While the call for the creation of a catastrophic insurance fund for MBS has been gaining ground in recent weeks, two leading Federal Reserve Board economists are poised to push the concept one step further, suggesting a backstop for all ABS.
According to an unpublished paper provided to American Banker, the central bank officials are proposing to create a deposit insurance-like system for the secondary market. The economists — Wayne Passmore and Diana Hancock, the associate director and deputy associate director, respectively, in the division of research and statistics at the Fed — argue that an explicit backstop of certain ABS could ensure the stability of the system in future financial crises and help eliminate the concept of "too big to fail" institutions.
"People who hold mortgage-backed securities or asset-backed securities are happy as long as they know there is no credit risk," Hancock said in a recent interview. "When they're really concerned that there is credit risk, they may run. That's not good for a securitization market."
To protect against such securitization runs, which can dry up credit availability, the two economists said an insurance fund should be created to cover catastrophic risks on a wide range of asset classes, including mortgages, credit cards and auto loans.
"We are arguing we should create an Federal Deposit Insurance Corp. (FDIC)-like entity to explicitly price this form of guarantee," Passmore said in the same interview. "It will capture many of the benefits that have been associated with the GSEs, they will allow the government to accumulate an insurance fund, or reserves, to pay for supporting the fund up front. That's really the essence of why people want the government in the mortgage market. It defines well what the government's role will be."
The paper, which is due to be published in coming weeks, has been circulated over the past few months as a discussion draft, including at the Chicago Fed's conference in May. But it has yet to receive widespread attention.
When it is finally published, it will likely arrive at a critical juncture of the debate over the future of the GSEs. Leading policymakers have mostly remained silent about how they plan to revamp the structure of housing finance, but at a Treasury Department conference last week, several endorsed the creation of an insurance fund for MBS.
Under separate proposals from the Housing Policy Council and others, Fannie Mae and Freddie Mac would be replaced with privately capitalized, federally chartered companies that buy mortgages from the primary market and deliver them into a federally guaranteed mortgage-backed security.
The new companies would pay a risk-based fee used to establish an insurance fund, similar to that of the FDIC, which would cover catastrophic losses on MBS.
The Fed economists' view is different in some critical respects. For one, they appear to envision a government-run agency running the fund, either Fannie, Freddie, or a combination of the two. That entity's sole purpose would be limited to providing a guarantee and running an insurance fund. It could not sell its own unsecured debt or build a mortgage portfolio.
More important, the guarantee would not be confined to mortgages and could be expanded to include any asset-backed security to prevent disruptions in other securitization markets in a future crisis.
"Issuers and investors want to believe that implicit guarantees extend to other asset classes so we want this authority to be able to expand the authority to other classes if needed," Passmore said. "If there is an implicit guarantee, it should be made explicit."
The proposal would preserve the most lucrative part of the GSEs' business model: the guarantee fee, in which the enterprise assumed the credit risk of the mortgages it was buying. Instead of using those fees for profit, however, it would use them to build up a fund, like the Deposit Insurance Fund, which could absorb losses in a crisis.
"We're trying to leverage off the talent the organizations [GSEs] have and put it into the FDIC-like format, rather than for a profit making business," Hancock said.
To be sure, the Fed economists are not suggesting the government carry all of the risk. They said that both the borrower and originator of the mortgage should have "skin in the game" as well.
The new system's primary target is the GSEs' implicit guarantee. Investors bought Fannie and Freddie debt under the impression it would be backed by the government if the two failed.
Although government officials insisted no such guarantee existed, when the GSEs were taken into conservatorship in September 2008 the U.S. stood behind their debt.
Under the economists' proposal, there would be no implicit guarantee since the GSEs would no longer sell debt or hold portfolios. Instead, there would be an explicit guarantee for asset types that the government could define, restricting them to relatively safe loans with certain underwriting standards, for example.
Retail investors, who the economists argue generally are not equipped to properly evaluate the riskiness of ABS, would no longer panic in the event of a crisis if they had certainty over what was backed.
"We argue a government wrap or a government guarantee for those securities will mean they won't have to worry, so there is no need to run, and at the same time by the government providing that insurance or government guarantee the government can control underwriting standards," Hancock said.
Although Fed Chairman Ben Bernanke and the rest of the board have not endorsed the paper, the economists' suggestion appears to dovetail with some of the central banker's past views.
In a speech in 2008, Bernanke pointed out that the GSEs' ability to securitize mortgages was largely dependent on investor confidence that the government would stand behind both entities.
"Eroding investor confidence in the GSEs endangered not only the U.S. mortgage market but the financial system more generally, given the enormous quantities of the companies' debt outstanding in private and public portfolios around the world," he said.
The economists said their approach would also help curb the notion of "too big to fail." By explicitly guaranteeing that all institutions would share the same expense in issuing mortgage securities, it would eliminate the idea that the government would be more likely to back a larger financial institution over a smaller one.
Additionally, the government may be more willing to let a large player in the secondary market fail if it knows such a collapse would not overly disrupt the market.
"It allows all players to face the same cost of issuing this form of mortgage backed securities," Hancock said.