A policy proposal to manage the risk of leveraged MBS and CDO purchases

Abstract

This article presents a Monte Carlo-based mechanism for systematically curbing the risk borne by lenders when extending loans for the purchase of mortgage-backed securities (MBS) or collateralized debt obligations (CDOs) on leverage as investment vehicles. On the basis of the contention that the recent credit crisis of 2008 was chiefly derived from perverse incentives created by the enormous borrowing appetite of the hedge funds and other market participants and the fallacious appearance of credit default swaps, the authors propose a more rigorous implementation of well-known mechanisms for systematically quantifying risky debt interest rates, along with a government policy to require capital reserves and regulate maximum leverage, which would have quelled the real estate bubble that burst in 2008, still unfolding today. A thrust towards the potential systematic implementation of the suggested debt risk curbing mechanisms as a precondition to originating loans by the banking community, thus constituting potentially enforceable policy matter for urgent prudential regulation of the financial markets in the future, hints at the new light under which banks should consider dynamically managing their capital reserve structures. This could contribute to the safe continued growth of the CDO and MBS derivatives markets, while shifting the focus of value creation for bank stockholders to asset growth without undue systematic risk. The authors also recommend academia to consider emphasizing the teaching of risk management and the pricing of risky debt in the MBA curricula, given the pivotal role MBA graduates have in providing intellectually intensive labor to banks and other financial institutions.