that financial markets can efficiently allocate capital without putting the economy and taxpayers at this degree of risk again

TO BE NOTED: From Reuters:

"Fed's Rosengren: Need better research on markets, economy link

Fri Jun 5, 2009 3:41pm EDT

NEW YORK (Reuters) - Forecasters may have been able to recognize the severity of the global downturn earlier, if they had had a better understanding of the interaction between financial markets and the economy, the president of the Federal Reserve Bank of Boston said on Friday.

Eric Rosengren, speaking at a Federal Reserve conference in Washington, said the increased importance of liquidity disruptions and changes in the securitization markets, are likely to have a "long-lasting impact on financial markets and perhaps on how economists perceive them".

"My point is that even after serious problems in housing and financial markets are revealed, many forecasters underestimated the size and severity and length of the downturn," he said.

"The financial crisis of the last 20 months highlights the need for better understanding of the links between financial intermediaries, financial markets and the real economy."

Rosengren noted that a range of financial institutions and markets have been changing significantly as a result of liquidity concerns during the crisis.

"These disruptions have not been short-lived, even more than 20 months into the crisis many markets are still not functioning as they did," Rosengren said.

Investors in money market mutual funds have shifted away from commercial paper -- which companies use to cover short-term funding needs -- to more liquid government securities since the financial crisis escalated in October, Rosengren said.

"I suspect that the shift in money-market funds' liquidity preferences is likely to have longer-term repercussions for the medium-term financing needs of firms," he said.

Securitization markets, also suffering from a decrease in investor confidence, have been "severely impaired", Rosengren said.

"In an environment where investors are less willing to rely on third-party ratings, securitizations will need more transparent structures," he said.

The fact that exchange-traded markets have suffered less than those dominated by dealers, has broader implications for market structure and potential systemic risk, Rosengren said.

INTEGRAL ROLE

Rosengren, a former bank supervisor, said the Federal Reserve "can and must play an integral role in the regulatory framework in the United States."

"Reform efforts need to consider appropriate regulatory and supervisory measures to insure that financial markets can efficiently allocate capital without putting the economy and taxpayers at this degree of risk again," he said.

He said that government "stress tests" of how the 19 biggest U.S. banks would fare in an even worse economic environment highlighted shortcomings in banks' management information systems and data.

But he noted the tests had helped banks raise additional capital, as the transparency helped raise investor confidence in the institutions.

The role of debt on banks' balance sheets should also be considered, he said, as many banks use debt instruments to meet capital requirements. He said a way to reform this could be that banks can only use debt to meet capital requirements if they have automatic triggers to convert to common equity in the event of an economic downturn, for example.

Thirdly, he said, the role of banks' off-balance sheet activities also needs "significantly more supervisory attention going forward. It will be important to ensure that capital held for off-balance sheet exposures is commensurate with the risk that they pose," he said.

(Reporting by Kristina Cooke, Editing by Chizu Nomiyama)"

"The Impact of Liquidity, Securitization, and Banks on the Real Economy

by Eric S. Rosengren, President & Chief Executive Officer
Panel Discussion at the Conference on Financial Markets and Monetary Policy
Sponsored by the Federal Reserve Board and the Journal of Money, Credit, and Banking
Washington, D.C.
June 5, 2009

Complete speech, with figures

Introduction
1. The Role of Liquidity
2. The Role of Securitization
3. The Role of Banks
Concluding Observations

It is a pleasure to be here with everyone participating in the conference, and my fellow panelists and Vice Chairman Kohn.[Footnote 1]

The financial crisis of the last 20 months highlights the need for better understanding of the links between financial intermediaries, financial markets, and the real economy. Consider the fact that many models of the economy underestimated emerging problems, in part because the financial links to the real economy are, in my view, only crudely incorporated into most macroeconomic modeling. Indeed, most forecasters did not recognize we were in a recession in the spring of 2008 even though the recession, as now dated by the National Bureau of Economic Research (NBER), began in December 2007. Of course this happens with recessions, but my point is that even after serious problems in housing and financial markets were revealed, many forecasters underestimated the size, severity, and length of the downturn. In fact, many analysts and economists were focused on short-term inflation risks in the spring of 2008, when we were entering the most severe recession of the past 50 years.

Part of the reason, I think, relates to three critical features of this crisis I would highlight – features, I would add, that are likely to have a long-lasting impact on financial markets and perhaps on how economists perceive them:

• the first is the increased importance of disruptions to liquidity;
• the second involves the significant changes that occurred in securitization;
• the third involves banks and their role in the economy.

