August 29, 2007
Central banks should not rescue fools
Sometimes a picture is worth a thousand words. The one last Wednesday showing Christopher Dodd, chairman of the US senate’s banking committee, flanked by Hank Paulson, Treasury secretary, and Ben Bernanke, governor of the Federal Reserve, was such a picture. This showed Mr Bernanke as a performer in a political circus. Mr Dodd even announced Mr Bernanke’s policies: the latter had, said Mr Dodd, told him he would use “all the tools” at his disposal to contain market turmoil and prevent it from damaging the economy. The Fed has its orders: save Main Street and rescue Wall Street.
Such panic-driven politicisation is almost certain to lead to both overreaction and the creation of bad precedents. What then would be the right response to this latest scrape that supposedly sophisticated financial markets have fallen into?
The remainder of this column can be read here (FT.com subscription required). Discussion from our guest economists is free.
Jim O’Neill: I so often agree with Martin, but on this one, I think he is very wide of the mark. The Fed needed to do what it did, and will need to do more, to rescue millions of people in the US who are, in any case, going to suffer from large negative equity from their houses losing value. Martin appears to, indirectly, be suggesting that individuals should know the value of the housing market, which is not very reasonable in my view.
Posted by: Jim O'Neill | August 29th, 2007 at 1:31 pm | Report this commentMartin Wolf: I think Jim, whom I greatly respect, is seriously missing the point.
The Fed may need to rescue the US economy by cutting rates, as I argued the previous weeks. But it is not its responsibility to rescue imprudent borrowers. If Congress wishes to do that, so be it. The fools, I wrote of, are not these people, in any case, but those who invested in dud paper put together by people engaged in his business - the Landesbanken, pension funds and all the rest. They must not be rescued, nor must the institutions that have made vast fortunes out of creating this paper, nor even the securitised markets themselves. They must sort themselves out, using the skilled and highly paid people employed by institutions like Goldman Sachs.
I hardly dare to say this, but Jim is confusing the interests of Wall Street with those of hapless home-buyers suckered into borrowing more than they can afford. It is a good populist line. But it is highly misleading. I have some (limited) sympathy for the home-buyers, but none for the financial institutions and investors. It is they that must not be rescued.
One final comment. Yes, home purchasers cannot know the value of the housing market. But they should know what they can afford and so should those who lend to them.
Posted by: Martin Wolf | August 29th, 2007 at 8:08 pm | Report this commentStephen Cecchetti: Like Jim O’Neill, I normally think that Martin has perfect pitch on economic matters. This, however, is not one of those times. The column starts off well, but then veers off course.
The financial instability of the last three weeks is clearly a problem caused by information asymmetries. What we are witnessing is analogous to a bank run. Since even sophisticated investors have limited information about the quality of financial institutions’ balance sheets, when they see trouble they become concerned about their ability to distinguish high from low risk activities, and they flee to quality.
This time, the problem has been concentrated in the commercial paper and uncollateralized inter-bank lending markets. From August 8 to August 22, the total quantity of commercial paper outstanding in the United States declined by nearly $200 billion, 10 percent of the total. Data on commercial bank balance sheets suggests that something like one-half of this was replaced by bank lending. That is, firms that were unable to issue commercial paper turned to their banks and drew down existing lines of credit. The big question is what the banking system’s capacity is to increase lending of this sort. At some point banks will hit their regulatory capital constraint and be forced to cease issuing new loans. That’s the day none of us want’s to see.
Returning to the column, Martin goes on to chastise the Federal Reserve for rescuing some of the players. I don’t see it. My interpretation of recent policy actions is as follows.
Chairman Bernanke and his colleagues have done three things. First, they lowered the federal funds rate in the market by between 25 and 50 basis points for roughly two weeks beginning on 10 August. Second, they issued a statement suggesting that they may lower the official target from its current level of 5.25 percent. And third, they reduced the rate on discount lending by 50 basis points from 6.25 to 5.75 percent.
The first of these was explicitly temporary and aimed at ensuring that financial markets continued to function. The flight to quality that was occurring was leaving people without the ability to trade in certain markets. That, it seems to me, is sensible: Make sure that people can buy and sell as they wish, reaping the gains or losses of their investment strategies.
