This must be acknowledged in advance, and paid for by the insured institutions.

From Free Exchange:

"Blanchard roundtable: An insurer of last resort

Posted by:

Ricardo Caballero l MIT

Categories:

Blanchard roundtable

Ricardo Caballero is the Ford International Professor of Economics at MIT. This discussion can be followed in its entirety here.

ALTHOUGH the title of Olivier Blanchard’s article may be a bit of an exaggeration, the main characterisation of the crisis and the policy prescriptions are right on the mark. Following Lehman’s demise, world financial markets have been ravaged by uncertainty and fear. The prices of all forms of explicit and implicit financial insurance have skyrocketed and hence, by a basic identity, the prices of risky assets have plummeted or the corresponding markets have disappeared. Nowhere is this scenario more problematic than in institutions with strict capital requirements, such as banks, insurance companies, and monolines. For them, fire-sale asset prices quickly wipe out capital and, simultaneously, destroy their option to raise new capital since equity values implode.

The conventional advice is for these institutions to deleverage and to raise capital. While this is sound advice when dealing with a single institution in trouble, I believe this is exactly the opposite of what we need at this juncture, amid a massive systemic crisis. Forcing institutions to raise capital, be it private or public, at panic-driven fire-sale prices threatens enormous dilutions to already shell-shocked shareholders, further exacerbating uncertainty and fueling the downward spiral. This is self-defeating.

Instead, we need to replace the two functions of bank capital—a buffer for negative shocks and an incentive device to reduce risk-shifting—by the provision of a comprehensive public insurance, and by strict (and intrusive) government supervision while this insurance is in place.

This can be done in many ways, and probably more than one approach will have to be employed. A few days ago Britain announced a policy package that almost got it right, by pledging to insure banks’ balance sheets and other private liabilities. Unfortunately, it backfired and caused a worldwide run on financials because it did not dissipate, and even exacerbated, the fear of forced capital raising (or nationalisation).

The events following Lehman’s demise should have taught us that this fear needs to be put to rest until we can return to normality. Financial institutions are too intertwined to predict with any precision the impact of diluting any significant stakeholder, and the markets are too fearful to handle any more uncertainty. Strong guarantees with strict supervision, and the commitment of no further dilutive capital injections (directly or through bonds converted to equity at fire sale prices) should go a long way in building a foundation for a sustained recovery. Removing from financial institutions’ balance sheets the assets ravaged by uncertainty, paying non-Knightian prices for them, is yet another alternative.

Importantly, some of the lessons learned during this crisis also hint at some of the characteristics of an optimally designed financial system for after the crisis. Contrary to what investors thought at the peak of the boom, the (private) financial sector in America is not able to satisfy the global demand for AAA assets when large negative aggregate events take place. However, the American government does have the capacity to fill this gap, especially because it is the recipient of flight-to-quality capital, even when the core of the global financial crisis is located within its borders.

Thus, I believe we can go back to a world not too different from the one we had before the crisis (real estate prices and construction sectors aside), as long as the government becomes the explicit insurer for generalised panic risk. That is, while monolines and other financial institutions can lever their capital for the purpose of insuring microeconomic risk and moderate aggregate shocks, they cannot be the ones absorbing extreme, panic-driven, aggregate shocks. This must be acknowledged in advance, and paid for by the insured institutions. Reasonable concerns about transparency, complexity, and incentives can be built into the insurance premiums. Collective deleveraging, as currently being done, should not constitute the core response; macroeconomic insurance should."

Me:

Don the libertarian Democrat wrote:

This sounds like FDIC insurance to avoid Bank Runs, only for Calling Runs. How much and what, then, are you saying that the government will guarantee? Is it going to be insurance or a CDS? Will I be able to write a CDS mirroring this insurance?