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1. The Role of Liquidity
Liquidity risk has received relatively scant attention in academic research. And the Basel II Capital Accord, which focused on a bottom-up assessment of risks at financial institutions, emphasized holding capital for credit risk, market risk, and operational risk.

While liquidity risk was acknowledged, it had no explicit treatment in “Pillar 1” of the Basel II framework, and received relatively little attention in other portions of the framework.[Footnote 2]

Similarly, liquidity receives relatively little focus from most macroeconomists. While it is mentioned in money and banking texts, liquidity is generally characterized as a short-lived problem that can be handled by effective use of the Fed’s discount window. With most liquidity problems short-lived (for example, after the September 11 terrorist attacks), liquidity did not receive that much attention from most economists, financial institutions, or regulators.

But this crisis has been different in that there has been an extended period where bid-to-ask spreads have widened( NB DON ), where conditions have hindered buying or selling in short-term credit markets absent significant price movements, and where there has been a drying up of the ability to engage in various financial transactions that were formerly quite routine and markets that were quite active. I refer to the notion of a "liquidity lock," by which I mean extreme risk aversion by many investors and institutions that fear they will not be able to sell assets in a timely fashion without steep discounts( NB DON ).[Footnote 3] This makes short-term financing difficult to come by, for even creditworthy firms – including financing for very short maturities, measured in days. At certain points in this crisis, market participants saw few if any bids for even high-grade financial paper that had a maturity greater than one day. Another manifestation was the unwillingness of many of the largest financial institutions to lend to each other – as represented by the very large spread between the London Interbank Offered Rate (Libor) and the overnight index swap rate.[Footnote 4]

This unwillingness to take credit risk or to lend money other than overnight constrains creditworthy borrowers from undertaking worthwhile projects – and thus has implications for economic growth. And these disruptions have not been short-lived; even more than 20 months into the crisis many markets are still not functioning as they did.

Exchange-traded markets seem to have been less disrupted than markets dominated by dealers. This has broader implications for market structure and potential systemic risk – implications that I hope will get more attention from researchers and regulators in the future.

A variety of financial institutions and markets are undergoing significant change as a result of liquidity concerns. Considering our time today I will focus on just one example, changes occurring in the money market mutual fund industry. Money market funds do not generally receive much attention. They receive short-term deposits that are then invested in highly liquid short-term investments. But the size and role of the industry has probably been underappreciated – at the end of the second quarter of 2007, money market funds had $2.5 trillion in assets, and were major holders of financial and non-financial commercial paper and large certificates of deposit (CD’s).

Following the failure of Lehman Brothers, investors in some money market funds that held Lehman securities began to withdraw money. Redemptions rose dramatically. Because of losses on the Lehman securities, the Reserve Primary Fund was unable to maintain the standard $1 per share current net asset value – they “broke the buck.” This had very significant implications, as did the need of numerous banks to support their money market funds to avoid a similar outcome. For example, because of concern over redemptions, money market funds that were still willing to purchase commercial paper wanted only very short maturities.( NB DON )

As Figure 1 shows, the overall result was a significant outflow from prime money market funds, which merited a policy response. The Treasury announced a temporary insurance program and the Federal Reserve created two liquidity facilities under its “Section 13-3” authority.[Footnote 5] Since market participants largely viewed the programs as temporary, there have been significant shifts in the holdings of money market mutual funds. Figure 2 and Figure 3 show that such funds have shifted their composition materially, away from commercial paper and toward more liquid government securities. In part this represents a change in preferences of investors, who have shifted assets to government funds, and in part a change in preferences of fund managers seeking more liquid positions. However, the shift has disrupted the commercial paper market, increasing spreads and causing some issuers to rely on the Federal Reserve’s commercial paper funding facility. All in all, I suspect that the shift in money-market funds’ liquidity preferences is likely to have longer-term repercussions for the medium-term financing needs of firms.

This is just one example of how liquidity issues may have longer run implications. A broader question for economists is how illiquidity could persist for so long. While this is a good topic for future research, I would highlight two interrelated factors. First, much of the illiquidity results from concerns with counterparty risk. Major financial firms were unwilling to trade with other major firms in volume, because of concerns about solvency risk – and the opaqueness of firms made it difficult to ascertain their true financial health. Financial firms and regulators need to consider ways to make entities less opaque. Second, securitization often relied on financial firms to provide liquidity and credit support, and was dependent on investor confidence in ratings. As investor confidence in financial firms and ratings of structured products waned, securitization declined dramatically – and many markets became significantly less liquid, as firms did not want to hold assets they could not securitize.

