PrefBlog

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.

DBRS has announced that it:

today assigned final ratings of “A” to the Master Asset Vehicle I Class A-1 Notes and Class A-2 Notes and the Master Asset Vehicle II Class A-1 Notes and Class A-2 Notes. DBRS has also assigned final ratings to certain of the Master Asset Vehicle III Notes as follows: Class 5A Notes – AAA, Class 7A Notes – AAA, Class 10A Notes – AA (high), Class 12A Notes – AA (high), Class 15A Notes – AAA and Class 16A Notes – A (low).

There was a teleconference at noon today; slides are available.

I have no information as yet regarding quotations on these instruments. I suspect that these notes will not be available to retail because, you know, you’re just not smart enough.

Update: A replay of the teleconference is available:

until the close of business on January 28, 2009.
…
The teleconference presentation slides are also available at www.dbrs.com or by clicking the link below.

TELECONFERENCE REPLAY ACCESS NUMBERS
Telephone: +1 416 695 5800 or +1 800 408 3053
Pass Code: 328-1452

Willem Buiter has an excellent blog post today advocating that the UK nationalize all “high-street” banks:

But even if the UK is not the next European country to face a sovereign debt challenge, there is a non-negligible risk that before too long, the growing exposure of the British sovereign to the banking system (and especially to the foreign currency funding risk faced by the UK banking system), together with the 9 and 10 percent of GDP general government fiscal deficits expected for the next couple of years, may prompt a loss of confidence by the global financial community in the British banks, currency and sovereign.

We may well witness the UK authorities going cap-in-hand to the IMF, the EU, the ECB and the fiscally super-solvent EU member states (if there are any left), prompted by a triple crisis (banking, sterling and sovereign debt), to request a bail out.
…
The balance sheets of the British banks are too large and the quality of the assets they hold too uncertain/dodgy, for the British government to be able to continue its current policy of extending its guarantees to ever-growing shares of the banks’ liabilities and assets, without this impairing the solvency of the sovereign.
…
Limiting the exposure of the sovereign to what is fiscally sustainable may imply giving up on saving (all of) the banks.

This builds upon his analysis of the Icelandic situation, which was discussed on November 5.

What caught my eye,however, was the massive numbers involved in British banking:

RBS, at the end of June 2008 had a balance sheet of just under two trillion pounds. The pro forma figure ws £1,730 bn, the statutory figure £1,948 (don’t ask). For reference, UK GDP is around £1,500 bn. Equity was £67 bn pro forma and £ 104bn statutory, respectively, giving leverage ratios of 25.8 (pro forma) and 18.7 (statutory), respectively.
…
Lloyds-TSB Group (now part of the Lloyds Banking Group) reported a balance sheet as of June 30, 2008 of £ 368 bn and shareholders equity of £11 bn, giving a leverage ratio of just over 33. Of course, for all these banks, the risk-adjusted assets to capital ratios are much lower, but because the risk-weightings depend both on private information of the banks (including internal models) and on the rating agencies, they are, in my view, worth nothing – they are the answer from the banks to the question “how much capital do you want to hold?”. That the answer is “not very much, really”, should not come as a surprise. For the same date, HBOS, the other half of the new Lloyds Banking Group, reported assets of £681 bn and equity of £21 bn, giving a leverage ratio of just over 32; Barclays reported total assets of £1,366 bn and shareholders equity of £33bn giving a leverage ratio of 41, and HSBC (including subsidiaries) reported assets of £2,547 bn and equity of £134 bn for a leverage ratio of 19.

The total balance sheets of these banks about to around 440% of annual UK GDP.

440%! While it must be remembered that a balance sheet is a measure of wealth, while GDP is a measure of income, this is a staggering figure anyway.

And let us not forget the mechanism whereby Royal Bank of Scotland got into trouble:

The scale of losses at RBS is breathtaking. The bank, which also owns NatWest, estimated that bad debts and writedowns on past acquisitions could leave it as much as £28 billion in the red for 2008, nearly double Vodafone’s record £15 billion loss in 2006.

