Ricardo Cabellero on the Credit Crunch

Ricardo Cabellero is the Ford International Professor of Economics at MIT, Co-Director of the World Economic Laboratory, and Head of the Economics Department. He has just written a pair of columns for VoxEU, liberally sprinkled with accessible references addressing first the causes of the credit crunch and secondly his prescriptions for future policy.

I was immediately impressed by his rejection of currently fashionable scapegoating:

There is an emerging consensus on the causes of the crisis which essentially rehashes an old list of complaints about potential excesses committed in the phase prior to the crisis. The sins include uncontrolled global imbalances, unscrupulous lenders, and an insatiable Wall Street, all of them lubricated by an ever expansionary Federal Reserve.

It follows from this perspective that the appropriate policy response is to focus on reducing global imbalances, boosting financial regulation, bringing down leverage ratios, and adding bubble-control to the Fed’s mandate.

I do not share this consensus view and its policy prescriptions

I have often complained – e.g., yesterday – that the targetting of “perverse incentives” as the root of all evil misses the point. You have to sell what you manufacture. If you can’t sell it, no profit for the company, no bonus. Targetting Wall Street and its 30-year-old traders implicitly absolves the grey-haired financial managers and regulators who created the demand, bought the product, and demanded more.

I will point out that it is very difficult to talk an investor out of making money. You can convince them that a future investment making $1 a month has $10 worth of risk and should be avoided. You can commiserate with them after they’ve lost their $10. But in between, don’t try telling somebody who has just made $1 that he was lucky, not smart.

For quite some time, but in particular since the late 1990s, the world has experienced a chronic shortage of financial assets to store value. The reasons behind this shortage are varied. They include the rise in savings needs by aging populations in Japan and Europe, the fast growth and global integration of high saving economies, the precautionary response of emerging markets to earlier financial crises, and the intertemporal smoothing of commodity producing economies.

Moreover, because of the US’s role as the centre of world capital markets, much of the large global demand for financial assets has been channelled toward US assets. This has been the main reason for the large global “imbalances” observed in recent years. The large current account deficits experienced by the US are simply the counterpart of the large demand for its assets.

I once asked an economist I respect about the US current account deficit and financing by US debt. Could the root cause, I asked, be a demand for US debt by the rest of the world, rather than US demand for foreign goods? I didn’t get much of an answer … I should have asked Cabellero!

However, there was one important caveat that would prove crucial later on. The global demand for assets was particularly for very safe assets – assets with AAA credit ratings. This is not surprising in light of the importance of central banks and sovereign wealth funds in creating this high demand for assets. Moreover, this trend toward safety became even more pronounced after the NASDAQ crash.

Soon enough, US banks found a “solution” to this mismatch between the demand for safe assets and the expansion of supply through the creation of risky subprime assets; the market moved to create synthetic AAA instruments.

Wall Street met the demand of blind investors. What’s unusual about that? I have also noted some academic experimental work indicating that the price of an asset tends to increase to the money available to buy it, regardless of intrinsic quality.

The AAA tranches so created were held by the non-levered sector of the world economy, including central banks, sovereign wealth funds, pension funds, etc. They were also held by a segment of the highly-levered sector, especially foreign banks and domestic banks that kept them on their books, directly and indirectly, as they provided attractive “safe” yields. The small toxic component was mostly held by agents that could handle the risk, although highly levered investment banks also were exposed.

Much of the focus on the regulatory and credit agency mistakes highlights the fact that the AAA tranch seems to have been too large relative to the “true” capacity of the underlying risky instruments to create such a tranch. While I agree with this assessment, I believe it is incomplete and, because of this, it does not point to the optimal policy response.

Instead, I believe the key issue is that even if we give the benefit of the doubt to the credit agencies and accept that these instruments were indeed AAA from an unconditional probability of default perspective (the only one that counts for credit agencies), they were not so with respect to severe macroeconomic risk.

This created a highly volatile concoction where highly levered institutions of systemic importance were holding assets that were very vulnerable to aggregate shocks. This was an accident waiting to happen.

It’s very hard to forecast a paradigm shift. If the people being advised are making good money, they won’t listen to such a forecast anyway. Even if they do acknowledge the possibility of such an event, they will be serenely confident of their ability to recognize the turning point when it happens and cash out at the top.

To paraphrase a recent secretary of defence, risk refers to situations where the unknowns are known, while uncertainty refers to situations where the unknowns are unknown. This distinction is not only linguistically interesting, but also has significant implications for economic behaviour and policy prescriptions.

There is extensive experimental evidence that economic agents faced with (Knightian) uncertainty become overly concerned with extreme, even if highly unlikely, negative events. Unfortunately, the very fact that investors behave in this manner make the dreaded scenarios all the more likely.

Worsening the situation, until very recently, the policy response from the US Treasury exacerbated rather than dampened the uncertainty problem.

Early on in the crisis, there was a nagging feeling that policy was behind the curve; then came the “exemplary punishment” (of shareholders) policy of Secretary Paulson during the Bear Stearns intervention, which significantly dented the chance of a private capital solution to the problem; and finally, the most devastating blow came during the failure to support Lehman. The latter unleashed a very different kind of recession, where uncertainty ravaged all forms of explicit and implicit financial insurance markets.

