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A new insurance proposal
From Mehrling and Kotlikoff:
Rather than ask Hank Paulson to determine the price of each and every toxic asset, let's have him simply set prices for the ABX insurance policies (or credit default swaps, as they are called). Right now these insurance policies are selling for crazy prices because nobody can insure against systemic risk. Nobody, that is, except the government. The government is in a unique position to insure against system-wide risk because its own decisions determine, to a very large degree, the extent of this risk.
Were the government to start selling the ABX insurance policies at reasonable prices, our Cinderella mortgage-derivatives market would suddenly wake up and start pricing every mortgage-related security in sight based on these ABX prices. If Hank does this, the market will do essentially all the pricing; Hank will have only a handful of prices to set, not thousands.
Here is another explanation of the same. And more here. I miss the good 'ol days of squabbling about single-payer plans and the Milton Friedman Institute.
Posted by Tyler Cowen on September 28, 2008 at 05:15 PM in Economics | Permalink
Comments
You're assuming the goal of the bailout *really is* to prevent widespread financial collateral damage.
It's not. It's a giveaway to Paulson's buddies at best, an attempt to make the financial industry dodge a loss that the rest of us are going to have to eventually take at worst.
Do not continue to dignify Paulson's lies.
Posted by: Person at Sep 28, 2008 5:45:41 PM
Person - so why's Bernanke and the Federal Reserve going along with it?
Posted by: jason voorhees at Sep 28, 2008 5:52:36 PM
I don't see how this is a good idea.
The bonds are BAD. If they're insured, they'll still be bad. That will just be bad bonds where the US government is paying out. This is the most expensive way I can think of to shore up the market.
Credit default swap insurance has nothing to do with the market prices of the assets. It has everything to do with underlying value. As an insurer, I am not on the line for a cent unless it ACTUALLY DEFAULTS. Insurance rates are insane because these are junk bonds, and insuring junk bonds is expensive.
Govt backed insurance would be a much bigger giveaway, with the US paying out for decades to come. It would also do nothing to help in the long run, since these assets would still be opaque and unknown.
Posted by: Peter at Sep 28, 2008 7:05:20 PM
Peter,
The government already influences systemic risk levels. As I understand it, this approach would more directly incentivize enforcement policies and practices to the end of reducing that risk while maximizing govt. returns. If they undershoot or overshoot this idealized regulatory equilibrium, they're liable to increase their risk exposure or reduce their rate of return and that of the larger economy potentially.
Posted by: anonymist at Sep 28, 2008 7:28:32 PM
Peter, I think the difference is that a government insured bond, no matter how toxic, would be more readily accepted as collateral for debt, allowing credit to start flowing again.
The flaw in the plan it seems to me, is that the only stuff to be insured will be the stuff where the the gov't premium is a bargain.
Posted by: David at Sep 28, 2008 7:51:06 PM
This doesn't make sense to me at all. Running reverse auctions is at least a stab at supplying liquidity while respecting the market's pricing. Having the government specify a price for ABX, in defiance of the market's price, would be a huge gamble. What if the current price, which admittedly reflects a once in a century collapse of real estate values and economic production, is right? You could indeed bankrupt the Treasury.
P.S. I realize we borrow in our own currency, and can't literally go bankrupt. At worst, we would be looking at hyperinflation. Hey, no biggie.
Posted by: y81 at Sep 28, 2008 9:18:19 PM
It would be better *for the bond holders* to get government insurance. It would be much worse for taxpayers as far as I can tell.
In order for the insurance to not drain the treasury dry, it will need to be pretty expensive, thus causing only people with bonds which they know won't pay to buy it.
Treasury backed bonds will sell well, but they'll also be defaulting at very high rates. The underlying bonds are junk.
It seems like a much more expensive, and much less fair way to get credit flowing.
Posted by: Peter at Sep 28, 2008 10:16:51 PM
I miss it, too.
Posted by: Jeff H. at Sep 29, 2008 12:06:15 AM
Person - so why's Bernanke and the Federal Reserve going along with it?
We should ask Bernanke that after the smoke clears and the mirrors are broken.
Posted by: J Thomas at Sep 29, 2008 3:33:46 AM
Um, ABX is an index. Each ABX class/vintage is a bundle of 20 bonds. Having the government "set a price" for ABX makes about as much sense as having the government "set a price" for the Dow. I realize that (based on Paulson's description of the bailout he wants) we're intentionally trying to achieve something kinda-sorta equivalent in the context of actual bonds, i.e. 'set a price', but at least the story behind that involves market forces (=we buy bonds & add liquidity and the market takes care of the price-setting).