The bank’s admission that it had paid between £15 billion and £20 billion too much for the Dutch bank ABN Amro last year prompted an angry response from Mr Brown.

The Prime Minister was furious that British taxpayers were now having to pay for losses that were incurred on foreign investments.

“Almost all their losses are in the sub-prime markets in America and related to the acquisition of the bank ABN Amro,” he said. “And these are irresponsible risks which were taken by a bank with people’s money in the United Kingdom.”

So, I took myself to the OSFI Bank Data Lookup Page and found that “Total All Banks CONSOLIDATED MONTHLY BALANCE SHEET” as of November 30 showed total assets of $3,213,563-million, supported by common equity of $122,117-million, preferred shares of $14,205-million, and sub-debt of $41,235-million (I’m pretty sure that OSFI’s line for sub-debt includes Innovative Tier 1 Capital). So, for quick comparison purposes, banks reporting to OSFI lever up their common equity with a ratio of 26:1 (total capital is levered up 18:1).

Also, Statistics Canada reports that Canada’s GDP at current prices is $1,639,540-million … so, rounding off a few million here and there, we arrive at a bank asset to GDP ratio of about 200% … well below the UK figure, even though the UK figure includes only their megabanks, while I have no reason to believe that the OSFI figure is not comprehensive.

It’s early days yet, but I’m beginning to wonder whether or not banking regulation should be rationed … Canada might say, for instance, “Only 300% of GDP will be allowed. Licences to purchase the right to have regulated – and implicitly protected – assets will be auctioned off annually for staggered 5- and 10-year terms.” Only a rough idea, but rough ideas are where good ideas come from … sometimes, eventually.

Such rationing runs the risk – if you want to call it that – of bloating the shadow-banking system, made up of things like non-banking leasing companies, payroll cheque cashing outfits, hedge funds and, currently, money market funds but that is not necessarily a bad thing.

James Hamilton of Econbrowser has posted an interesting piece Signs of a Thaw in which he points out that the Fed balance sheet is shrinking:

Good news indeed, although I want do do a little work attempting to estimate the proportions of total debt that the Fed is financing. The last post in this series of notes was Financing the Fed’s Balance Sheet.

Maybe I’m just a suspicious person. Maybe I’m too cynical. And I always worry about cluttering up this blog with politics, which in normal times is irrelevant to real life – for which westerners in general and Canadians in particular can be very grateful.

But two stories in the Globe today were on the same page:Economists’ advice to Flaherty: Cut taxes now:

At the Economic Club of Canada’s annual outlook roundtable, economists from the country’s five biggest banks called on Mr. Flaherty to make tax cuts and well-focused infrastructure spending the centerpieces of his Jan. 27 budget, and to resist futile bailouts for dying industries.

They also called on the Bank of Canada to continue cutting its interest rates to lend further stimulus to the struggling economy and credit markets.

And they stressed that any personal tax cut – something Mr. Flaherty has already hinted could be in the budget – needs to be permanent if it’s going to be effective, and needs to be offset in future years by reining in government spending.

A permanent tax cut starting now, to be offset by spending cuts, er, later? Haven’t I seen this movie before? The very suggestion is thoroughly irresponsible.

I will also point out that permanent tax cuts have very little stimulatory effect compared to other forms of stimulus:

The chart is from Moody’s Economy.com chief economist Mark Zandi’s testimony to the US House Committee on Small Business.

Why would the banks – and remember, sell-side economists are similar to sell-side analysts of any other description: sold for entertainment value only – be pushing such an lunatic plan that so conveniently fits into Spend-Every-Penny’s electoral strategy? Here’s a clue, in a story titled Loosen capital rules, banks ask watchdog:

The big banks are pushing Canada’s financial services regulator to loosen the rules about what counts as capital, a change that they say would enable them to hand out more loans.

