, and rather silly, insult to mortgage lenders. Everyone knows that a low-down-payment loan is riskier; the "reform" should be to remove incentives *to make such loans in spite of their riskiness*.

"The clearing house could become insolvent itself if enough of its counterparties fail to meet their obligations... there could be extreme circumstances where a government rescue would be required."

But of course that's so improbable they will ignore it, like they ignored the improbability of housing prices falling across the country simultaneously.

So the solution to the current crisis includes the seeds of the next crisis, i.e. the clearing house counterparties fail to meet their obligations and the clearing house becomes insolvent.

I wonder what a bailout of the derivatives clearing house will cost and how long it will take?

I view a central clearinghouse for derivatives as AIG scaled upward about 10,000x. How different is their function, really, than AIG was doing writing CDS's? (Not how different is the mechanism, how different is the purpose.) Beside the insurance function of an exchange (usually a secondary function) why would we expect it to be safer than ad-hoc contracts? I don't think one-size fits all margin requirements, the only other thing it really brings to the table, are nearly enough to prevent it from being a time bomb.

My "macro problem" with securitization relates to systemic transaction costs, not regulatory arbitrage. The latter presumably is "easily fixed" by making sure system wide capital is the same regardless of structure--inside the banking and insurance world at least. This will eliminate regulatory arbitrage.

But there is nothing inherently irrational or inefficient with certain buyers seeking to purchase first or second to default securities versus last to default securities. This would seem to provide more choices for investors.

There are fees and transactions costs associated with this, of course, but perhaps they are partially offset by a greater diversity of investment options. This sounds like the original argument for securitization in the first place. But this product was always about regulatory arbitrage from day one.

Ironically (or "self-servingly" perhaps), many thought the more aggressive capital rules were "correct" rather than the less aggressive rules. Even with the housing crash in hindsight, this is not obviously wrong to me. The loans made at the point of sale were the problem as much as any regulatory arbitrage was the problem. An oligopolistic ratings process helped contribute as well. If these original loans were structured more soundly, we would not have had nearly the size of the problem, even if the more aggressive capital rules were the norm. Securitization did not "cause" the bad loans at origination, but were better described as part of the same "whole". Maybe capital rules should be linked to the leverage and credit worthiness of the borrower. It seems this was not the case.

I guess my point is that; 1) capital rules based on the credit worthiness of the underlying loan; and; 2) arbitrage free capital rules will result in structures that will all be on an equal capital footing. This presumably enables markets to focus on risk-reward choices, rather than finding loopholes.

Then, when that is solved, we can all scratch our heads about how the next crisis happened.