A Sovereign Portfolio Management Office for Britain

In today’s Daily Telegraph there is a column of mine that proposes turning the Debt Management Office of the United Kingdom, a branch of HM Treasury, into a full-fledged Sovereign Portfolio Management Office or Sovereign Wealth Management Office.

The purpose is to kill two birds with one stone: (1) to get the state to invest in residential mortgage backed securities (RMBS) to unclog that market and restore access of first-time buyers to mortgage financing; (2) to get the state to issue more index-linked long-term debt and other useful instruments, like longevity bonds (bonds whose coupon or interest rate is tied to the survival rates /life expectancy of particular age cohorts). Longevity bonds index-linked to the CPI or to average earnings would be especially useful for pension funds and other institutional investors that are short longevity risk.

When one proposes additional (large) issues of long-term index linked debt to the DMO, a standard reply is that they are constrained in the volume of what they can do by the size of the government deficit and the amount of maturing debt. If they issue more index linkers than the sum of the government deficit and the amount of maturing debt, so the argument goes, they would have to retire other debt instruments – nominal debt, both long-term and short-term. They wish to remain present in some volume in all market segments, short and long, nominal and real to set benchmarks. So no radical increase in the volume of index linked gilts issuance. Longevity bonds are just too radical to consider at all.

I have news for the DMO. A balance sheet has two sides: assets as well as liabilities. The two sides even add up, or are supposed to, if you include net worth or equity on the liability side! The DMO can issue long-term index linkers and longevity bonds to my heart’s content without crowding out any other existing or planned issuance of public debt instruments if they are willing to invest the proceeds of the additional debt issues in other securities, domestic or foreign private instruments or foreign government securities. They have to think as a portfolio manager, not just a manager of the liabilities of the government.

The DMO does in fact have a fund management arm, the Commissioners for the Reduction of the National Debt. According to my friend Toby Nangle of Baring Asset Management Ltd, who has been investigating these issues for a long time, they reported as of March 31, 2008, £61 bn of assets under management. As far as one can determine from publicly available information, most of that money is parked in overnight cash. If this is correct (and both the amount and the investment model of the CRND are just my best guesses), there is a huge opportunity to do some good: correct a drastic case of market failure in the RMBS markets, grant access to mortgage financing to first-time buyers who might otherwise have to wait for years, and give the tax payer a chance of earning a risk-adjusted rate of return better than overnight cash.

It may be necessary to change the official mandate of the CRND to do this, because under my proposal the CRND would be taking on credit risk (default risk) of the ultimate mortgage borrowers and the private originators of these mortgages. But provided the RMBS are properly priced, the tax payer can be adequately compensated, through a superior expected return, for the credit risk he is taking on.

So here’s the proposal. The DMO issue another £55 bn of index-linked long-term debt and longevity bonds (nominal, CPI-linked and average earnings-linked). They use the funds to obtained to acquire outright a £55 bn issue (market value) of residential mortgage backed securities (RMBS), put together by all the mortgage lenders in the UK market, orchestrated,say, by the Council of Mortgage Lenders. The £55 bn is roughly half the size of Northern Rock’s loan book, and the amount by which it plans to shrink its loan book over the next two or three years. The CRND can either hold the RMBS issue to maturity, or part or all if it as market conditions normalise.

It is, of course, key to price the RMBS to ensure that the tax payer’s expected return reflects the default risk the CRND is taking on. To further guard against subsidising the shareholders of the British mortgage lenders rather than correcting an extreme case of market failure, participation of private mortgage lenders in the issue could be made contingent on a commitment not to pay dividends for at least a year and to engage during that year in a rights issue of a certain minimal size to build up the capital base for future mortgage lending.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website