Just when I thought I had heard it all, here comes another working paper from the Federal Reserve titled "An Analysis of Government Guarantees and the Functioning of Asset-Backed Securities Markets" by Diana Hancock and Wayne Passmore. This time the topic is about whether the US government should create a bond insurer to guarantee the asset backed securities market. This new bond insurer would act much like Fannie Mae does in the mortgage market. This new insurer would guarantee selected ABS for a premium, which would be invested and used to pay out any losses. The authors note that the securitization market is a great and much needed source of liquidity for financial markets, but it occasionally blows up during crises. The reason for the blow up is because investors suddenly realize that the collateral in the ABS is not quite as a good as they though it was. A "run" ensues, and the market stops functioning, which can lead to liquidity problems within the financial system. To solve this problem there needs to be a bond insurer who act as guarantor of asset backed securities. This would create a viable backstop and prevent the securitization market from seizing up during market panics. Investors could rest assured that the government has effectively abolished all risk in owning ABS (for a small fee and with no counter party risk). It is almost too good to be true. A world without risk.
