Chairman Bagehot's Response

Chairman Bernanke gave a speech on "The Future of Mortgage Finance in the United States":

"The financial crisis that began in August 2007 has entered its second year. Its proximate cause was the end of the U.S. housing boom, which revealed serious deficiencies in the underwriting and credit rating of some mortgages, particularly subprime mortgages with adjustable interest rates. As subsequent events demonstrated, however, the boom in subprime mortgage lending was only a part of a much broader credit boom characterized by an underpricing of risk, excessive leverage, and the creation of complex and opaque financial instruments that proved fragile under stress. The unwinding of these developments is the source of the severe financial strain and tight credit that now damp economic growth."

The financial crisis was caused by the end of the housing boom. This boom showed problems in mortgages:
1) Poor underwriting ( True )
2) Poor credit ratings ( True )
3) Allowing subprime mortgages with variable interest ( True )

A good start. 3 obvious principles that investors forswore at their own peril.

However, the general problems are:
1) underpricing risk ( What caused this? )
2) excessive leverage ( True )
3) complex investments ( ? )
4) not transparent investments ( ? )

Okay. I think 1 and 3 and 4 go together, but that's me. Now he says this:

"To address these issues, we must consider both the part played by securitization in the mortgage market and the role of the government and government-sponsored entities in facilitating securitization."

Here I don't agree. I've already considered securitization with the help of Derivative Dribble.

Here's why they're worthwhile:

"The ability of financial intermediaries to sell the mortgages they originate into the broader capital market by means of the securitization process serves two important purposes: First, it provides originators much wider sources of funding than they could obtain through conventional sources, such as retail deposits; second, it substantially reduces the originator's exposure to interest rate, credit, prepayment, and other risks associated with holding mortgages to maturity, thereby reducing the overall costs of providing mortgage credit."

Okay. They give:
A: Originators more sources, e.g., retail deposits
B: Originators risk decreased on:
a: interest rates
b: credit
c: Prepayment
d: Holding mortgages to maturity
And these lower costs of providing mortgage credit.

This sounds good. The only things needed for using securitization properly are:
1) Ultimate investors invest in good quality mortgages and underwriters
2) All investors in process must be able to manage risk
3) Must be transparent, because hard to price

Here's the thing: These are all common sense and not complicated. I'm sorry, but this is investing 101.

He gives a bunch of remedies, but, I'm sorry, it wasn't the products. It was the investors. The question is why did these investors take these risks? So, all the remedies are last year's news to me. Go ahead and fool around with regulating these things. Good luck.

I believe that investments involving shifting risk to third parties or magnifying risk, often with complicated models, should be looked into or regulated, but the principles need to be broad to capture future innovations.

In any case, we need better investors, and having government guarantees makes that impossible.

Here's Beranke's conclusion:

"Conclusion
Regardless of the organizational form, we must strive to design a housing financing system that ensures the successful funding and securitization of mortgages during times of financial stress but that does not create institutions that pose systemic risks to our financial markets and the economy. Government likely has a role to play in supporting mortgage securitization, at least during periods of high financial stress. But once government guarantees are involved, the problems of systemic risks and contingent taxpayer involvement must be dealt with clearly and credibly. Achieving the appropriate balance among these design challenges will be difficult, but it nevertheless must be high on the policy agenda for financial reform."

I agree that government has a role to play. I just gave one area above.
I agree that if government is guaranteeing these investments, they should be highly regulated and limited in risk in order to keep the risk to the taxpayer at small as possible.

Is there any better plan?

I believe that there is.
First, I accept what I call Bagehot's Principle: If the B of E exists, it will be the ultimate guarantor, and that must be taken into account. Given the Fed and our government, they are the ultimate guarantors and must be taken into account. And, following Bagehot, I would like to see the following:

A: Real moral hazard for banks or financial entities far short of a crisis. No propping up.
B: General supervision as I recommended above. Minimal, but effective.
C: Serious penalties if these businesses need government help. I recommend effectively taking them away from them,i.e., nationalization, which is why I favored a Swedish type plan, that would divest these nationalized entities back into private concerns as soon as possible. But such conditions as TARP are not nearly onerous enough.

These principles have been known since Bagehot, and, since him, we have known that a pure free market plan is not real, as long as certain financial and government entities exist. It's time we follow his advice.