The second action simply said, as Martin notes, that the federal funds rate target is adjusted in order to meet the Fed’s medium term stabilization objectives. If and when forecasts for inflation and growth change, the target will be changed.
Finally, there is the change in the discount rate. This, it seems to me, was entirely for show. For reasons that I explain elsewhere (see Federal Reserve Policy Actions in August 2007: Answers to More Questions) lending is very rare. U.S. banks simply do not borrow from the Federal Reserve. Instead, the cut was aimed at trying to bring confidence back into the system. There is no sense in which this bailed anyone out.
The objective of all of the Federal Reserve’s action is to bring confidence back into the market. Many of the Fed’s actions and statements have been about the quality of various types of collateral. The point is to get people to realize that there still are good credits out there, and go back to accepting them as collateral. High risk securities should be priced properly at the same time that low risk paper is not underpriced.
So far the Fed has been very creative in using the tools at its disposal. The big question is whether what they’ve done so far will be enough. Let’s hope so.
Posted by: Stephen G. Cecchetti | August 30th, 2007 at 12:22 pm | Report this commentMartin Wolf: I am a little puzzled by Stephen Cecchetti’s criticism. Perhaps the problem is partly one of tone. I admit that this latest financial “crisis” has made me quite angry. How do these hugely powerful, profitable businesses get away with making such huge messes again and again and again. What, above all, should public policy do about it?
My answer to the latter question is that all policy can ultimately do is make sure the players that have made mistakes lose lots of money. They have, the Lord knows, made enough of it in recent years. Of course, I also agree with Stephen that this necessary purge must occur without damaging the economy. But that is not the same thing as eliminating all its effects on economic activity. That is impossible.
Capitalist economies cannot be perfectly stable. No central bank should try to make them so. I think one of the big errors of recent years is that a great many people seem to believe this is what the Fed is for. It is why I once called Alan Greenspan the great Keynesian.
More important, this wider economic objective does not mean – indeed, cannot and must not mean - attempting to eliminate every glitch in the markets. Provided the core financial system is maintained, through lender-of-last-resort activities to banks, I am prepared to see a great deal of short-term volatility in credit markets, including the recent spike in commercial paper rates and the collapse in Treasury bill rates. These are, I am sure, both educational and self-correcting. If the big players cannot work out that major commercial enterprises are solvent, without needing the Fed to point this out to them (as if it knows more than they do on this) then what on earth is the good of them? How much nannying do they need?
Now let me turn to points of disagreement. My comments were addressed to three questions: the political circus in which Mr Bernanke got involved; the policy decisions of the Fed; and the wider question of what caused the credit meltdown and what the central bank should do about it.
Stephen doesn’t comment on my remarks on the political circus. So I will not refer to that again. He does comment on the Fed’s efforts to restore confidence in markets. The discount rate reduction is, he says, “for show”. If he knows that, presumably smart people in markets know that too. If it has an effect it is because it indicates a willingness to cut rates in future. The temporary reduction in Fed rates is a bail-out, of course: what else is cheapening the cost of money to the financial system, when in trouble? The likely longer-term reduction in rates to keep the economy going seems to me to have been pre-announced, on the hoof. If that is not the case, then the Fed has been sending very confusing signals.
So my assessment of Fed statements and actions so far remains different from Stephen’s. I think this is because he thinks the sole criterion by which the Fed is to be judged is whether it restores confidence to markets as quickly as possible. I don’t think that is the sole objective, because a period in which there is a loss of confidence in markets, though not in the survival of the banking system itself, is going to be healthy in the longer run. It will teach everybody some fear.
We also differ, I think, because he wishes to treat panic in securities markets as very similar to a bank run, to be dealt with in similar ways. This gets us close to the suggested market-maker-of-last-resort function for the central banks that was a central part of my analysis. Stephen does not comment on this issue directly or on my “lemons” analysis. But I stand by what I wrote. Central banks cannot guarantee liquidity in the securities markets without taking on big new regulatory responsibilities.
So, with the greatest respect, I beg to differ. It is time for a bit of a purge. We cannot have a better time for one than now, when the world economy is doing well and credit spreads more broadly have moved very little. Let’s not panic about the panic. Let central banks focus on their core tasks of ensuring macroeconomic stability and providing liquidity, at a penal rate, to the banking system. Then let the market work things out. That seems to me to be the right policy.