In the second column, Dr. Cabellero developes the “financial insurance” theme:

An economy with no financial insurance operates very differently from the standard modern economies we are accustomed to in the developed world.
  • There is limited uncollateralized or long-term credit (since such loans always have an insurance built in through the possibility of default),
  • the risk premium sky-rockets,
  • economic agents hoard massive amount of resources for self-insurance and real investment purposes.

During the last quarter of 2008 we witnessed the beginning of a transition from an economy with insurance to one without it.

Fair enough! That’s as good a summary as any I’ve seen. But what are the implications?

At this juncture of the crisis there are mountains of investment-ready cash waiting for some indication that the time to enter the market has arrived. But investors are frozen staring at each other, and by so doing, they are further dragging the economy downward. The normal speculative forces that trigger a recovery are for everybody to want to arrive first, to “make a killing.” But with so much fear around us, investors have changed the paradigm and they are now content with letting somebody else try his or her luck first, so we are stuck.

We need to reverse this mechanism by restoring the appetite for arriving first.

My sense is that, to a first order of approximation, the correct policy response should build on the following three observations:
  • Many of the ex-ante “imbalances” are more structural in nature than is implied in the consensus view, and hence will remain with us long after the crisis is over.
  • They stem from a global excess demand for financial assets and, especially, for AAA financial assets.
  • The main policy mistakes took place during rather than prior to the crisis.


Contrary to what investors thought at the peak of the boom, the (private) financial sector in the US is not able to satisfy the global demand for AAA assets when large negative aggregate events take place. However, the US government does have the capacity to fill this gap, especially because it is the recipient of flight-to-quality capital.

As long as the government becomes the explicit insurer for generalised panic-risk, we can in the medium run go back to a world not too different from the one we had before the crisis (aside from real estate prices and the construction sector).

This must be acknowledged in advance, and paid for by the insured institutions. Reasonable concerns about transparency, complexity, and incentives can be built into the insurance premia. Collective deleveraging, as currently being done, should not constitute the core response; macroeconomic insurance should.

The recent government intervention with respect to Citi – with its mixture of (paid) insurance and capital – is a promising precedent. So too was the second government package for AIG.

These interventions need to be scaled up to the whole financial system (banks and beyond), and it is better to do it all at once, for in this case the likelihood of the government ever having to disburse funds for its insurance provision becomes remote.

In all these contexts, trimming the (lower) tail-risk offers the biggest bang-for-the-buck. In this sense, capital injections are not a particularly efficient way of dealing with the problem unless the government is willing to invest massive amounts of capital, certainly much more than the current TARP. The reason is that Knightian uncertainty generates a sort of double-(or more)-counting problem, where scarce capital is wasted insuring against impossible events (Caballero and Krishnamurthy 2008b).

Does this mean that there is no role for capital injections? Certainly not. Knightian uncertainty is not the only problem in financial markets, and capital injections are needed for conventional reasons as well. The point is simply that these injections need to be supplemented by insurance contracts, unless the government is willing to increase the TARP by an order of magnitude (i.e. measure it in trillions).

Very well argued!

It is amusing to note – given the tendency to blame complexity nowadays – that the “insurance contract” represents a Credit Default Swap on the equity tranche of a tiered product made up of other tiered products, ie. CDO-squared. Ha-ha!

And, as it happens, there is a manner in which private companies can apply this prescription – more or less – on the public markets.

Assiduous Readers will remember that Manulife got into difficulty with its seg-fund guarantees. The problem is that they are – as managers – ascribing a very low probability to those guarantees being required, while at the same time they are – as regulated bodies – ascribing a higher probability to the melt-down scenario. Sound familiar?

So here’s a modest proposal … and I’ll use Manulife as an example, but any institution with any clearly definable tail-risk will do:

  • MFC sets up a wholly owned subsidiary that provides disaster insurance to the parent.
  • The sub is capitalized with $1-billion
  • The sub buys government bonds (preferrably strips, but any immunized portfolio will do) worth, say $1.2-billion in ten years.
  • The sub sells ten-year disaster insurance to the parent on commercial terms; e.g. “If the TSX is below X in 10 years, sub pays parent $1.2-billion.”
  • Parent distributes all the common of the sub to the parent’s shareholders.

MFC has the money to do this. According to their Annual Report, they spent $2.245-billion on share buybacks in 2007 and $1.631-billion in 2006. Just divert some money from that.

With this plan, MFC reduces its vulnerability to tail risk, while at the same time giving the shareholders the benefit of the positive (as perceived by management) net present value of the insurance. As a bonus, the risk has been unbundled for investors to retain or dump, as they see fit.

Update, 2009-1-26: Aleablog supports the Caballero plan. Dealbreaker is somewhat suspicious.

4 Responses to “Ricardo Cabellero on the Credit Crunch”

  1. […] also comments on the Caballero Insurance Plan that I have previously written about: Typically when Congress can’t get the political backing to actually pass a bill to pay for […]

  2. […] every effort yet to persuade banks to sell their so-called toxic assets has failed. I think that Caballero’s plan has a better chance of […]

  3. […] Caballero’s idea of ‘tail-insurance’ is the best way forward. […]

  4. […] J. Caballero, last mentioned on PrefBlog in connection with tail-risk insurance, presented a paper titled The “Surprising” Origin of Financial Crises: A Macroeconomic […]

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