Bank chief executive officers brought up the issue at this week’s meeting with the Finance Minister, the central bank Governor and the banking regulator, according to sources familiar with the discussion.

They want Julie Dickson, the head of the Office of the Superintendent of Financial Institutions, to let them develop new hybrid financial instruments that would count toward their capital ratios.
…
OSFI gave the banks new leeway in November, when it raised the level of preferred shares they could count as capital. As a result, the banks have been issuing a flurry of them. This week alone, Bank of Nova Scotia and Royal Bank of Canada each said they will sell $200-million worth of preferred shares, and Toronto-Dominion Bank said it is selling $300-million.

But bankers say they can’t issue enough preferred shares to use up all of the room OSFI has given them, because there is not enough demand from investors. Part of the problem, they say, is that pension funds are not inclined to buy preferred shares because of tax rules. So the banks want to develop a hybrid instrument that will generate higher demand from institutional investors.

Other countries give banks more flexibility when it comes to what types of instruments count as Tier 1 capital.

It is not clear just what is meant by the last paragraph – just what, precisely, are the banks asking for that is not permitted here but permitted elsewhere? The have recently been allowed to issue cumulative Tier 1 Capital with a set maturity, something that virtually unknown anywhere else.

Remember that OSFI is not independent: I’m sure Julia Dickson remembers who’s the boss – and why that’s important.

OSFI has shown gross irresponsibility in the past year, with no more public justification that bland reassurances that they know what’s best. It would be a tragedy if Canadian banking regulation were to be gutted as part of deal for the banks to support a boneheaded electoral strategy.

The SEC has announced that it:

today delivered a report to Congress mandated by the Emergency Economic Stabilization Act of 2008 that recommends against the suspension of fair value accounting standards. Rather, the 211-page report by the SEC’s Office of the Chief Accountant and Division of Corporation Finance recommends improvements to existing practice, including reconsidering the accounting for impairments and the development of additional guidance for determining fair value of investments in inactive markets, including situations where market prices are not readily available.
…
Among key findings, the report notes that investors generally believe fair value accounting increases financial reporting transparency and facilitates better investment decision-making. The report also observes that fair value accounting did not appear to play a meaningful role in the bank failures that occurred in 2008. Rather, the report indicated that bank failures in the U.S. appeared to be the result of growing probable credit losses, concerns about asset quality, and in certain cases, eroding lender and investor confidence.
…
While the report does not recommend suspending existing fair value standards, it makes eight recommendations to improve their application, including:

• Development of additional guidance and other tools for determining fair value when relevant market information is not available in illiquid or inactive markets, including consideration of the need for guidance to assist companies and auditors in addressing:
  • How to determine when markets become inactive and whether a transaction or group of transactions are forced or distressed
  • How the impact of a change in credit risk on the value of an asset or liability should be estimated
  • When should observable market information be supplemented with and/or reliance placed on unobservable information in the form of management estimates
  • How to confirm that assumptions utilized are those that would be used by market participants and not just a specific entity
• Enhancement of existing disclosure and presentation requirements related to the effect of fair value in the financial statements.
• Educational efforts, including those to reinforce the need for management judgment in the determination of fair value estimates.
• Examination by the FASB of the impact of liquidity in the measurement of fair value, including whether additional application and/or disclosure guidance is warranted.
• Assessment by the FASB of whether the incorporation of credit risk in the measurement of liabilities provides useful information to investors, including whether sufficient transparency is provided currently in practice.

The full report is available on-line.

Whoosh! This will take a certain amount of work to understand!

The Federal Reserve has announced:

that it expects to begin operations in early January under the previously announced program to purchase mortgage-backed securities (MBS) and that it has selected private investment managers to act as its agents in implementing the program.