Posted by: Martin Wolf | August 31st, 2007 at 1:58 am | Report this commentDerry Pickford: Stephen Cecchetti asserts that the objective of all of the Federal Reserve’s action (in the last couple of weeks) is to bring confidence back into the market. This initially sounds very reasonable but raises more questions more than it answers. First of all, what do we mean by, and how do we measure, market confidence? In effect is market confidence very different from market prices? If this is the case, restoring confidence, i.e. preventing/reversing large falls in asset prices, but not ever tackling overconfidence clearly leads to moral hazard. In the short term, there may appear to be a trade-off between financial stability and introducing moral hazard, but in the long term far greater financial instability will occur from creating a belief that the Fed will always bail out speculators.
Stephen is partly right in implying that the cut in the discount rate is just a placebo. However, even placebos can be effective, especially if they lead to an expectation of some stronger medicine. It is notable that the S&P500, barring any fall today will be up over the month of August. There is clearly now a belief in a “Bernanke put”. Furthermore, the antics of Dodd suggest that the Fed is susceptible to political pressure and this will only reinforces the perception of such a put. The damage to the credit creation mechanism that we have seen will have a significant impact on US aggregate demand. If the notion of a “Fed put” hadn’t developed, the Fed would legitimately be able to offset this with rate cuts. I suspect that pain of establishing moral hazard fighting credentials will be smaller than the cost of establishing anti-inflation credentials in the early 1980s, provided the battle is undertaken now. Nonetheless, if they do avoid cutting there will still be pain, and this will undoubtedly lead to much criticism. The blame for this pain will lie not with the FOMC though but with the previous FOMCs who did cut in response to market falls and politicians who have forced the Fed to re-establish its credibility.
Derry Pickford is global economist at Sloane Robinson LLP, a London hedge fund manager. He is writing in a personal capacity
Posted by: Derry Pickford | August 31st, 2007 at 2:02 pm | Report this commentWillem H. Buiter and Anne C. Sibert:In his column, Martin characterises the credit crunch/liquidity crisis of August 2007 as a ‘lemons’ problem due to asymmetric information. We argue that this is not the case.
Consider the securities for which the liquidity crunch was most serious: collateralised debt obligations backed by US subprime mortgages (CDOs) and commercial paper backed by (not necessarily subprime) mortgages and hire purchase receivables such as credit card debt (ABCP). If the market failure was due to a “lemons” problem, then potential buyers of the assets that became illiquid must have suddenly realised that there was an asymmetric information problem in the markets for these assets and that they were on the wrong side of it. That is, potential lenders realised not only that they knew a lot less about the creditworthiness of the securities being offered than they had thought they knew, but that this increase in uncertainty was not shared to the same degree by the sellers of these securities. This discovery caused the market to shrink and to cease to function. Was this what happened?
It is true that the asset-backed securities in the markets that became illiquid are not homogeneous; the quality of the underlying assets (for example, mortgages) is not uniform. If the would-be sellers of the securities have private information about the quality of the underlying assets and are unable to reveal this private information to the buyers, then a lemons problem can arise in the following way. Potential buyers of the securities are only willing to purchase the securities if the price is no higher than what they would pay for securities backed by underlying assets of average quality. If the dispersion in the quality of the underlying assets is large enough, the sellers of assets backed by the best-quality underlying assets will be unwilling to sell at that price and withdraw from the market. Potential buyers know this and realise that the average quality of the underlying assets is lower than it would have been if the sellers with the best-quality underlying assets had not departed the markets. Thus, the price at which they are willing to buy securities falls and additional sellers of good-quality assets may leave the market, causing the purchase price to fall further. A continuation of this process can cause the market to shrink further and perhaps even to collapse entirely.
Is this what happened? Consider the case of mortgage-backed securities. There is certainly asymmetric information in the primary market for individual mortgages. Typically, the applicant for a mortgage knows more about his creditworthiness than the loan officer of a bank. In some subprime mortgage markets, the asymmetric information problem may have been on the other side. Smooth-talking salesmen may have convinced uninformed or gullible mortgage applicants to take on loans that the mortgage sellers knew to be in excess of the homeowners’ capacity to service.
