Getting to the Heart of the Crisis: A Deeper Look into Mortgage Securitization and Credit Default Swaps
The process of understanding the causes of and solution to the current financial crisis is consumed in large part to identifying villains – the actors who made mistakes or took advantage of opportunities which put the economy at risk. The recently inaugurated Financial Crisis Inquiry Commission created by Congress (modeled after the Pecora Commission in the 30s and the 9/11 Commission earlier this decade) has been given over 20 targets to investigate. A recent Congressional Research Service report identifies a similar number of culpable entities, including human frailty and greed.
But insufficient attention has been paid to the financial instruments and arrangements that are no doubt at the heart of the crisis, whether responsible or not. This issue of Lombard Street takes a closer look at two poorly understood but widely implicated of those instruments: securitization and credit default swaps (CDSs).
In a recent hearing at the Senate Banking Committee, Ranking Member Richard Shelby (R-AL) repeatedly asked how, after having seemed to work pretty well for so long, securitization could be revived. Arnold Kling offers a skeptical view of the future of securitization. Once at the heart of mortgage financing, the market for mortgage securities has in recent months precipitated and leaves Kling wondering if it should ever be revived. A companion piece, by Hanweck, Sanders, and Van Order takes, if not an opposing, a slightly more sanguine view of securitization. They pin certain problems in the housing finance sector to the dual, hybrid nature of many of the institutions therein, and offer a future which allows originate-to-hold and originate-to-distribute to co-exist so long as they are given an even regulatory playing field. Both explain the crucial role that the GSEs played in the mortgage market as it previously existed.
In a third piece, Charles Davi takes a closer look at credit default swaps, and their fundamental characteristics which make them a beneficial part of the financial sector. He points out, that in order to more completely hedge and diversify one’s credit risk, relying only on underlying bonds would be insufficient. He also discusses the oft-repeated but mistaken notion of CDSs as insurance. While they do in part act much like an insurance arrangement, they also possess a “dynamic life between execution and termination, and therefore, have more in common with forward contracts than insurance.” He also addresses the externality argument surrounding regulation of derivatives, and submits that CDSs, much more than imposing a negative externality which denotes market failure, may actually provide a positive externality from which market participants benefit from.
While ongoing discussion of regulatory structure is merited and much needed, Congress and the Administration continue to debate reform along lines of a static financial structure with fixed and well-defined instruments. In many cases, in my own interactions with policymakers, even existing and well-established financial instruments are poorly understood. How then can policy be made which protects innovation while protecting from undue and unforeseen risks? The authors in this issue of Lombard Street give us a more nuanced view of certain instruments and offer an alternative future contrary to the dominant view that mortgage finance will look much the same as it has, and credit default swaps only offer high-stakes betting on the failure of companies† Satya Thallam is associate director of economic education, responsible for connecting Mercatus scholars and their research to leveraged audiences within Congress, federal agencies, and state and local governments, ensuring that policy ideas get into the hands of those people who need it most, in the most timely fashion. He is also responsible for writing and editing op-eds, the Mercatus On Policy series, and other vehicles for dissemination based on Mercatus research.
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