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2. The Role of Securitization
Turning to a second major issue, securitization, I would note that the aforementioned liquidity concerns initially had their roots in credit concerns – for example, in worries about the potential of mortgages bundled into securities to go into default. Some of my colleagues have observed that credit worries have existed for centuries – so why, this time, have credit problems turned into severe liquidity stresses? I suspect that securitization has played a role, in particular the rise of what I have called “surrogate securitization” (where investors were willing to buy debt assigned high credit ratings by rating agencies, to whom they basically delegated due diligence).[Footnote 6]

With that thought, allow me to discuss securitization, where loans are pooled together and sold to investors. Originally, the securitization market served as a source of financing primarily for home mortgages, but increasingly it was used to finance credit card receivables, home equity loans, and car loans. Because assets were financed by issuing securities directly to the marketplace, many assumed that securitization would provide a more resilient source of financing than depending on financial intermediaries. But ironically, the events of this crisis led to a state where securitization has been severely impaired, leading to increases in the cost of financing for assets that could no longer be easily securitized.

Figure 4 shows the significant decrease in asset-backed commercial paper (ABCP) outstanding. ABCP was frequently sold to money market funds and other intermediaries interested in holding short-term, high-quality paper. ABCP usually was sponsored by commercial banks that provided liquidity, credit support, or both. With the onset of the crisis it became increasingly difficult for such sponsors to place their commercial paper, as potential investors became concerned about both the credit quality of the assets and the credit quality of some sponsors. In addition, changes in accounting rules for off-balance-sheet conduits made this type of financing less economical. As a result, ABCP issuance has significantly decreased.

Similarly, other types of securitization have been under severe stress. As investor demand for structured finance decreased, relatively few securitizations have occurred. Figure 5 shows the dramatic decline in securitization of home equity loans, credit card receivables, student loans, and car loans. While there are alternatives to securitization, such as bank lending, this represents a narrowing of financing sources – and in the case of bank loans, has implications for capital requirements.[Footnote 7] Overall, the cost to borrowers is likely to go up.[Footnote 8]

More research is needed on the links between banks and the securitization markets, and the structure of securitization. Many securitizations are sponsored by financial institutions, and rely on their credit and liquidity support. As a result, securitization is not as insulated from banking problems as many assumed. Also, lack of confidence in ratings has reduced investor demand. In an environment where investors are less willing to rely on third- party ratings, securitizations will need more transparent structures that allow for easier monitoring of risks.

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3. The Role of Banks
Turning to the role of banks, in this crisis large banks have been extended unprecedented support – extensions of deposit insurance, federal guarantees of debt, and equity infusions. The support required to alleviate the crisis suggests that clearly, financial supervision and regulation must be enhanced going forward. In the limited time we have today, we cannot do justice to all the lessons we should draw from recent experience, but I would like to highlight three.

First, the stress tests conducted earlier this year were instructive to banks and supervisors. Some banks had difficulty providing the data needed as inputs to the tests – data that would ideally exist as inputs to robust budgeting and risk-management systems. Thus, like the crisis itself, the stress tests highlighted shortcomings in management information systems and data.

Because the stress-tests were done simultaneously across institutions, using the same assumptions, it was possible to compare results – and, indeed, to observe differences in institutions’ ability to undertake a rigorous test. Previously supervisors did conduct comparative exercises (called horizontal reviews), but the sequential nature of those exercises (that is, their occurrence in different time periods) made it more difficult to compare results across institutions.

The stress tests provide a top-down assessment of capital, based on economic assumptions – and thus provide a very good complement to the bottom-up risk assessment that is the cornerstone of most risk-management frameworks at major banks and is the cornerstone of the Basel II Capital Accord. In addition, making the results public allowed outside investors to “bound” the likely losses at financial institutions, even considering the more dire outlook (compared to the base forecast of many) that was part of the stress tests. This ultimately helped financial institutions raise additional capital at a critical juncture for the economy.[Footnote 9]

A second area that should be considered is the role of debt. A variety of debt instruments are issued by banks and qualify as capital for institutions’ capital requirements, and the use of subordinated debt has been advocated by some economists. However, the reluctance to require debt to be converted to equity, or to shoulder more of the losses, should cause us to reexamine the role of debt in systemically important institutions. A number of proposals exist, but one possibility for reform would be to establish that debt instruments could be used to meet capital requirements only if they have automatic triggers to convert to common equity under certain circumstances.[Footnote 10] While such instruments would not likely be attractive in the current environment, they may find acceptance once the economy and financial markets have recovered.

