Opinion

Felix Salmon

Replacing Frannie with a new bond guarantee

By Felix Salmon
August 24, 2010

Donna Borak has found an upcoming paper from Fed economists Wayne Passmore and Diana Hancock proposing a government backstop for asset-backed securities. This sounds very much like Gary Gorton’s paper back in May, which was a very bad idea back then, and is just as bad of an idea now.

The Fed paper doesn’t go quite as far as Gorton, since it’s based more on an FDIC model where the insurance is paid for by the issuers. But the fundamental problem remains the same: from an investor perspective, the bonds would become risk-free. And we don’t want to create risk-free bonds: we want investors to price risk. If they think they’re buying risk-free paper, in fact what they’re doing is pushing risk out into the tails, where it can explode unpredictably and disastrously.

There is something new and interesting here, though: the idea that this guarantee be used specifically for mortgage bonds, and specifically to replace Fannie and Freddie. Since the government is already guaranteeing Frannie’s bonds, this new scheme can’t be any worse than we’ve already got, from a systemic perspective. So I’ll be very interested to read the paper, when it comes out.

Comments
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With securities, and even to some extent with deposits, it kind of seems to me that if we want a government guarantee on these sorts of things, we should just let the government buy what it would be guaranteeing and let whomever would be buying the guaranteed whatsit buy government bonds instead. If say Morgan Stanley were guaranteeing something, I could see one making a liquidity distinction — MS doesn’t want to have to tie up capital like that — but the US government has a lower cost of capital than any of the ultimate buyers or sellers anyway, so I don’t think that really applies.

Posted by dWj | Report as abusive
 

Did the bandwagon for “Covered Bonds” just never get going? I seem to recall a few sessions scheduled at an ASF conference (in those halcyon times, at Vegas) on that topic; to me, the funding & accounting for the issuance of these just would not seem to mesh well for a large bank like JPM or Wells Fargo.

Asset-backed securities can function well enough for shorter-dated receivables like Cards or Autos, since money-funds can buy up all those 1yr Fixed / Floater pieces.

Posted by McGriffen | Report as abusive
 

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