Under the MBS purchase program, the Federal Reserve will purchase MBS backed by Fannie Mae, Freddie Mac, and Ginnie Mae; the program is being established to support the mortgage and housing markets and to foster improved conditions in financial markets more generally.

Of great interest are the published FAQs:

How will purchases under the agency MBS program be financed?
Purchases will be financed through the creation of additional bank reserves.

It is not clear to me just what this means. Will the Fed be getting a deposit from Treasury, financed by sale of Treasuries? Or will they finance it via a bookkeeping entry, aka “printing money”?

One way or another, watching the Fed’s balance sheet has been a lot more interesting than normal lately!

Update, 2008-12-31: Another interesting thing about this is the lack of duration hedging. Players will often hedge the duration hedging of an MBS portfolio by taking market action in Treasuries and entering fixed-receive swaps:

As a consequence of record levels of refinancing in the second half of 2002 and the first half of 2003–which, by our estimates, encompassed roughly 45 percent of the total value of home mortgages outstanding–MBS duration fell to exceptionally low levels. As mortgage and other long-term rates rebounded last summer, a consequence of rapidly improving economic conditions and the fading of deflationary concerns, refinancing fell sharply, removing most downward pressure on duration. Holders of MBS endeavoring to hedge developing interest rate gaps rapidly shed receive-fixed swaps and Treasuries, and these actions markedly aggravated last summer’s long-term interest rate upturn.

There’s a comment on an unsigned blog:

Credit spreads on corporate debt have generally made yet another explosive move higher, as treasury yields have imploded in the recent blow-off move in government notes and bonds. Note in this context that we have once again a case of ‘unintended consequences’ at work here, as the implosion in treasury yields can be attributed directly to the Fed’s decision to [monetize] $800 bn. in MBS and ABS, forcing duration hedging of large MBS portfolios.

James Hamilton of Econbrowser writes another marvellous review of the Fed’s Balance sheet, updating his prior commentary which was also reviewed on PrefBlog.

One thing I had been unclear about was the precise nature of the “Supplementary Financing Program Account” of Treasury at the Fed, which is financing all the special programmes. While the assertion has been made that the Fed’s intervention is sterilized (meaning that it is causing no increase in monetary aggregates) … I wasn’t sure. However, the Monthly Treasury Statement referenced by Dr. Hamilton shows clearly (Table 6 on page 20) that Treasury has issued about $630-odd billion in Treasury Securities in fiscal 2009 to date, of which $588-billion has been from the public. This more than covers the $134-billion increase in the Supplementary Account, while still leaving $402-billion to finance the deficit … which is the total deficit for F2009 reported in Table 5 on page 18.

OK, so that’s cleared up!

Dr. Hamilton concludes:

For the record, let me reiterate my personal position on all this.

(1) I am doubtful of the Fed’s ability to alter interest rate spreads through the kinds of compositional changes in its balance sheet implemented over the last two years. Whatever your prior ideas were about this, surely it’s time to revise those in light of incoming data– if the first trillion dollars didn’t do the job, how much do you think it would take to accomplish the task?

(2) I think the Fed’s goal should be a 3% inflation rate. Paying interest on reserves and encouraging banks to hoard them is inconsistent with that objective, as would be a new trillion dollars in money creation.

I would therefore urge the Fed to eliminate the payment of interest on reserves and begin the process of replacing the exotic colors in the first graph above with holdings such as inflation-indexed Treasury securities and the short-term government debt of our major trading partners.

I’m not sure that point 1 is phrased in a useful manner. As I see it, the objective is not so much to maintain spreads as it is to ensure that the market exists at all. It has been observed that securitization has declined, which has had essentially forced banks to intermediate between borrowers and lenders, as opposed to simply engaging in the disintermediation inherent in packaging their loans and taking the spreads and servicing fees.