Regardless of who has the informational advantage in the market for the original individual mortgages, when these mortgages get securitised there is an asymmetric information problem between the banks originating the mortgages and the special purpose vehicle (SPV) that buys the mortgages from the banks and then issues the securities backed by these mortgages. The SPV is unlikely to know as much about the quality of the underlying mortgages as the originator. When the SPV sells its asset-backed securities, the purchasers have little idea about the quality of the underlying assets that were pooled.
When the current holders of asset-backed securities try to sell them in the market, neither the sellers nor the buyers have superior information. The only parties with private information – that is, the original mortgage borrowers lenders — are not in the market or not in a position to make use of their superior, asymmetric information.
The recent illiquidity in financial markers is certainly an information problem, but it is not an asymmetric information problem. I think Martin and we agree that in July-August (perhaps even a bit earlier), there was a general realisation that the credit ratings granted by the main rating agencies to many asset-backed securities and structured financial products in general, were wildly generous. There therefore was an associated increase in the market’s perceived average probability of default for wide classes of securities. But the greater awareness of ignorance and the increased uncertainty are market-wide and symmetric, affecting would-be buyers and sellers equally. The private information that could have caused a lemons problem was destroyed by the process of securitisation and pooling.
It is not clear why the recent uncertainty caused such upheaval. Perhaps – for some reason — uncertainty has become more Knightian in that it has become less possible to attach a subjective probability distribution to the range of possible outcomes or even to describe the set of possible outcomes. Pervasive, Knightian uncertainty could be associated with the fear, panic and herding behaviour that caused market failure.
Illiquid markets prevent financial firms from raising cash by selling the securities that become illiquid. These firms will have to fund themselves in other ways and this may lead to a lemons problem. If firms try to raise money through unsecured loans or debt or through loans and debt secured against assets about which do indeed have private information, then asymmetric information may play a role in causing these sources of credit to fail. It will be interesting to uncover, when the history of this crisis is written, to what extent asymmetric information caused certain sources of credit to vanish. It played no role, however, in the drying up of the asset-backed security markets.
Posted by: Willem H. Buiter and Anne C. Sibert | September 1st, 2007 at 7:37 pm | Report this commentWillem H. Buiter and Anne C. Sibert: Martin criticises our Market Maker of Last Resort (MMLR) proposal. Not surprisingly, we disagree with his comments and we respond and clarify.
Central banks should support key financial institutions with strong public goods features. These institutions include important financial markets and mechanisms that support these markets, such as the payments system and clearing and settlement systems. Central banks should not support or bail out financial businesses or households unless this is necessary to support key economic institutions (it is not helpful that financial businesses are sometimes referred to as financial institutions).
In Bagehot’s days, commercial banks accounted for the lion’s share of financial intermediation. They were the credit system and played a key role in the payments system. Support of the credit markets and the maintenance of a functioning payments system therefore required the support of commercial banks in a financial crisis. Thus, Bagehot advised that in times of crisis the central bank should lend (to commercial banks) freely, at a penalty rate and against good collateral (that is, collateral that would be good in normal times but has become impaired temporarily because of the crisis). A penalty lending rate and the collateral requirement serve to minimise moral hazard.
Today, a growing share of financial intermediation bypasses commercial banks completely, going through financial markets in which commercial banks are just one of many types of participants. It now becomes possible to support the credit system and key financial markets without supporting individual, or even particular types of financial businesses.
We propose that liquidity problems can be addressed by the central bank making a market for assets which would be liquid in normal times but are illiquid because of the crisis. The central bank can do this either by buying the asset outright or by accepting it as collateral against loans at the central bank’s discount window or in repurchase operations in the money markets.
Our proposal expands the set of what is generally considered “good” collateral for Bagehot’s Lender of Last Resort. We suggest that central banks accept a much wider range of assets as collateral than is currently the case. Specifically, they should accept securities that are below investment grade (‘junk’), and accept securities backed by impaired assets such as impaired subprime mortgages. The ECB’s self-imposed rules of practice prohibit accepting as collateral, either in repos or at its discount window, anything rated less than A-. The Fed is permitted to accept anything as collateral at its discount window, but has done little to enlarge its menu of eligible collateral.
