April 14, 2008
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.
A very interesting proposition. Debt offices have shown that they can manage foreign exchange and interest rate risk as a portfolio manager. Still, could they accumulate ever more credit risk in a business cycle downturn or how do you define their mandate? How should the Debt Office respond as losses materialize? Can the Bank of England maintain price stability if the Debt Office monetizes the losses?
Posted by: Otto | April 14th, 2008 at 3:13 pm | Report this commentI think you’re on to something. But why not go further and just have the government take over ALL of the businesses in the country? Just think of the return the taxpayers would receive! Plus there could never be any market failures, ever.
Posted by: Nemo | April 14th, 2008 at 3:45 pm | Report this commentCareful state management of debt laden companies can work; Malaysia’s Danaharta did a pretty creditable job of it in the six years following the 97/8 Asian economic crisis and that in a country not noted for the effectiveness of its state institutions (the other exception being Malaysia’s Securities Commission). Singapore I believe had something similar.
Posted by: Jonathan | April 14th, 2008 at 8:02 pm | Report this commentThe wider question of moral hazard has already been raised by ‘the Guv’nor’ - the question of whether the state should manage private debt cannot be decoupled from that of how to penalise the corporate wombats who cooked up this entire mess while pocketing obscene bonuses in recognition of their criminal incompetence.
Nice idea, but why not use the portfolio managers at the Bank of England who are already investing the FX reserves? They are even doing this on the borrowed reserves, so exactly what you propose.
Posted by: ian | April 15th, 2008 at 10:05 am | Report this commentOn top of duplicatation it is not at all natural to mix issuing, liability expertise at the DMO with asset management.
Good piece, indeed I have no doubt that the government will provide direct intervention into the RMBS market soon. Darling has already flagged adding some form of government certification to certain RMBS pools, and with Gordon suffering at the polls because of his perceived economic mis-management, he will be desperate to nip it in the bud. He can’t suffer too many more gloom stories about housing before being tossed out.
Interesting to see that the Canadian market has already undertaken a similar excercise but guaranteeing qualifying RMBS pools.
Direct assistance to first home owners has had the directly opposite consequence of that intended in Australia. In 2000 the government introduced the first home owners grant, which, coupled with very low interest rates has lead to a massive boom in property prices which has left home ownership out of reach for most first time buyers.
Posted by: John Evans | April 15th, 2008 at 11:31 am | Report this commentAs far as can be seen, the problem remains solvency and gearing rather than liquidity. There are private sector buyers for these assets. The nub of the matter still seems to be that these offers, if taken, would force firms to the receivers. Much of the heat in this debate seems to be wishful thinking about the eventual recovery value of these assets in light of that fact.
Suggesting that the government, with its lack of expertise in valuing these assets, step into this quagmire, could only end up a bailout without the greatest good fortune. It would be much better to let the private sector sort out its problems without overt interference.
Posted by: SS | April 15th, 2008 at 5:17 pm | Report this commenthmmm…..govt is just as exposed to longevity as anyone else through the state pension and nhs. so unless we start cutting taxes on fast food and fags, how exactly is the creation of liabilities linked to life expectancy helping the govt manage its liabilities? all you re creating is enormous financiial perverse incentives.
the crnd manages the national lottery funds and national insurance funds,. these are invested in nilo (non marketable) stock so it is incorrect to say that the money is invested overnight. s do we really want national lotterty money invested in rmbs?
Posted by: fi-geek | April 16th, 2008 at 11:02 pm | Report this commentCRND investments are a bit more of a mystery than fi-geek suggests. Until Dec-06 the DMO says that they were invested in a range of instruments(including NILO), the composition of which depended upon the particular CRND account, but since then it appears that things have changed and NILO have (according to DMO website) been scapped.
An educated guess might put the CRND assets into the market via the DMO’s Account Deposit Facility. In such case (given the CRND’s self-stated brief of targeting a return equal to BoE base rates) it is unclear to what extent the DMO would invest these assets with a maturity beyond a few days. Another question relates to whether they are currently placed into the market at all rather than spent by HMT (having been exchanged for something looking like a NILO T-Bill, but without being called NILO).
Posted by: fi-geekier | April 17th, 2008 at 7:48 am | Report this comment