A Comparison of the Bush-Paulson Plan and a Plan Based on Mortgage Guarantees

I compare the Bush-Paulson plan of intervention in secondary markets for mortgage-backed securities (MBS) with an alternative based on insuring mortgages directly. Fully insuring mortgages achieves the same bottom-line effect as buying all outstanding MBS but instantaneously with no upfront costs. A plan based on partial insurance can match most effects of a partial Paulson-style intervention. Mortgage insurance also has advantages of transparency and simplicity and would probably be more politically popular. Model A bank has a portfolio consisiting of zero cash and a distribution of illiquid mortgage claims each with a face value that is normalized to 1 and an idiosyncratic default probability p. The cumulative distribution of p across the bank’s portfolio is denoted F . The value of p for each individual mortgage in the portfolio is the bank’s private information. The Bush-Paulson intervention. In the Bush-Paulson plan, the government offers a price 1− z which induces the bank to sell all mortgages having a default probability p ≥ z. The fraction of such mortgages in the portfolio ∗Department of Economics, Northwestern University. I thank Rob Shimer for helfpful coments. This is the adverse-selection problem due to asymmetric information about p that limits the effectiveness of the Bush-Paulson intervention.