We maintain Bagehot’s requirement that lending be at a penalty rate. Central banks should only offer to buy an illiquid asset at a punitive price, that is, at a price representing a severe ‘haircut’ or discount relative to what its fair or fundamental price would be with orderly markets. This could be implemented as follows. First, the monetary authority should clarify what kinds of assets it is in principle willing to purchase.
Martin objects that the central bank would have to end up dealing in and setting prices for complex structured instruments that it knows little or nothing about. Clearly, there would have to be a ‘positive list’, updated regularly, of securities eligible for discounting. Only systemically important instruments would have to be considered, not every over-the-counter concoction some quant has dreamt up. Then, the central bank would have to be active, even during normal times, albeit on a small scale, in the market for each of the eligible instruments. That way the central bank staff will acquire a familiarity with the instruments that will be helpful during disorderly market conditions. What we are recommending for this wide range of eligible instruments is what central banks routinely do in the foreign exchange markets, even when the exchange rate policy is a free float. The central bank would have to recruit staff with new skills, or retrain existing staff, to do this affectively.
The central bank should only deal with and lend to “eligible” counterparties, which could include non-bank financial businesses, including hedgefunds. Eligible counterparties are all those who abide by a prudential regulatory/supervisory regime approved by the central bank. Financial businesses that do not abide by these regulatory and supervisory constraints cannot come to the discount window and will have to try their luck obtaining liquidity from those that do meet the prudential norms.
How can the central bank set a price in a market that has ceased to function? There are many ways of structuring markets or auctions in such a way that they become price or value discovery mechanisms. An example of such a mechanism - one which discovers the reservation prices of all potential sellers without the central bank having to have any superior knowledge of the fundamental determinants of the value of the illiquid security - is the Dutch auction.
For a given eligible instrument and a give set of eligible counterparties, the central bank would announce that it is willing to buy up to, say, $10bn (at face value) of an impaired asset. It would start the auction by offering to the asset at, say, one cent for each dollar of face value. All sales at that price would be accepted, up to the $10bn face value limit. If the total amount offered at one cent on the dollar were to exceed $10bn face value, there would be pro-rata sharing among those who made offers to sell. If less than $10bn face value is offered at one cent on the dollar, the central bank would increase its bid. Thus if, say, $2bn were offered, the central bank would allocate the $2bn to the sellers who accepted one cent on the dollar and then would offer to buy up to $8bn at, say, 2 cents on the dollar. The central bank would then continue this process, offering increasingly higher prices, until it had purchased the entire $10bn.
The central bank as Market Maker of Last Resort effectively performs the role of a publicly owned ‘vulture fund’, buying up distressed, illiquid assets from sellers desperate to realise some value somewhere. Martin argues that this job should be left to regular private vulture funds. We agree that if private vulture funds can do this in a timely matter, so much the better. There are times, however, when waiting for private vulture funds to step forward risks an avalanche of illiquidity that creates unnecessary and socially costly defaults and bankruptcies. In such circumstances, only the central bank has the deep pockets to make a market in an expeditious fashion.
Posted by: Willem H. Buiter and Anne C. Sibert | September 2nd, 2007 at 2:23 pm | Report this commentMartin Wolf: I am very grateful to Willem and Anne for their comments on my original column. The issues we are discussing are serious and complex. It is obviously helpful to have them fully aired.
In this post I want to consider whether the form of uncertainty that emerged in the markets in recent months is asymmetric rather than merely pervasive. If I understand the argument Willem and Anne put forward, lemons problems may well emerge at the initiation phase of the securitised lending and at the time of the panic (if owners of bad securitised debt try to offload other bad debt, on which they have private information. I do not understand why Willem and Anne are so sure that holders of securitised debt know no more about their likely performance than potential customers. I would have thought that that was something they were quite likely to have learned at least something about, by virtue of holding the debt. The lemons problem may also explain why it will prove hard to restart the securitised debt markets, now that people have become aware of the risks.
Yet I agree that the lemons metaphor is too limited to describe the massive increase in uncertainty at a time of panic. It may be, for example, that buyers are concerned about suffering the winner’s curse in such a market. I have also no problem with the idea that Knightian uncertainty is deemed a good reason for not buying assets at a time of upheaval.