A third area involves the off-balance sheet operations of banks. Many large banks are market makers in assets held off of balance sheets. This has resulted in banks having very sizeable positions in derivatives instruments relative to their capital positions. In addition, banks had significant positions in structured investment vehicles and conduits that had much more risk than many financial institutions and their supervisors thought prior to the crisis. Examination and understanding of the role of off-balance sheet activities deserves significantly more supervisory attention, going forward. It will be important to ensure that capital held for off-balance sheet exposures is commensurate with the risk that they pose.

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Concluding Observations
Allow me to close with a few concluding observations. This crisis highlights the important role of financial institutions and markets on the real economy. In my view this is an area that does not receive sufficient attention in research, or in the teaching of economics.

The contributions of financial institutions and markets to the length and severity of this recession are likely to be a topic of research well into the future. However, given the extent of government intervention that has been necessary, more preventive measures must be considered.

Reform efforts will need to consider appropriate regulatory and supervisory measures to insure that financial markets can efficiently allocate capital without placing the economy, and taxpayers, at this degree of risk again. To accomplish this, I would suggest that lawmakers and policymakers will need to keep in mind the complex but undeniable way that financial markets, financial institutions, and financial matters such as liquidity and securitization interact with the real economy. And this, I firmly believe, means the Federal Reserve can and must play an integral role in the financial regulatory framework in the United States.

Thank you.

Complete speech, with figures

No animal spirits, no recovery

TO BE NOTED: From Inner Workings:

"No Risk, No Volatility, No Economy May 14th, 2009
By David Goldman

LIBOR fell today to 85 basis points, the lowest level since the crisis began. All other risk parameters look benign. My favorite is the failsafe risk measure, the cost of protection against sovereign defaults by the major industrial nations. Here are the last numbers from Markit:

G7 Industrialised Countries CDS

Ticker CLIP Name 5Y Today Daily Chg (bp) Weekly Chg (bp) 28 Day Chg (bp) USGB 9A3AAA Utd Sts Amer 23 1 -14 -22 JAPAN 4B818G Japan 50 1 -17 -23 DBR 3AB549 Fed Rep Germany 25 1 -11 -17 UKIN 9A17DE Utd Kdom Gt Britn & Nthn Irlnd 61 0 -29 -28 FRTR 3I68EE French Rep 29 2 -9 -15 ITALY 4AB951 Rep Italy 75 0 -22 -37

The US sovereign had traded at 75 basis ponts above LIBOR; it is now down to +23 basis points. Notably, the UK sovereign has tightened nearly 30 basis points over the past week. That is the one to watch, given that a systemic banking crisis threatened to overflow the banks of the Thames in emulation of Iceland only a few months ago.

This is worth taking note of. There’s no sense of systemic risk in the midst of a worldwide reversal of sentiment and retreat of stock markets. That’s because the financial system is in the zombie embrace of the governments. VIX picked up a bit yesterday, but per my expectation remains on a downward trend.

No risk, but no economy. There is no sign of improvement in world trade, and China’s export numbers yesterday were terrible. There is no real sign of life from the American consumer, as yesterday’s retail numbers suggested in the United States.

The only way to get an economy moving out of a stall of this magnitude is animal spirits. Greed has to flicker in the cowardly hearts of investors and get them out of their holes. But that is not going to happen, for greed is a bad thing. Greedy speculators who want to squeeze what they are entitled to by law out of the exploited auto workers of the Midwest will be denounced by the White House, subject to public humiliation, and given private death threats. Greedy Wall Street bankers will have their bonuses reduced by law. And those greedy capitalists who earn too much will pay a great deal more in taxes.

No animal spirits, no recovery. Send out for sandwiches. This is going to be a long, long adminstration."

"that the central bank should lend to illiquid but solvent banks, at a penalty rate, and against collateral deemed to be good under normal times."

Xavier Freixas and Bruno M. Parigi consider the concept of the Lender Of Last Resort on Vox:

"This column argues that the financial crisis of 2007 and 2008 redefines the functions of the lender of last resort, placing it at the intersection of monetary policy, supervision and regulation of the banking industry, and the organisation of the interbank market.