John Kiff, Paul Mills & Carolyne Spackman wrote a piece for VoxEU, European securitisation and the possible revival of financial innovation:

Collapsing global securitisation volumes in the wake of the subprime crisis have raised fundamental questions over the viability of the originate-to-distribute business model.1 Issuance has dropped precipitously in both Europe and the US, with banks keeping more loans on their balance sheets and tightening lending standards as a result (Figure 1). The decline has been particularly sharp for mortgage-backed securities and mortgage-backed-securities-backed collateralised debt obligations. The originate-to-distribute model was thought to have made the financial system more resilient by dispersing credit risk to a broad range of investors. Ironically, however, it became the source of financial instability.
…
The risk transfer and capital saving benefits of securitisation, combined with underlying investor demand for securities, should eventually revive issuance. But the products are likely to be simpler, more transparent, and trade at significantly wider spreads.

All that lost securitization issuance is staying on banks’ balance sheets and there are only a few possibilities:

• let the market collapse: in this case, banks will simply cease to make new loans; their balance sheets won’t take the strain and they can’t really issue new equity while the markets are so awfully depressed without really sticking it to their existing shareholders, or
• let the markets adjust.

An adjustment in the market can take place in several different ways:

• banks can re-intermediate: this will require balance sheet expansion, which can’t happen until they can sell equity at reasonable prices, or
• securitization markets can get restarted

I suggest that it is a Public Good for securitization markets to restart and agree with Kiff et al. that this will likely be accompanied by greater transparency and wider spreads. Trouble is, nobody knows what those spreads will be like.

What should the spread of mortgages over governments be? Agency spreads in the US were minimal prior to the current crisis and it seems clear to me that they should be wider. I’ve tried to find an easy graph for mortgage spreads in Canada – where securitization is nowhere near as important – but the best I’ve been able to come up with is a chart from 1999:

Mortgages are not, perhaps, the best example to choose because as I have repeatedly noted, there is a lot more that’s wrong with the American mortgage market than mere sub-prime:

Americans should also be taking a hard look at the ultimate consumer friendliness of their financial expectations. They take as a matter of course mortgages that are:

• 30 years in term
• refinancable at little or no charge (usually; this may apply only to GSE mortgages; I don’t know all the rules)
• non-recourse to borrower (there may be exceptions in some states)

• guaranteed by institutions that simply could not operate as a private enterprise without considerably more financing
• Added 2008-3-8: How could I forget? Tax Deductible

Clearly, in the particular case of US mortgages, the underlying pools must not just trade at wider spread, but they must be more investor friendly.

However, I do recognize Dr. Hamilton’s desire to put a limit on the amount of reintermediation that is being done by the Fed, but must disagree with the prescription of keeping the balance sheet grossed up with government bonds of any description.

I suggest that a schedule be put into place whereby, for instance, the Commercial Paper Funding Facility have its spreads gradually widened. Rates are now 2.19% for unsecured commercial paper and is scheduled to cease purchasing new paper on April 30, 2009. The current rate paid on excess & required reserve balances is now 0.25%. Thus, it is apparent that in the current environment, a spread of 194bp is not enough to get the banks to move into commercial paper in a big way. The same applies to the general public.

I suggest that this is a distress-level spread, being paid for CP of perfectly good quality; indicating a flight to safety. Eventually the climate of blind fear will dissapate, but until that happens the Fed should continue to apply the implicit Bagehot prescription of making credit freely available at punitive rates. And, perhaps, announce that the programme will be extended past April, but at spreads on CP of 110+110 (for the duration of the extension), rather than the current 100+100. Eventually, one of several things will happen:

• Greed will overcome fear, and banks (et al.) will cease lending to the Fed at 0.25% and start lending to solid companies at 2.25%, or
• Companies will refinance with longer term paper, or
• Companies will go bust.

Menzie Chinn of Econbrowser highlights an exchange between researchers sponsored by the Minneapolis Fed and some sponsored by the Boston Fed.