I am now about to fly from Australia to China. While in the air I will think about the role of central banks should be in securitised debt markets and respond to the second of the two posts some time after I have landed.
Posted by: Martin Wolf | September 4th, 2007 at 10:40 am | Report this commentMartin Wolf: Willem Buiter and Anne Sibert have elaborated upon their suggestion that central banks should become “market-makers-of-last-resort”. I think this is an important idea that needs to be thoroughly debated. But I do not myself believe that this is the direction in which the central banks should go.
Stripped to its basic elements, the argument put forward by Willem and Anne is that, today, credit is advanced not by banks but increasingly by markets. A panic in the markets works like a run on banks. It generates the insolvency of sound institutions, due to withdrawal of their funds, at the same time as the assets they own plummet in value.
The result is a disruption to credit-creation. The answer, they suggest, is for the central banks to be prepared to purchase from a positive list of market instruments and from a wider range of financial institutions (’”eligible” counterparties’), at a discount. In return, these institutions and the instruments would be regulated or at least monitored.
One way of thinking about this proposal is as follows. Many non-banks now perform bank-like functions. Similarly, many instruments previously not considered significant in markets now perform that function. So central banks must widen the range of both the counterparties and instruments they deal with.
The arguments in favour of this proposal are evident. So I would like to consider the counterarguments, trying to deepen the arguments I advanced in my column. To do so, I will address two questions. First, what is the public interest in supporting the financial system? Second, what should be the limits of such support?
The public interest in supporting the financial system derive from the fact that it provides at least three public goods: the payment system; a safe place to hold the most liquid of all assets - money; and financial intermediation, on which the market system itself depends.
The problem, evidently, is that these public goods are provided by profit-seeking (and how!) financial institutions with a demonstrated capacity to exploit both public sector support and opportunities for regulatory arbitrage to - and indeed well beyond - any reasonable limit.
In particular, the financial system relies on four mechanisms for earning its profits (beyond fees for services): term-transformation - borrowing short and lending long; illiquidity - holding illiquid assets (assets difficult to sell, particularly at times of market turmoil), while offering more liquid liabilities; risk-taking - offering safe securities and holding risky ones; and deception - persuading lenders or investors that pig’s ears are silk purses.
It is evident that all are dangerous strategies: if lenders and investors come to the view that they have been deceived or are going to be disappointed (which is sure to happen from time to time), they will seek to withdraw funds, leaving institutions in a dangerous position. A chain of bankruptcies is possible - a run. It is evident that if similar strategies are followed in securities markets, something like a run will happen there too. Indeed this is what we have been seeing in recent weeks.
This leaves the authorities in a difficult situation. They wish to sustain the capacity of the financial system to provide public-goods without encouraging institutions to take on excessive risk. Moral hazard really does work in the financial system (even though I have never been persuaded that it has much influence on governments).
So what should be the limits to assistance? The classic answer - recommended by Walter Bagehot - is to insure the ability of selected institutions (namely, banks, the most important financial institutions of all) to meet a run without closing their doors. By insisting that money will be advanced only against good securities, central banks encourage banks to be prudent. The beauty of this mechanism is that it encourages banks to behave in ways that limit the dangers, without need for detailed regulation.
Of course, governments have, in practice, provided more assistance than this. There are various forms of deposit insurance, for example. But the more insurance the authorities provide, the more regulation they also have to impose.
Unfortunately, it is desperately difficult to regulate contemporary financial institutions. The role of “special investment vehicles”- classic examples of regulatory evasion - in the present crisis gives a good indication of the difficulties. Banks are far better at getting round regulations than regulators are at enforcing them. Given the quality, number and remuneration of their employees, this can hardly be a surprise.
So how can the public authorities insure the system against runs without encouraging excessive risk-taking? The answer is: by making clear what they will not do. Above all, they should not reward banks for taking excessive risk. What that means is hard to define. But investment in highly illiquid or relatively risky securities by institutions that offer liquid and supposedly safe liabilities is guaranteed to generate crises. It should not be subsidised. Subsidising term-transformation (through classic lender-of-last-resort activity) is surely enough.
