PrefBlog

The Kansas City Fed has released the proceedings of the 2009 Jackson Hole Symposium on Financial Stability and Macroeconomic Policy.

Ricardo J. Caballero, last mentioned on PrefBlog in connection with tail-risk insurance, presented a paper titled The “Surprising” Origin of Financial Crises: A Macroeconomic Policy Proposal, which, rather oddly, has been encrypted. He argues that three elements are necessary to produce a financial crisis:

• Negative Surprise (not that sub-prime blew up, but that linkages were so strong and that transmission was so virulent)
• Excessive Aggregation of Risk in systemically important leveraged institutions
• Slow Policy Response

Dr. Caballero proposes the establishment of Tradable Insurance Credits, issued and backed by the Central Bank. In normal times, these would carry no pay-off; in times of crisis, the Central Bank would make them convertible and holders would have the option of, essentially, converting them into Credit Default Swaps. This addresses the risk of Knightian uncertainty that was addressed in Dr. Caballero’s prior proposals.

Stephen Cecchetti, Marion Kohler & Christian Upper presented a paper titled Financial Crises and Economic Activity, also encrypted. Pretty gloomy stuff – he suggests that even in a best-case scenario, it will take years to make up for the current loss of output. Dr. Cecchetti was last mentioned on PrefBlog on April 10, 2008.

Carl Walsh presented a paper titled Using Monetary Policy to Stabilize Economic Activity, in which he suggests that, overall, Price Level Targetting is superior to Inflation Targetting, due to its automatic stabilizing influence. He cautions, however, that changing horses in mid-stream (mid-raging-torrent might be a better metaphor in this economy) is not advisable. Price Level Targetting was the subject of the BoC Spring 2009 Review and the paper’s respondant was BoC Governor Mark Carney.

Auerbach & Gale presented Activist Fiscal Policy to Stabilize Economic Activity. They explicity exclude “automatic stabilizers” (e.g., Unemployment Insurance, Welfare) from the discussion, focussing more on discretionary fiscal stimulus.

Update, 2009-8-26: Mark Carney’s response to the Walsh paper have been published by BIS.

A kind soul has sent me an unencrypted version of the Caballero paper:

Coval et. al. (2008) argue that the correlation between economic catastrophe and default by highly rated structured products went largely unappreciated by investors, who seemed to treat ratings as a sufficient statistic for pricing. Highly rated single–name CDSs and structured product tranches traded at very similar spreads (their data is for September 2004 to September 20 2007), despite the fact that on average the structured product tranche would likely default in a much worse macroeconomic state.

Regardless of whether this correlation was underappreciated or not, the systemic consequence of this risk was that highly leveraged institutions were bearing more aggregate risk than would have been thought from simply observing the ratings of their assets. Having the highly leveraged financial sector of the economy holding the risk with respect to an aggregate surprise proved to be a recipe for disaster.
…
A standard advice stemming from the moral hazard camp is to subject shareholders to exemplary punishment (the words used by Secretary Paulson during the Bear Stearns intervention). This is sound advice in the absence of a time dimension within crises. With no time dimension, all shareholders were part of the boom that preceded the crisis and as soon as the bailout takes place the crisis is over; the next concern is not to repeat the excesses that led to the crisis. Punishing shareholders means punishing those that led to the current crisis, and it is better that they learn the lesson sooner rather than later, the righteous speech goes.

However, this advice can backfire when we add back the time dimension. Now, the expectation that shareholders will be exemplarily punished if the crisis worsens delays investors’ decision to inject much needed capital. As a concrete example, sovereign wealth funds were much less eager to inject equity into the U.S. financial system after the Bear Stearns exemplary punishment policy (March 2008) than they were before the policy, as illustrated in Figure 6. Some of the capital injections that did take place after this, such as UFJ Mitsubishi’s $9 billion investment in Morgan Stanley in October 2008, only took place after the U.S. Treasury assured them that the investment would not be wiped out in a future government intervention. Conversely, destabilizing speculators and shortsellers saw the value of their strategy reinforced by the policy of exemplary punishment.23 Moreover, from the point of view of future crises, memories of this intervention may also hamper any chance of a private sector resolution as new equity will be less likely to attempt to arbitrage the initial fire sales. In other words, once the within-crisis time dimension is considered, the anti-moral hazard strategy may morph into a current and future crisis enzyme.