Since the creation of the first central banks in the 19th century, the existence of a lender of last resort (LOLR) has been a key issue for the structure of the banking industry. Banks finance opaque assets with a long maturity with short-lived liabilities – a combination that is vulnerable to sudden loss of confidence ( A BANK RUN ). To avoid avoidable disasters when confidence evaporates, the classical view (Thornton 1802 and Bagehot 1873) is that the central bank should lend to illiquid but solvent banks, at a penalty rate( ONEROUS ), and against collateral deemed to be good under normal times( YES ).

With the development of well-functioning financial markets, this view has been considered obsolete( IT IS ? ). Goodfriend and King (1988) in particular argue that the central bank should just provide liquidity to the market and leave to banks the task of allocating credit and monitoring debtors. This view, however, assumes that interbank markets work perfectly and in particular are not plagued by asymmetric information – but that is one of the main reasons why banks exist. The problem with asymmetric information is that liquidity shocks affecting banks might be undistinguishable from solvency shocks, thus making it impossible to distinguish between illiquid and insolvent banks( TRUE ) (Goodhart 1987 and Freixas, Parigi and Rochet 2004).

LOLR and bank closure policy

LOLR is thus connected with the efficient bank closure policy and, more generally, with the costs of bank failures and of the safety net. In cases of illiquidity, the LOLR is channelling liquidity and improving the efficiency of the monetary policy framework( TRUE ). In insolvency cases, the LOLR acts as part of a safety net and thus is directly related to the overall regulatory framework( TRUE ).

Clearly, the design of an optimal LOLR mechanism has to take into account both the banking regulation context and the monetary framework that is intended to cope not only with inflation but also with the management of aggregate liquidity ( YES ).

These issues are compounded by the fact that financially fragile intermediaries are exposed to the threat of systemic risk. Systemic risk may arise from the existence of a network of financial contracts from several types of operations: the payment system, the interbank market, and the market for derivatives. The tremendous growth of these operations recent decades has increased the interconnections among financial intermediaries and among countries. This has greatly augmented the potential for contagion( TRUE ) (Allen and Gale 2000 and Freixas, Parigi and Rochet 2000).

The panic of 2008 and subprime crisis of 2007

The panic of 2008, originating with the subprime crisis of 2007, offers key insights into systemic risk and illustrates vividly the new role of a lender of last resort.

Years of accommodating monetary policy( LOW INTEREST RATES ), regulatory arbitrage to save capital( SEEKING INVESTMENT WITH LOWER CAPITAL STANDARDS ), and waves of financial innovations( CDSs, CDOs, etc. ) – which by definition tend to escape traditional prudential regulation( TRUE ) – have created the conditions( I'LL ACCEPT CONDITIONS, BUT NO MORE ) for slack credit standards and rating agencies that fail to call for adequate risk premia( BUT THEY TOOK ADVANTAGE OF THE CONDITIONS FREELY ).

The opacity of the assets of the banks and of the financial vehicles they created to hold mortgages resulted in a dramatic and sudden reappraisal of risk premia( FEAR AND AVERSION TO RISK, AND THE ACCOMPANYING FLIGHT TO SAFETY ). As with a thin market typical of the Akerlof lemons problem (Freixas and Jorge 2007), financial intermediaries have become reluctant to lend to each other if not for very short maturities. The fear that the interbank market might not work well and might fail to recycle the emergency liquidity provided by the central banks around the world in various and coordinated ways has induced banks to choose the rational equilibrium strategy of hoarding some of the extra liquidity instead of recycling it to the banks in deficit.

The resulting equilibrium closely resembles the gridlock described by Freixas, Parigi and Rochet (2000), where the fear that a debtor bank will not honour its obligations induces the depositors of the creditor bank to withdraw deposits, thus triggering the liquidation of assets in a chain reaction. This is the modern form of a “bank run” – financial intermediaries refuse to renew credit lines to other intermediaries, thus threatening the very survival of the system( TRUE. IT IS LIKE A BANK RUN. THAT'S ESSENTIALLY WHAT THE FLIGHT TO SAFETY IS ).

