The Gap Between Government and Private Securitizaton

The Gap Between Government and Private Securitizaton

Tom Toles' piece in the Washington Post today (<http://www.washingtonpost.com/wp-dyn/content/article/2011/02/12/AR2011021203363.html>)  neglects any mention of the gap between Public and Private Securization, as defined by the GSEs and FHA role in the secondary market vs. the private market.  The government dominates the secondary market today with over 90% of all securitization.  The gap between the two is what needs to be fixed.  During the Housing Crisis of 2007, the GSEs generated less than half  (HMDA, 2007, Loans Sold by Purchaser Type) of all  loans sold.  One of the differences was the standards for loans originated by the GSEs and private market. The securization function of buying whole subprime loans versus subprime securities also offered different results.  Although the GSEs leverage ratios were too high, they insure around half of all loans, they represent a much smaller portion of delinquent loans, and enable the market to provide lower interest rates with their funding advantage.  The creation of a government entity such as the FDIC acts to insure bank deposits would go a long way and play an important role in bridging the gap between the public and private market.

The gap between the public and private market could be bridged over a time horizon of 7-10 years, with the ultimate goal of reducing government involvement to less 50% of all insurance and new production of home purchase and refinance loans. The Consumer Financial Protection Bureau created standards for qualified mortgages to be insured by the public and private market.  Deviation from these standards would invite cream-skimming and cherry picking by private insurers (Calem, et. al), whose risks could become opaque over time, positively correlated with the rate of change in house prices. The trade off between government and private securitization is the insurance risk, counterparty credit risk, transparency, and funding costs involved in a given transaction.

Currently the funding costs are determined in bond auctions by FHLMC and FNMA securities. Liquidity considerations would need to be considered, given the function represented in the price.

http://www.washingtonpost.com/wp-dyn/content/article/2011/02/12/AR2011021203363.html

Information Asymmetries exists between counterparties in the securitization of mortgages.   These risks could be mitigated with additional transparency and information provided in the TBA market.  Complete transparency could be established in a bond trading over public exchanges providing details of a security. For example, a generic ticker symbol could represent all 30-year fixed rate mortgages with FICOs above 700 originated by entity Z in the state of NY.

All mortgages meeting this criteria would be packaged into this bond and traded in the open market, just like any other stock.  The securities would be grouped with similar loan amounts and other characteristics as deemed necessary and serve as a future proxy for the credit characteristics of new househoulds or U.S. consumers in a specific geographic region (U.S. national, Census region, State).

Currently the funding costs of mortgages are determined in bond auctions by FHLMC and FNMA securities. Liquidity considerations would need to be considered, given the function represented in the price.  The transition to an entity that combines the FHLMC and GSE securities to one entity could take a significant period of time given the infrastructure, technology and resources that enable them to insure 30 year fixed rate mortgages at significant funding advantages in the bond market.  The price passes through to consumers when they obtain a mortgage because of the governments ability to tap bond markets and baseline funding cost advantages.  


Throughout history, governments have always stepped in when markets (and other governments) fail.  The investment in U.S. military resources is the ultimate provider of insurance in the event of a crisis (Ferguson, N., Ascent of Money: Financial History of the World) . 

Market Information Asymmetry (M.I.A.) Hypothesis

The Information Asymmetry Hypothesis is a form of counter-argument to the Efficient Market Hypothesis.  In economics, information asymmetry occurs in a transaction when one party is privy to more information than the other.  The information may be collected voluntarily or involuntarily, but markets do not adjust to equilibrium until the information is disposed to both sides of the parties involved in the transaction.  In an asymmetric market, one could achieve returns in excess of the market average if they possess knowledge of information that has not been accepted by the public.

This information could be possessed in common knowledge with insiders. The ex-post structure of private label securities sold by Wall Street investment banks is an example of an asymmetric market. The  collapse of Bear Stearns is an example of a bank that profiteered and failed because of information asymmetries during the boom and bust that transpired from the Financial Crisis of 2007-2008.

When a bank such as BS (pun intended) sells a PLS rated AAA to investors, they are able to produce a profit from the asymmetric market.

In a crowd mentality, it may be difficult at first to convince the insider that security is not truly what it appears to be on the surface.  Only when the cash flows fail to materialize for a large cohort of investors with access to capital, does the information become transparent, at which point the market may or may not adjust efficiently. A sufficient time lag may exist between the point that cash flows and information passes through to the investors. The time lag is correlated with the remittance cycle of the security and the share of their portfolio that the security represents.  An investor with large capital position in a PLS security may/may not liquidate immediately. They could choose to act on their new information and buy a put option or credit-default swap as insurance.  The investor cohort creates a liquidity run and the market adjust to the information as it dissipates through the economic system.

The Efficient Market Hypothesis assumes that all information publicly available is transparent.  The information can be publicly available and opaque until the investor cohort acts on the information with real capital.  This creates even greater information asymmetries because of the large position and access to liquidity of the investor cohort in the failed security. The investor cohort has first mover advantage resulting in a cascading effect as the information transforms from translucent to transparent through market pricing.

The investor cohort experienced information asymmetry when they purchased and liquidated the PLS.  The herd mentality piggy-backs off the liquidation creating a liquidity run as the bottom falls out of the infected markets.
http://en.wikipedia.org/wiki/Information_asymmetry
http://en.wikipedia.org/wiki/Efficient-market_hypothesis