Monday, January 2, 2012

Safe Assets, MBS, and Sovereign Debt

David Beckworth kindly links to my last post on safe assets:

Gupta also makes some other points, but this is his main one.  His point sounds reasonable, but I wonder how important this effect is explaining the overall trend.  As I mentioned in my previous post, this shortage of safe assets can arguably be traced all the way back to the bursting of Japan's asset bubble.  It is also influenced by the gap between the rapid economic growth in the emerging world and their own inability to produce safe assets.  And then there is the demographic challenge: all the baby boomers in the rich world are shifting out of riskier assets into safer ones as they retire.  Is Basel really more important than all these other factors? 

This is a fair point. It’s tough to figure out how important Basel regulations might be relative to all of the various other factors driving the use of AAA-rated securities. 

First, I would point to role of various policies in driving the growth of repo to begin with. Martin Oehmke has two recent papers that touch on this issue. The first, with Patrick Bolton, argues that the super-seniority given to derivatives like repo under the bankruptcy law results in a socially inefficiently large repo market. The argument is that granting derivatives higher status in bankruptcy (done in the 2005 bankruptcy reform) induces firms to invest far more in derivatives. The issue is that expanding derivative contracts is equivalent to creating high-seniority collateralized debt; and in the event of default, derivative counterparties can seize that collateral even as other creditors are subject to an automatic stay. As a result, firms want to take advantage of the repo market as an additional form of risky investment. The authors argue: 

Our model thus predicts that under the status quo equilibrium derivative markets will be inefficiently large: the positions taken in derivatives, swaps and repo markets will be larger than is socially efficient. This incentive to speculate disappears if the special treatment for derivatives in bankruptcy were removed. These results are consistent with the view that the special treatment of derivatives in bankruptcy may be one of the driving forces behind the tremendous growth of derivatives, swaps and repo markets in recent years. In particular, it may explain the increase in the size of derivatives markets since the 2005 bankruptcy reform, which widened the set of derivatives and types of collateral assets to which the special bankruptcy treatment applies.

Another paper by Oehmke and Markus Brunnermeier expands on the short-term basis of financing contracts. Starting with the standard Diamond-Dybvig model, the trend has been to see maturity-mismatch in bank financing as in some sense inherent to the act of banking. Others, such as Diamond and Rajan, have articulated other motives for having banks lend for long-term loans while financing themselves through short-term debt. 

Oehmke and Brunnermeier instead develop a model in which banks come to rely on an inefficiently large amount of short-term financing. The issue here is similar as with repos: short-term debt contracts induce externalities on the other creditors to a bank. Shortening one form of financing allows that creditor to update their contracting terms more frequently in response to fast-changing information, as happens for instance during a period of financial crisis. As a result, there is a maturity “rat-race” in which pressure from creditors results in a level of short-term financing that needlessly encourages bank runs and financial crises. 

The reason this matters is that the role of safe assets in Beckworth/Gorton’s model comes in exactly as collateral to fuel repos. To the extent that repos themselves are risky and socially wasteful, a lack of assets to fuel there growth may not be very troubling.

Then there’s the issue of how important Basel ratings were in determining the choice of assets, as opposed to various other factors. As I referenced earlier, Jeffrey Friedman and Vladimir Klaus make the argument extensively in Engineering a Financial Crisis that the advent of Basel-II and the Recourse Rule was associated with a dramatic level of bank interest in AAA-rated securities. The present the following graph, which shows the regulatory nature of capital adequacy regulations:

That is, Basel-II (and its US counterpart in the Recourse Rule) dramatically reduced the amount of regulatory capital needed as a hedge against high-rated assets. As Friedman and Klaus discuss, this had an enormous impact on the incentive for banks. While unsecured lending or traditional mortgage lending carried large capital buffer requirements, holding AAA-rated debt carried very little capital requirements, leaving open bank capital for other purposes. Friedman and Klaus argue that this rule change was behind the enormous surge in interest in AAA-rated mortgage securities. They document how the growth in private-label mortgage securities took off in 2002, just as the regulations came into effect, and how banks came to hold hundreds of billions in AAA-rated securities on their books. Hyung Shin, too, has described how European financial institutions came to hold large amounts of AAA-rated securities on their books. This pattern doesn’t explain the repo/safe asset explanation. Nor do typical explanations for the credit boom suggest why capital was directed towards mortgages specifically.

All of that applies to mortgage debt; but a similar story can be made for sovereign debt. As with high-rated mortgage securities, regulators ensured that holdings of all European sovereign debt needed to carry no additional capital buffer. This decision dramatically lowered the yields on European bonds, and falsely declared an actually risky asset (sovereign debt) to be risk-free. European banks, in particular, came to hold enormous quantities of risky European sovereign debt on their books — again, not for the purposes of conducting repo, but as part of their traditional lending portfolio. The whole problem with the European debt crisis recently has revolved around the fact that this debt was not, in fact, risk-free. Ratings downgrades have now left European banks scrambling to raise new capital, while the threat of actual sovereign default threatens to make insolvent major financial institutions and their counterparties. 

None of this is conclusive, and records of actual holdings of actual assets by particular banks is hard to come by. Still, I believe it adds up to at a plausible case for why rather than thinking there is a genuine shortage of safe assets, instead regulatory changes have unnecessarily encouraged short-term financing and ratings-driven investment. 

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