Systemic Significance of SIFMA’s Local Response

SIFMA’s decision to exclude mortgages coming from a jurisdiction where the threat of eminent domain being exercised is material was a hot topic on Naked Capitalism on 7/20 (last Friday) where it turned into a wrangle about public policy that, IMHO, missed the point of Yves’ blog.

To me, it is an interesting case study in how market microstructure changes.

SIFMA’s justification is that an involuntary seizure of property by the government has the financial effect of a prepayment. The message is, “if you assert government dominance over contractual rights in the private market, then we will not give your government-guaranteed market the benefit of the liquidity coming from the government guarantee.”

I agree with the logic of SIFMA’s response because it can be applied to default risk as well as prepayment risk. How is that? By their own logic, if the holding is liquidated below the nominal value of the loan balance, it has the effect of involuntary prepayment, ie, default. And here’s a bit of economic reality: if you undo a market’s underpinnings, no matter who wins and loses as a result, you must learn to live with less liquidity. At least until a new set of rules is established that everyone agrees to play by.

Any suggestion by SIFMA that its own TBA market is less than homogeneous opens the door to a deeper critique that SIFMA surely did not intend. The TBA market has all the trappings of a contract market without the imposition of criteria to standardize it. Ie, the banks can have their liquidity cake and eat it away from the spotlight of exchange disclosure. Real standardization means measuring and disclosing the credit strength of the loan, not that of its guarantors, before the point of sale.

To have that, well, it would be a first for our mortgage market, and a giant leap forward for financial system integrity.