Mortgage Securities and Credit Default Swaps

In his interview with Conor Clarke, Michael Lewis says,

That market is huge as a result. But if people actually had to have the capital, like a real insurer, to back up the contracts they're riding, the market would shrink by -- who knows? Who knows what would be left of it?

He applies that logic to credit default swaps, but not to mortgage securities. Instead, he praises mortgage securities. I think that both credit default swaps and mortgage securities are artifacts of government policies and regulatory anomalies.

My view on credit default swaps is that there is no natural seller. There is no party for whom being short a credit default swap is a natural hedge. In contrast, in the corn futures market, the farmer is a natural seller and the maker of corn chips is a natural buyer. In the futures market for oil, producers are natural sellers and airlines are natural buyers.

Credit default swaps arose because the Basel capital accords made AAA-rated securities inexpensive for banks to hold. The goal for banks came to be to get the highest yield possible on AAA-rated securities. The could transform riskier securities into AAA securities by buying credit default swaps from AAA-rated companies, such as AIG. Given how things turned out, I don't expect that market, which reached $60 trillion in notional outstanding contracts at the end of 2007, to revive any time soon.

Mortgage securitization has never existed "in the wild" in the United States (I do not know about other countries). That is, government has always been involved in propping up mortgage securities. In the early days, government created the market with GNMA and Freddie Mac, which were government agencies. In the 1980's, Fannie Mae (which by that time was shareholder owned) got into the act. Later in that decade, Freddie Mac was spun off to shareholders. Of course, the ability of Freddie or Fannie to actually operate as private entities is now in doubt, to say the least.

For a few years, a "private-label" market emerged for mortgage securities, specializing in the subprime mortgage area. I think it is safe to say that we won't see that market return any time soon, either.

I worked at Freddie Mac in the late 1980's and early 1990's, and I never would have believed that they would go under. Our internal capital standard was to be able to survive another Great Depression, with house price declines of 40 percent. Obviously, those standards were not maintained in recent years.

Given the disaster at Freddie and Fannie, nobody is going to trust any private mortgage-backed securities market. If such a market is going to continue, it will be entirely dependent on government backing.

If it were up to me, I would let the mortgage securities market fade into history. I would just let mortgage lending revert to what it was in the 1960's and 1970's, with banks originating loans and holding them. That model blew up because inflation was allowed to get out of control in the 1970's.

We know how to keep inflation from getting out of control. We do not have a proven mechanism for regulating mortgage securities. So I think that the old-fashioned model would be better.

Would mortgage rates be higher without a mortgage securities market? Perhaps. But from a public policy perspective, if we want to subsidize home ownership, there are better alternatives than providing subsidies to mortgage indebtedness.

If the mortgage securities market dies, then the "end of Wall Street" to which Lewis refers will be assured. It would also mean the end of one of the most well-heeled, heavy-handed lobbying networks in history, combining investment bankers, Freddie and Fannie, and various trade groups. If that rent-seeking operation is shut down, then we can say that some good came out of this financial crisis.