CHAPTER 10 Economic Analysis of Financial Regulation 249 Increased Regulation of Mortgage Brokers Mortgage brokers, who did not have proper incentives to make sure that borrowers could afford to pay back mortgages and were virtually unregulated, are now likely to be subjected to more regulatory scrutiny Licensing requirements for mortgage originators are likely to be tightened up, and more regulations will require them to disclose mortgage terms more clearly and prevent them from encouraging borrowers to take on more debt than they can afford Fewer Subprime Mortgage Products Some of the complex mortgage products that were offered to subprime borrowers may be banned by regulation Even with full disclosure of these products characteristics, they may still be so complicated that subprime borrowers, who are unlikely to be financially sophisticated, cannot understand them and make informed choices Government ban or regulation of certain mortgage products might help prevent subprime borrowers from getting in over their heads again in the future Regulation Compensation Compensation schemes for all the parties in the chain from origination of mortgages to the eventual distribution of mortgage-related securities may be constrained by government regulation The high fees and executive compensation that have so outraged the public created incentives for the financial industry to push out securities that turned out to be much more risky than advertised and proved to be disastrous Higher Capital Requirements Regulation and supervision of financial institutions to ensure that they have enough capital to cope with the amount of risk they take are likely to be strengthened Given the risks they were taking, investment banks did not have enough capital relative to their assets and their risky activities Similarly the capital at AIG was not sufficient to cover the high risk it was taking by issuing credit insurance Capital requirements will almost surely be beefed up for these institutions Capital requirements at banks are also likely to be tightened up, particularly for some of their off-balance-sheet activities Banks sponsoring of structured investment vehicles (SIVs), which were supposedly off-balance-sheet but came back on the balance sheet once the SIVs got into trouble, indicate that some off-balance-sheet activities should be treated as though they were on the balance sheet Additional Regulation of Privately Owned GovernmentSponsored Enterprises New regulations are needed to rein in privately owned government-sponsored enterprises such as Fannie Mae and Freddie Mac in the United States There are four routes that the U.S government might take here: Fully privatize them by taking away their government sponsorship, thereby removing the implicit backing for their debt Completely nationalize them by taking away their private status and make them government agencies Leave them as privately owned government-sponsored enterprises, but strengthen regulations to restrict the amount of risk they take and to impose higher capital standards Leave them as privately owned government-sponsored enterprises, but force them to shrink dramatically in size so they no longer expose taxpayers to huge losses or pose a systemic risk to the financial system when they fail