Securitization and Credit Default Swaps
The latest issue of FinReg21 looks at them. First, Charles Davi makes a big deal out of the fact that credit default swaps are derivatives, which allow institutions that do not own securities to make side bets on the value of those securities. I need to think about this more, but my initial instinct is that this is not such a big deal. Historically, derivatives have reduced the transaction costs involved in trading. There is an element of that here. But there is also a huge element of regulatory capital arbitrage–at least when AIG used its AAA rating to reduce the regulatory capital required to hold mortgage securities.
Next, I make my full argument against reviving mortgage securitization.
The story until recently was that the main source of moral hazard was government guarantees, but we have discovered that the least guaranteed sector, private label securitization, indulged in a very large amount of moral hazard. The private market, for reasons related to policy decisions (e.g., delegating too much regulatory authority to rating agencies), did not monitor risk very well.
Hanweck is a former colleague of mine at the Fed, and Van Order was the Freddie Mac colleague who taught me everything I know about mortgage risk, capital regulations, and the factors that affect the competition among Freddie Mac, Fannie Mae, and banks.
Read their whole paper. Their proposals make tremendous sense in theory. Their ideal is a market in which securitization and old-fashioned bank lending compete on a level playing field, with neither banks nor securitizers used as political pawns to create subsidized, lenient mortgage credit. Again, very nice in theory, in a financial system administered by wise technocrats. In practice, we need to take into account the fact that the system is going to be influenced by Wall Street’s cognitive capture of the regulators and by the affordable-housing lobby and Barney Frank. That makes it a much tougher problem, which is why my paper, although less theoretically elegant, may be relevant.