All of these proposals seem premised on one idea: the market is pricing these bonds incorrectly, wildly too low. My problem is, where does everybody get that idea and what if it is not true? Based on collateral performance, I rarely if ever see anything jumping out at me as being out of line. At some point, "deciding prices are too low" becomes equivalent to "deciding to throw money away", and I fear that's what's going on here.
Posted by: Sonic Charmer at Sep 29, 2008 4:44:08 AM
I keep hearing that there is no market for mortgages. This is pure nonsense. Sellers simply haven't discounted far enough to find the market -- it's there.
The owners of these securities need to spend some time un-bundling them to provide some transparency. The government needs to provide them the time to do that -- possibly by setting a price for valuation purposes prior to a true valuation -- like a market price when the market is closed. Then we need an organized market to clear them. A market price will appear.
Posted by: SheetWise at Sep 29, 2008 5:37:35 AM
"All of these proposals seem premised on one idea: the market is pricing these bonds incorrectly, wildly too low."
Sonic, here's my mental model for this. If your rent and light bill are due tomorrow, it's rational to sell Grandma's wedding band to the pawn shop who will only pay you half of what it's worth. However, if you take it in a box and refuse to show the pawn broker, he won't give you much for it.
The market price is the correct price, but it's also not the true long-term value. But, since banks will have runs if they divulge what the best guess real value of the assets are, they won't. Even though the real value isn't zero, it's pretty close. So, the market doesn't know whether they are being sold discounted goods or complete crap, so the market has to assume that it is all crap.
The government has the ability that Noam Chomsky claims is a feature. It can "run at a loss indefinitely." So it can assume it is buying complete crap, and do it anyway. They really do believe the banks will go away. And without the ability for the gov't to use banks to inflate the money supply and monetize debt, they are toast, so the bailout really is a good thing for them in any event.
Posted by: Andrew at Sep 29, 2008 6:06:47 AM
Andrew, I'm talking about "the true long-term value". What is the likely future cash-flow of a 4th pay sequential bond with 9% current credit support, that takes losses sequentially and for which 40% of the collateral is already 90+ days delinquent? Last I checked you can find such bonds in recent ABX-AAA vintages.
Metaphors/models involving pawn shops and fire sales are nice and easy to understand and all, but I'm looking for evidence that the people convinced, with Paulson, that current levels are way too low have actually looked at the actual collateral and cashflows.
Posted by: Sonic Charmer at Sep 29, 2008 7:07:03 AM
SheetWise:
I keep hearing that there is no market for mortgages. This is pure nonsense. Sellers simply haven't discounted far enough to find the market -- it's there.
Exactly right! When did everyone forget their basic economics?
The Paulson/'no market' attitude reminds me of John McCain-style economics. Remember how John McCain asserted that if Mexicans weren't imported to pick lettuce, it wouldn't get picked? This was a very basic economic illiteracy on his part.
Paulson and others - others who should know better - are echoing John McCain-style economic reasoning. It would be humorous if the ramifications weren't so huge.
Posted by: Sonic Charmer at Sep 29, 2008 7:10:13 AM
P.S. to Andrew, I think there may be some confusion as to what banks are and aren't "showing". In some cases they may not be showing where they have a given bond marked, but as for what the bond is, for most of the bonds we're talking about (i.e. excluding some of the more obscure/privately-placed CDOs, etc) there's no huge secret here. Deal structure, basic collateral detail, current performance are all freely available, and cashflows/yield tables can be run by virtually anyone with the right tools. It is simply not the situation that other 'pawnbrokers' can't know how much a bond is worth because the bank 'won't open the box' and show it to them. Offering the bond for sale is showing it to them.
Posted by: Sonic Charmer at Sep 29, 2008 7:46:08 AM
A little while ago, a german bank made a routine 300 million euro transfer to Lehmann Brothers. Normally, Lehmann would quickly send them an equivalent amount of dollars. But this time Lehmann went bankrupt instead. Close to half a billion dollars lost forever.
The "toxic waste" stuff leaves lots of banks sick. They might go bankrupt any time. If you do routine business with them you might lose your money.
Perhaps it would help to require that any US bank give four days notice before they go bankrupt. Then if you do a routine transaction that's sure to be done in 3 days you'll be safe.
