New Fed Proposal to Bankrupt America: Government Guarantee of Entire ABS Market

Let us assume for the purpose of argument that our corporate bond market is and always has been backed by federal government insurance. In its many years of operations, companies would float bonds at relatively low interest rates because of the government's guarantee. Industry would be financed for their various projects, and, perhaps because of the lower cost, maybe this would be the preferred financing option for seasoned companies rather than common stock.

If anyone were to suggest that this market should shed its guarantee and rely on the private securities market to finance corporations, I'm sure they would be laughed down by most economists and politicians. They'd use the standard arguments against free markets. Everyone knows that without the guarantee corporate bonds wouldn't get financed, or there isn't sufficient evidence that the private market would finance bonds without the guarantee, or if they did, the lending covenants would be too harsh or the interest rate would be too high for corporations to afford. And, of course, the government has a "strong social interest" in maintaining a stable source of capital for corporations.

We all know, of course, that such thinking is wrong, and that the securities markets can well provide bond financing for business without the government's guarantee.

Yet I just read an article about a forthcoming paper coming from two Fed economists recommending that the federal government guarantee all asset-backed securities.
 

Wayne Passmore and Diana Hancock, the associate director and deputy associate director, respectively, in the division of research and statistics at the Fed -- argue that an explicit backstop of certain asset-backed securities could ensure the stability of the system in future financial crises and help eliminate the concept of "too big to fail" institutions.

"People who hold mortgage-backed securities or asset-backed securities are happy as long as they know there is no credit risk," Hancock said in a recent interview. "When they're really concerned that there is credit risk, they may run. That's not good for a securitization market."

To protect against such securitization runs, which can dry up credit availability, the two economists said an insurance fund should be created to cover catastrophic risks on a wide range of asset classes, including mortgages, credit cards and auto loans.

"We are arguing we should create an FDIC-like entity to explicitly price this form of guarantee," Passmore said in the same interview. "It will capture many of the benefits that have been associated with the GSEs, they will allow the government to accumulate an insurance fund, or reserves, to pay for supporting the fund up front. That's really the essence of why people want the government in the mortgage market. It defines well what the government's role will be."

Just the other day Pimco's Bill Gross said:
 

"Without a government guarantee, mortgage rates would be hundreds -- hundreds -- of basis points higher, resulting in a moribund housing market for years," Gross said.

He said Pimco would not consider investing in a private, or privately insured, mortgage pool unless it was accompanied by 30% down payments -- far above the current norm.