Three years ago, I published a biography of Fischer Black1. As a monetary economist, this was my way of coming to terms with the modern world and our financialized economy. Writing in the 1970s, Fischer Black imagined a world yet to come: « a long-term corporate bond could actually be sold to three separate persons. One would sup- ply the money for the bond; one would bear the interest rate risk; one would bear the risk of default. The last two would not have to put any capital for the bonds, although they might have to post some sort of collateral. » What is the financial product of the second person, the one that bears the interest rate risk? Obviously, it is an interest rate swap.The third person holds a credit default swap. In other words, in the 1970s Fischer Black was imagining a world that we live in today.
I see the current crisis as the first actual test of that world. This is the first serious downturn of our new financial system, and we dis- cover where its weak spots are, where it breaks. The temptation is to throw it out, but then we will redo 40 years and that’s a recipe for a very long recession. Another proposal would be to look where and how it broke, and how we can fix it. This is a story about free markets and their failures: where are the externalities? What is the role for government? What regulation do we need in order to control this brave new world?
I’ll tell you a little story about how I came to that proposal: in April of this year, I wrote my first letter to the Financial Times about credit default swaps, saying that the problem is that credit default swaps are actually quite old. The bankers’ acceptance is basically a kind of credit default swap; it’s a kind of insurance where a bank says, « if this person doesn’t pay, I’ll pay ». It was the key to the organization of the British ban- king system in the 19th century. The entire banking system was built on bankers’ acceptances, basically what we call today commercial papers.
I happen to know that because I know monetary history. And so I said to myself what’s different about the modern system is that this credit default swap floats freely, it’s not attached to a particular instrument. The second difference is that there’s no lender of last resort. There’s no support for it. What’s happening right now is that these instruments are getting dislocated from the actual underlying credit risks. And what’s even worse, those prices are the prices that we’re using to mark to market on actual balance sheets. This sort of free-floating instrument is driving down valuations away from their fundamentals.
That was a short letter, on the basis of which I got invited to a meeting that Joseph Stiglitz held in Manchester in June, and I turned it into a short paper. And they liked the paper and suggested I turn it into a chapter for the book. I spent about a month in the summer, revising it for the book. Then, when the crisis came in mid- September, when AIG went down, the penny dropped for me and I said, « Okay, I get it. I see what’s happening, and I now think I know what we can do to fix it ». And I wrote another letter to the Financial Times, which they published September 19. I immediately started working on expanding that into a proposal, which was published in the Economists’ Forum in the Financial Times a couple of days later, called « Budget plus RFC (Reconstruction Finance Corporation) Equals the Right Financial Fix." I suggested the government should go into the business of writing credit insurance, as premiums you would accept payments with preferred stock. I proposed that while TARP was being designed and eventually got involved in the legislation pro- cess. I don’t know if I can take any credit for that but in fact there’s a Section 102 in that legislation that allows TARP to write credit insurance. Nobody seems to have noticed that, the press has not written about it, but it’s there.
The idea is thus that the government should be serving as credit insurer of last resort. AIG and others were serving this function, but they aren’t anymore. They’re certainly not writing any new policies. Nobody is writing new policies, and as a consequence, the securitized credit markets are just completely frozen. The reason they are frozen is because there’s no insurance backstop. So I’m proposing that we create one and that the government should be in that business.
The first idea is that it could use existing credit default swap markets; this goes back to what I said about the 19th century, that we need a lender of last resort
to backstop this thing. More generally, the government should be in the business of selling insurance against disaster risks. Most of the time, it does exactly the opposite; it feeds « the next 10 percent of losses we’ll help you with ». What I suggest is that we don’t pay for the next 10 percent but for the bottom 90, or the bottom 50; so that we create a floor. This insurance would then be a new policy instrument, just like bank rate was a new policy instrument invented by the Bank of England in the 19th century.
The price of this insurance would be the price of systemic risk, because you’re insuring the triple-A securitized credits, the very best ones. Those are the ones that go down only when the system is in systemic crisis. No private insurer can actually fulfill an insurance contract like that, but the government can. And actually it is fulfilling that func-tion right now, but without getting any premiums for it beforehand.