Liquidity in a non-functioning interbank market

Clearly channelling emergency liquidity assistance through the interbank market will not work if the interbank market is not functioning properly. Thus, to limit the systemic feedbacks of the sudden deleveraging of financial institutions, the Fed has taken the unprecedented steps of both increasing the list of collateral eligible for central bank lending and extending emergency liquidity assistance to investment banks, government sponsored entities, money market mutual funds, and a large insurance company (AIG). Preventing a complete meltdown of the financial system has required the central bank to guarantee (and accept potential losses) that most if not all claims on financial institutions will be fulfilled( THAT'S IT. GUARANTEE ).
The panic of 2008 has showed that it would be erroneous to adopt a narrow definition of the LOLR, stating that its role should be limited to the funding of illiquid but solvent depository institutions, while capital injections should be the Treasury’s responsibility( TRUE ). This would lead to a very simplistic analysis of the LOLR’s functions, as the complex decisions would be either ignored or handed over to the Treasury. Such a narrow view of the lender of last resort would create an artificial separation between lending by the lender of last resort at no risk and the closure or bail-out decision by the Treasury. In fact, the recent crisis has proved that the lender of last resort cannot deny support to a systemic, too-big-to-fail financial institution in need( BINGO! AND THE MARKET AND INVESTORS BELIEVED THAT AND HAVE BEEN ACTING UNDER THAT PRESUMPTION ).
To understand the interventions of the lender of last resort in the current crisis, the view of its role has to be a broad one encompassing the closure or bail-out decision defining the lender of last resort as an agency that has the faculty to extend credit to a financial institution unable to secure funds through the regular circuit.

LOLR policy as part of the banking safety net

Once we establish that the lender of last resort policy has to be part of the overall banking safety net, the interdependence of the different components of this safety net becomes clear.

• First, the existence of a deposit insurance( FDIC ) system limits the social cost of a bank’s bankruptcy, and therefore, reduces the instances where a LOLR intervention will be required. ( TRUE )
  
• Second, capital regulation( REQUIRING HIGHER CAPITAL ) reduces the probability of a bank in default being effectively insolvent, and so has a similar role in limiting the costly intervention of the LOLR.( TRUE)
  
• Third, the procedures to bail-out or liquidate a bank, determined by the legal and enforcement framework will determine the cost-benefit analysis of a LOLR intervention( WE WISH ).

Adopting a perspective of an all-embracing safety net does not mean that the safety net has to be the responsibility of a unique agent. Often several regulatory agencies interact, because different functions related to the well functioning of the safety net are allocated to different agents( OK ).

It is quite reasonable to separate monetary policy from banking regulation, and the separation of the deposit insurance company from the central bank makes the cost of deposit insurance more transparent. Also, the national jurisdiction of regulation makes cross-border banking a joint responsibility for the home and host regulatory agencies, an issue of particular concern for the banking regulatory authorities in the EU.

Lessons for the LOLR’s role

• First, we have witnessed how an additional aggregate liquidity injection is not a sufficiently powerful instrument to solve the crisis. ( TRUE )
  

The illiquidity of financial institutions around the world is, in fact, directly linked not only to their solvency but also to asset prices.

• Second, central banks around the world have been much more flexible in providing support to the banking industry than initially expected( I DON'T AGREE ).

In other words, that central bank cannot credibly commit to a bail-out policy( YES IT CAN ). Indeed, the arguments regarding the bail-out of banks only if their closure could have a systemic impact (too-big-to-fail), that were intended for an individual bank facing financial distress were soon discarded in favour of a more realistic approach.

The case of Northern Rock, certainly not a systemic bank, illustrates this point. Its liquidation in such a fragile banking environment would have triggered a domino effect with contagion from one institution to another. From that perspective the lesson is that when facing a systemic crisis, the LOLR has to take into account also the “too-many-to-fail” issue, and consider how it will treat all banks that are in a similar position( TRUE ).

• A third point is that, in a systemic crisis, the safety net is extended to non-bank institutions. ( TRUE )
  

This may be the result of financial innovation. Yet, because AIG had been issuing credit default swaps, its bankruptcy would have affected the fragility of the banking industry by leading to losses and a lower capital.

• Fourth, regulators around the world have a mandate to protect the interests of their national investors. ( COME ON )
  

The international coordination of regulators, and in particular, the European coordination has been helpless when faced with the real cost of the Icelandic crisis. So, the theoretical models of non-cooperative behaviour( YEP ) are the ones to cope ex-ante with the burden-sharing issue."

Truthfully speaking, countries have been pursuing a beggar thy neighbor policy right from the start. A good article, but of limited scope.