The Minneapolis group, Patrick J. Kehoe, V.V. Chari and Lawrence J. Christiano, have published Facts and Myths about the Financial Crisis of 2008; this paper has been rebutted in a paper by the Boston Fed’s Ethan Cohen-Cole, Burcu Duygan-Bump, Jose Fillat, and Judit Montoriol-Garriga in a paper titled Looking Behind the Aggregates: A reply to “Facts and Myths about the Financial Crisis of 2008”.

• Bank lending to nonfinancial corporations and individuals has declined sharply
  • Minneapolis claims that:
    • Bank assets less vault cash have remained constant through the crisis
    • Loans and leases by US commercial banks have been constant
    • Commercial and Industrial Loans have been constant
    • Consumer loans have been constant
  • Boston claims that
    • Securitization has declined
    • There has been a significant increase in drawdowns from previously committed loans.
    • Unused lending commitments at commercial banks, especially for commercial and industrial loans, have contracted since the last quarter of 2007.
    • The price of loans (presumed to be related to LIBOR) has increased; spreads between jumbo and conforming mortgages have increased.
• Interbank lending is essentially nonexistent.
  • Minneapolis claims that:
    • Interbank lending has been constant
  • Boston claims that:
    • Data appears to be from Federal Reserve report H8
    • Anecdotal evidence suggest that interbank lending has become largely comprised of overnight loans secured by Treasuries, but H8 is silent on the subject
    • Cash assets of banks have skyrocketted, due to cash hoarding by big banks.
• Commercial paper issuance by non-financial corporations has declined sharply, and rates have risen to unprecedented levels.
  • Minneapolis claims that:
    • Commercial paper outstanding by financial corporations has declined, but non-financial paper has been constant.
    • Financial and lower-grade non-financial rates have increased, but high-grade non-financial rates have been constant.
  • Boston claims that:
    • New issuance by lower-grade non-financial corporations (the lion’s share of the total market) has plumetted since the Lehman default
    • The proportion of “overnight” (1-4 day maturity) paper has increased dramatically

I’ll give game, set and match to the Boston group (especially since Minneapolis ignored the securitization angle), but it’s an interesting exercise in seeing just how complicated things really are; I recommend the papers to any Assiduous Reader who doesn’t mind learning just how superficial is his understanding of the data!

Dr. Chinn also presents some conclusions from Tong & Wei, 2008:

First, we classify each non-financial stock (other than airlines, defense and insurance firms) along two dimensions: whether its degree of liquidity constraint at the end of 2006 (per the value of the Whited-Wu index) is above or below the median in the sample, and whether its sensitivity to a consumer demand contraction is above or below the median. Second, we form four portfolios on July 31, 2007 and fix their compositions in the subsequent periods: the HH portfolio is a set of equally weighted stocks that are highly liquidity constrained and highly sensitive to consumer demand contraction; the HL portfolio is a set of stocks that are highly liquidity constrained, but relatively not sensitive to a change in consumer confidence; the LH portfolio consist of stocks that are relatively not liquidity constrained but highly sensitive to consumer confidence; and finally, the LL portfolio consists of stocks that are neither liquidity constrained nor sensitive to consumer confidence. Third, we track the cumulative returns of these four portfolios over time and plot the results in Figure 6.

Dr. Chinn remarks that

They conclude that about half of the decline in stock prices is due to the credit crunch, with the other half attributable to the decline in consumer confidence

Well, I haven’t read the whole paper! But I will suggest that in using stock prices as a metric, Tong & Wei are not measuring “harm”; they are measuring “investor confidence”, which is not the same thing (Assiduous Readers will be all too well aware of my contempt for the Efficient Market Hypothesis!). However, I may well be in agreeement with Tong & Wei on this point, who state merely:

If subprime problems disproportionately harm those non-financial firms that are more liquidity constrained and/or more sensitive to a consumer demand contraction, could financial investors earn excess returns by betting against these stocks (relative to other stocks)? This is essentially another way to gauge the quantitative importance of these two factors.