Public policy Discussion Papers, Federal Reserve Bank of Boston 09,3
We review the period of the Latin American debt crisis in order to draw policy analogies from that experience for current U.S. credit securitization markets. During the earlier episode the Brady Plan used a zero-coupon U.S. Treasury security to provide a credit enhancement for the troubled assets. This revitalized the market for Latin American debt by: (1) ameliorating the dual solvency problem that affected both creditors and debtors, and (2) revealing asset prices as dominated by risk fundamentals rather than by short-run factors. The cost of the Brady plan was quite small relative to its social benefits. To address today's problems in some U.S. securitization markets, we argue that U.S. policymakers could implement a related form of cash flow enhancement with the potential for achieving similar outcomes. Analyzing the Brady bond credit enhancement as applied to a class of today's mortgage securities reveals that the optimal timing for the credit enhancement targets cash-flows that are somewhat distant from the present and its financial turmoil. An additional benefit of this, in both the Brady Bond case and under our proposal, is that the probability of the program sponsor needing to make payments associated with the enhancement is likely to be lower if the intervention is indeed effective. Hence, refining the timing of the suggested enhancements has two mutually-reinforcing beneficial effects; through this program, an optimally designed large-scale commitment can have a lower final cost for the tax-payer than a smaller one that is more likely to fail.