An interesting paper by Bernadette A. Minton & René Stulz & Rohan Williamson is How Much Do Banks Use Credit Derivatives to Hedge Loans?:

Before the credit crisis that started in mid-2007, it was generally believed by top regulators that credit derivatives make banks sounder. In this paper, we investigate the validity of this view. We examine the use of credit derivatives by US bank holding companies with assets in excess of one billion dollars from 1999 to 2005. Using the Federal Reserve Bank of Chicago Bank Holding Company Database, we find that in 2005 the gross notional amount of credit derivatives held by banks exceeds the amount of loans on their books. Only 23 large banks out of 395 use credit derivatives and most of their derivatives positions are held for dealer activities rather than for hedging of loans. The net notional amount of credit derivatives used for hedging of loans in 2005 represents less than 2% of the total notional amount of credit derivatives held by banks and less than 2% of their loans. We conclude that the use of credit derivatives by banks to hedge loans is limited because of adverse selection and moral hazard problems and because of the inability of banks to use hedge accounting when hedging with credit derivatives. Our evidence raises important questions about the extent to which the use of credit derivatives makes banks sounder.
…
Our evidence helps understand why the use of credit derivatives for hedging is limited. First, the market for credit derivatives is the most liquid for investment grade corporations and for countries. As a result, use of credit derivatives is going to be more intense for firms that have exposures to such credits, which we find to be the case. Second, for non-investment grade corporates, the market for credit derivatives is less liquid. Further, private information is more important for banks for loans to such corporates. As a result, hedging will be more expensive and banks will hedge such loans less. Using disclosures of banks, we find that banks that report hedging across credit ratings hedge relatively more credits that are less risky, which is consistent with our prediction. Finally, hedge accounting cannot typically be used for credit derivatives.
…
For 2005, we show that the total credit protection bought and sold by banks is roughly $5.5 trillion. In comparison, the net protection bought, which is a measure of hedging of credit risks, is roughly $0.5 trillion, or less than 10% of the overall credit derivatives gross positions of banks. While, the net protection bought is small compared to the loans of the banks that have positions in credit derivatives, the gross position of these banks is large compared to the loans they write. Consequently, since credit derivatives are used only to a limited extent to hedge loans, they can only make banks and the financial system sounder if they create few risks for banks when the banks take positions in them for other reasons than to hedge loans. Contrary to the optimistic view of regulators before 2007, the subprime crisis has shown that the dealer positions of banks in credit derivatives have substantial risks.

I’m not sure if it makes much sense for banks to systematically hedge their loan exposures through CDS. It seems to me that the whole point of being a bank in the first place is to hedge your issuer-specific risk through diversification and excess margin.

This is interesting in light of the CIT affair. When CIT drew down its credit lines – as reported on PrefBlog on March 20, 2008, CDS spreads spiked up to 27% up front and 500bp p.a. instantly – I recall, but cannot substantiate the existence of, rumours to the effect that this was due to bank buying.

This would make more sense, since CIT was drawing on credit lines with a pre-arranged spread. The Boston Fed looked at this issue. It is also my understanding that a lot of new lines are being negotiated as a spread off of CDS levels, which strikes me as a much better use of CDS by banks.

I can only hope the authors will re-examine the issue as data from the Credit Crunch trickles in!

James Hamilton of Econbrowser has announced a new paper he has co-authored: The Market-Perceived Monetary Policy Rule:

We introduce a novel method for estimating a monetary policy rule using macroeconomic news. Market forecasts of both economic conditions and monetary policy are affected by news, and our estimation links the two effects. This enables us to estimate directly the policy rule agents use to form their expectations, and in so doing flexibly capture the particular dynamics of policy response. We find evidence that between 1994 and 2007 the market-perceived Federal Reserve policy rule changed: the output response vanished, and the inflation response path became more gradual but larger in long-run magnitude. In a standard model we show that output smoothing caused by a larger inflation response magnitude is offset by the more measured pace of response. Our response coeffcient estimates are robust to measurement and theoretical issues with both potential output and the inflation target.
…
Our baseline results for the 1994-2007 sample suggest the market perceives that the Federal Reserve gradually responds to inflation and real activity. Similar to previous literature working on post-Volcker data, we find the Federal Reserve follows the Taylor Principle, a greater than one-for-one response to inflation. We also find evidence that the market-perceived monetary policy rule changed over our sample. During the 1990s market-perceived policy responded robustly to output and quickly to inflation; during the 2000s market-perceived policy doesn’t respond to output and responds at a more measured pace to inflation, though its long-run inflation response is greater than before. We quantify the importance of the inflation response path and long-run magnitude in a standard model, and find that raising the long-run magnitude is effective at lowering inflation volatility while making the path more gradual is counterproductive. Our baseline results were found to be robust to alternative possible specifications.