The Rise and Fall of the U.S. Mortgage and Credit ... - Milken Institute

These bonds are utilized in several European countries, most notably Germany. Currently, since the risk of issuing
such bonds by banks is shifted to other liability holders, including the FDIC, they are limited by the FDIC to 4
percent of liabilities.
Covered bonds should be viewed as a complement to, not a substitute for, securitization. Improvements, however,
should be made so that there is greater leeway to modify mortgage loans that have been securitized in the event of
defaults and to provide greater recourse to the various financial players (such as originators who had little of their
own money at risk) involved in selecting the mortgage loans that are securitized. With both covered bonds and
securitization available, banks can choose between keeping mortgage loans on their balance sheets with required
capital backing or securitize them to eliminate a required capital charge. However, banks must take precaution
when attempting to securitize assets off their balance sheets so they do not get caught short of capital if they must
be brought back onto the balance sheet, as happened during the recent crisis. This, of course, requires greater
scrutiny of off-balance-sheet activities of banks by the regulatory authorities and market participants.
Another issue that merits special attention is the use of various derivatives instruments, especially credit default
swaps. Creating a formal exchange for derivatives is important (and indeed, such an effort is underway as of this
writing) because exchange-traded contracts are centralized, with continuously adjusted margin requirements.
Further, if a trader defaults, the clearinghouse absorbs the losses with the capital contributed by the member firms.
The challenge is to devote more attention to financial activity that is unregulated or lightly regulated, including
off-balance-sheet activity of regulated financial institutions, without excessive, costly, and intrusive regulation
that unduly hampers innovation.
What will promote effective market discipline?
It is asking too much to rely solely on regulators to monitor and safeguard financial institutions and financial
market participants. There is an important role to be played by market discipline. But this requires timely and
adequate disclosure of information, greater transparency regarding risk, and more transparency in ratings from
the rating agencies. Regulators should redouble their efforts to promote market discipline to supplement, if not
lessen, their own authority over the major players in the financial sector.
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