The idea behind pricing the systemic risk is to change the behavior of people in this market. If you had priced the systemic risk right, if AIG was charging 15 basis points to insure the triple-A super-senior CDO tranches held by UBS - it’s in their report; they were charging 15 basis points - UBS was doing an arbitrage on this that they were earning about 15 basis points on. And they leveraged this to the hilt because they were allowed to treat this as tier one capital under Basel II. If you charged 30 basis points for that insurance, that arbitrage would go away. They would never have done that in the first place, since it would not have been profitable. And we know retrospectively that it wasn’t profitable socially; what I suggest is to make it unprofitable before it starts.
There are other benefits with this. For instance, you could use this measure counter-cyclically; changing the price of insurance cycli- cally, independently of the discount rate. You could also choose what instruments you’re going to insure and which ones you’re not. You can use it as an oversight of the ratings agency; because what counts is a triple-A securitized credit. It could be up to the government, not just up to the ratings agency.
Instead of doing that, the government has been doing the Central Bank balance sheet. The TARP is in fact a sort of side issue; they spent hardly any money.Everything that has happened in the last six weeks or even in the last year has happened on the balance sheet of the Fed. A year ago, the balance sheet of the Fed looked as follows: $900 billion-worth of Treasury bills on one side; $900 billion-worth of currency on the other side, then a few small items (bank reserves, a couple of billion dollars here or there). The major numbers were Treasury bills and currency. The currency is still there; the Treasury bills have all been sold, and the proceeds have been lent out to banks. Which means that the first trillion dollars of support for this system came from stripping the Central Bank of all of its Treasury bills. (Then the Central Bank balance sheet was expanded by $527 billion, up to $2.3 trillion.) And then another trillion dollars worth of lending went to private banks against mortgage-backed security collateral. In parallel, we see how banks’ reserve balance grows: the required reserve in our system is $50 billion; today it’s $550 billion. It all happens on the balance sheet of the Fed because the Fed has the freedom to maneuver.
« The idea behind pricing the systemic risk is to change the behavior of banks and financial institutions."
The point I want to make is that most of it was triple-A loans. When you hear about « toxic assets », you imagine that somehow it’s all garbage. In fact, most of the CDO tranches out there have not defaulted and will not default. But they are trading at 60 cents on the dollar, and they’re being marked on the books of the banks at 60 cents on the dollar.
What happened since? We had the collapse of asset-backed commercial paper and we’re moving the entire wholesale money market onto the balance sheet of the Fed - little by little, but eventually those « littles » add up, and you get trillions and trillions. We have new faci- lities for this: The Money Market Investment Funding Facility, with some $540 billion, and the Commercial Paper funding Facility with $300 billion. In sum, our policymakers are saying « we must make it possible for them to hold these mortgage-backed securities, so we’re going to help them with their unsecured funding. We’re going to take credit risks, and our credit risk is going to be to the banks themselves. We’re going to give them unsecured funding, non-recourse loans, etc. And we’re going to give them capital. » What I’m suggesting is to do it the other way around: Support the value of these assets, even at a very low level, and then they can get their own funding. Then you can use secured funding instead of using them at the discount window of the Fed.
At the moment we speak the Federal Reserve Bank has given some $2.2 trillion in credit, of which $615 billion to foreign central banks, in order to help foreign bankers hold dollar-denominated mortgage-backed securities they never intended to hold - they were in SIVS somewhere, and the SIVS collapsed. We’re lending them money: to the ECB, the ECB lending it on to their banks, and to Switzerland, and so forth.
The Central Bank used to issue currency at 0 percent rate of interest in order to hold the Treasury bills. The U.S. Fed used to be about financing the government. Now the government is about financing the Fed, the Fed is issuing liabilities to the Treasury and using those proceeds to lend to private banking.
1 Fischer Black And The Revolutionary Idea Of Finance, John Wiley & Sons 2005. Fischer Sheffey Black (1938-1995) was an American economist, best known as co-author of the famous Black-Scholes equation (presented in the article “The Pricing of Options and Corporate Liabilities”, Journal of Political Economy 81/3 May-June 1973, pp. 637-54.)