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.

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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.

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