I think this is what the "financial meltdown" is about. Anybody you send money to might go bankrupt before you get whatever they owe you in return. Anybody you borrow money from might possibly go bankrupt right after the agreement you owe them and before you actually receive the funds, leaving you with a debt to their creditors. Routine business stops until people can identify which entities are in trouble.
And of course these various financial entities depend on the flow of money for their income. They do lots and lots of little transactions and take a little bite from each one. If the flow stops for too long they'll be in trouble even if they aren't full of toxic waste.
Posted by: J Thomas at Sep 29, 2008 7:49:28 AM
Sonic,
No one can value many of the tranches accuratly. The only people making a bid on anything are a couple of funds who are bidding exceedingly low prices (Lone Star's Merrill Transaction). Either they are correct in their analysis of the collateral value and essentially every large bank in the country will soon be insolevent (in which the US follows a path to a very severe depression no matter what the government does).
The other alternative is that the bidders have monopsony powere and are excercising it. In that case, some banks can be saved and the government will likely make good money on their purchases (even if the underlying bonds eventually have high default levels).
Posted by: nelsonal at Sep 29, 2008 9:28:49 AM
Perhaps it would help to require that any US bank give four days notice before they go bankrupt. Then if you do a routine transaction that's sure to be done in 3 days you'll be safe.
woudn't that just cause a run on the bank, the very outcome a bankruptcy proceeding is supposed to avoid?
Posted by: Corporate Serf at Sep 29, 2008 11:49:05 AM
CS, if you believe your deposits are FDIC insured, you will believe your money is safe. Your money will in fact be safe so long as FDIC is solvent.
But more important, if the bank doesn't announce it will go bankrupt then your money is safe for the next few days.
At the moment it's more important that the good banks look good than that the bad banks avoid problems while they collapse.
Posted by: J Thomas at Sep 29, 2008 12:29:32 PM
CS, if you believe your deposits are FDIC insured, you will believe your money is safe. Your money will in fact be safe so long as FDIC is solvent.
...
Perhaps my point is not getting thru to you. I am not talking of fdic insured deposits. What I am talking about is the scenario where a bank / financial institution declares that it will declare bankruptcy in 4 days, as suggested by you above, and the counterparties quickly move in to liquidate their positions, leading to what is effectively the same as a bank run. What your proposal will do is move the market moving impact from the moment of declaring bankruptcy, to that of announcing that a bankruptcy will be announced in n days. This change of timing of market impact will not be matched by actual bankruptcy protection in the interim period, hence leading to almost certain disorderly withdrawal, unlike what happened in the case of LEH.
Posted by: Corporate Serf at Sep 29, 2008 12:55:53 PM
Let's add one more bank to the trouble mix. Wachovia is taken over by CitiBank today. Who's next?
Posted by: Debt Reduction at Sep 29, 2008 1:55:33 PM
Corporate Serf, let's assume that everything you say is right. So we will have some troubles when banks declare bankruptcy. OK.
The problem we have now is that banks which are not declaring bankruptcy are having great big troubles because nobody knows they won't do it today.
And we have a "bailout" proposal which is very very unlikely to do much good for that problem.
I say, if the central problem is that the solvent banks are hindered from doing business then let's solve that problem. Make it clear that they are in business this week, that you can do transactions with them today.
If the problem is how to give money to the banks that are in trouble then that method won't work. But to the extent that we've got something like a game of Old Maid where nobody knows who has the toxic waste, we don't need to give money to the losers -- we just need to establish who will do honest business in the short run.
Posted by: J Thomas at Sep 29, 2008 2:15:51 PM
Corporate Serf, let's assume that everything you say is right. So we will have some troubles when banks declare bankruptcy. OK.
The problem we have now is that banks which are not declaring bankruptcy are having great big troubles because nobody knows they won't do it today.
With your proposal of advanced notice of bankruptcies, this problem won't go away while the "rush to exit" problem will be far more dire.
Just to re-iterate, the following is the point I am responding to. Not the larger point that a problem of confidence exists in the credit market.
Perhaps it would help to require that any US bank give four days notice before they go bankrupt. Then if you do a routine transaction that's sure to be done in 3 days you'll be safe.
I think no purpose will be served discussing this any more.
Posted by: Corporate Serf at Sep 29, 2008 3:06:11 PM
I think no purpose will be served discussing this any more.
Good! I will continue to spread the idea and you can be quiet about it. Everybody wins.
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