TAILIEUCHUNG - Can Covered Bonds Resuscitate Residential Mortgage Finance in the United States?

By estimating the default jump risk premium, this paper essentially tests the assumptions underlying the conditional diversification hypothesis of JLY (2001). These authors prove that, if default jumps are conditionally independent across firms and if the economy contains an infinite number of bonds, default jump risk cannot be priced. Intuitively, in this case the default jump risk can be fully diversified. Our results indicate that default jumps are not conditionally independent across firms and/or that not enough corporate bonds are traded to fully diversify default jump risk. A particularly appealing explanation for the existence of a default jump risk premium is that investors take into account the. | WP 10 277 Can Covered Bonds Resuscitate Residential Mortgage Finance in the United States Jay Surti INTERNATIONAL MONETARY FUND 2010 International Monetary Fund WP 10 277 IMF Working Paper Monetary and Capital Markets Department Can Covered Bonds Resuscitate Residential Mortgage Finance in the United States 1 Prepared by Jay Surti Authorized by inci Otker-Robe December 2010 Abstract This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author s and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author s and are published to elicit comments and to further debate. This paper considers the case for mortgage covered bonds as an alternative to the originate-to-distribute mortgage funding model. It argues that the economic incentives provided to market participants under the covered bonds model are less susceptible to moral hazard even while retaining the key benefits of securitization such as capital market funding and flexibility in risk allocation. Notwithstanding these advantages however limited market size and the greater pro-cyclicality of mortgage loan quality in the United States potentially reflecting borrower incentives under the personal bankruptcy framework impose limits on the benefits ensuing from this model. The analysis underscores the need for a comprehensive legal-regulatory framework to underpin market development and discusses a number of ways in which the current draft legislation may be further strengthened. A potential strategy to hasten market development within the current institutional framework is identified. JEL Classification Numbers G18 G32 G33 K35 L22 L23 L24 L85 Keywords Covered bonds mortgage-backed securities personal bankruptcy United States. Author s E-Mail Address isurti@ 1 I thank Ashok Bhatia inci Otker-Robe David Parker and especially Robert Sheehy for helpful comments and .

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