Bagehot’s answer remains a good one. It means that banks which want liquidity assistance must invest adequately in safe assets (even if these carry some market risk), such as government bonds. The loss of income banks suffer as a result is the insurance premium they pay in return for the central banks’ role as lender of last resort. In other words, the banks pay for the liquidity services of central banks, as they should. It is not a free lunch.
This is the argument advanced by Raghuram Rajan, former IMF chief economist, in his column of September 6th, with which I agree. Willem and Anne argue that this is no longer good enough, because credit creation is now the province of financial markets. So central banks should become market-makers-of-last-resort, thereby guaranteeing liquidity in a far wider range of assets (including “junk”). They should impose a brutal haircut, however, to minimise the moral hazard.
I see five objections to this proposal.
First, the authorities should have no view on the structure of intermediation. It is particularly undesirable to subsidise the survival of securitised markets that seem to be off-balance sheet extensions of commercial bank activities.
Second, liquidity risk matters. The more liquidity risk is removed, the more of the kind of stuff likely to become illiquid there is also bound to be. There is surely no reason to subsidise the creation of markets in junk.
Third, if the market in junk grew, as a result of the extension of official liquidity insurance, the pressure to limit the size of the “haircuts” Willem and Anne recommend would also grow, since the bigger the absolute losses the more likely bankruptcy would become.
Fourth, once the relatively clear boundary between first-rate securities (i.e. government bonds) and junk was breached, the harder it would become to limit the market-maker-of-last-resort function to positive list of such securities.
Fifth, the central banks do not have the capacity to assess the risks in junk.
Finally, central banks would be taking open-ended credit risk if they made markets in junk. That would be a particularly blatant subsidy to excessive risk-taking.
I understand why Willem and Anne have made this interesting proposal. But I do not believe the extension of the central banks’ role they proposes would be wise. On the contrary, I think guarantees to the financial system should, if anything, be more tightly delimited.
This episode shows the burning importance of rethinking the way the financial system operates. The behaviour that generated the crisis shows yet again how irresponsibly these immensely important businesses - arguably, the most important businesses in the world – tend to behave. This surely cannot be allowed to go on. I believe the answer is less assistance, not more.
Posted by: Martin Wolf | September 9th, 2007 at 8:16 am | Report this commentNicholas Dimsdale: Martin, I found your explanation of the current crisis in the market for commercial bills in terms of the model of the market for lemons proposed by George Akerloff very persuasive. You could however have taken the comparison one step further.
Akerloff showed in 1970 how the market for used cars could break down because of asymmetries of information between buyers and sellers, the former being less well informed than the latter. He also suggested that the problem might be mitigated by the provision of warranties by well informed sellers. This could effectively transfer the risk of buying a used car from the buyer to the seller. Such warranties are provided in practice and they have helped to overcome the asymmetry of information in the market for used cars as shown by Offer (Oxford Economic Papers, forthcoming).
In the market for asset-backed commercial paper, buyers are unwilling to purchase assets, which could be contaminated with unacceptable risks associated with the US market for subprime mortgages .They are threatening a buyers’ strike so putting a severe strain on bank liquidity; a danger which has been highlighted by Professor Cecchetti. What is urgently needed is a measure which will unfreeze the market.
Meanwhile the sellers of asset-backed paper are arguing that the default rate on the securities will be extremely low. If they believe this, they should be willing to offer guarantees, which will reassure buyers, who are less well informed than they are. This can be achieved by transferring risk from buyer to seller.
Guarantees could be offered by individual banks or their subsidiaries in the same way as car dealers offer warranties to purchasers in the Akerloff model. Alternatively it might feasible to adapt a proposal by Diamond and Dybvig, (JPE 1983), which is designed to counter a bank run. Banks would collectively guarantee all newly issued asset-backed commercial paper. The costs of defaults would then be recovered from individual banks at a later date. If the risks of default are in fact small, the amounts to be recovered would be negligible. Under both schemes the risks associated with holding asset-backed securities would be shifted back to the banks, where they belong. Banks would have to face the consequences of their unwise investment decisions, but the market for commercial paper would be unfrozen and the demands on bank liquidity would be reduced.
Nicholas Dimsdale is emeritus fellow in economics at Queen’s College, Oxford
Posted by: Nicholas Dimsdale | September 10th, 2007 at 10:25 am | Report this comment