Editor’s note: This article draws in part on the work Freixas and Parigi (2008).

References

Allen, F. and Gale, D. (2000). Financial Contagion, Journal of Political Economy, 108, 1-33
Bagehot, W. (1873). Lombard Street: A Description of the Money Market. London: H.S. King
Freixas, X. and Jorge, J. (2007). The role of Interbank Markets in Monetary Policy: A model with rationing, Journal of Money, Credit and Banking, forthcoming.
Freixas, X. and Parigi, B.M. (2008) “Lender of last resort and bank closure policy” CESifo working paper 2286, April 2008
Freixas, X., Parigi, B.M. and Rochet, J-C. (2000). Systemic Risk, Interbank Relations and Liquidity Provision by the Central Bank, Journal of Money, Credit and Banking August, 32, Part 2, 611-638
Freixas, X., Parigi, B.M. and Rochet, J-C. (2004). The Lender of Last Resort: A 21st Century Approach, Journal of the European Economic Association, 2, 1085-1115
Goodfriend, M. and King, R. (1988). Financial Deregulation Monetary Policy and Central Banking, in W. Haraf and Kushmeider, R. M. (eds.) Restructuring Banking and Financial Services in America, AEI Studies, 481, Lanham, Md.: UPA
Goodhart, C. A. E. (1987). Why do Banks need a Central Bank?, Oxford Economic Papers, 39, 75-89
Thornton, H. (1802). An Enquiry into the Nature and Effects of the Paper Credit of Great Britain, London: Hatchard

"This process repeats itself and eventually market prices will develop."

Derivative Dribble with another excellent post:

"A Higher Plane

In this article, I will return to the ideas proposed in my article entitled, “A Conceptual Framework For Analyzing Systemic Risk,” and once again take a macro view of the role that derivatives play in the financial system and the broader economy. In that article, I said the following:

“Practically speaking, there is a limit to the amount of risk that can be created using derivatives. This limit exists for a very simple reason: the contracts are voluntary, and so if no one is willing to be exposed to a particular risk, it will not be created and assigned through a derivative. Like most market participants, derivatives traders are not in engaged in an altruistic endeavor. As a result, we should not expect them to engage in activities that they don’t expect to be profitable. Therefore, we can be reasonably certain that the derivatives market will create only as much risk as its participants expect to be profitable.” ( VERY TRUE )

The idea implicit in the above paragraph is that there is a level of demand for exposure to risk ( TRUE ). By further formalizing this concept, I will show that if we treat exposure to risk as a good, subject to the observed law of supply and demand, then credit default swaps should not create any more exposure to risk in an economy than would be present otherwise and that credit default swaps should be expected to reduce the net amount of exposure to risk ( TRUE ). This first article is devoted to formalizing the concept of the price for exposure to risk and the expected payout of a derivative as a function of that price. ( A GOOD IDEA )

Derivatives And Symmetrical Exposure To Risk

As stated here, my own view is that risk is a concept that has two components: (i) the occurrence of an event and (ii) a magnitude associated with that event. This allows us to ask two questions: ( 1 )What is the probability of the event occurring? ( 2 ) And if it occurs, what is the expected value of its associated magnitude? We say that P is exposed to a given risk if P expects to incur a gain/loss if the risk-event occurs. We say that P has positive exposure if P expects to incur a gain if the risk-event occurs; and that P has negative exposure if P expects to incur a loss if the risk-event occurs.

Exposure to any risk assigned through a derivative contract will create positive exposure to that risk for one party and negative exposure for the other ( THIS IS WHAT I SAID WAS A LOSS FOR ONE AND A GAIN FOR THE OTHER ). Moreover the magnitudes of each party’s exposure will be equal in absolute value ( THEY WILL BALANCE OUT ). This is a consequence of the fact that derivatives contracts cause payments to be made by one party to the other upon the occurrence of predefined events ( TRUE ). Thus, if one party gains X, the other loses X( I SAID THAT ABOVE. I AGREE ). And so exposure under the derivative is perfectly symmetrical ( TRUE ). Note that this is true even if a counterparty fails to pay as promised ( TRUE ). This is because there is no initial principle “investment” in a derivative. So if one party defaults on a payment under a derivative, there is no cash “loss” to the non-defaulting party ( TRUE ). That said, there could be substantial reliance losses ( TRUE ). For example, you expect to receive a $100 million credit default swap payment from XYZ, and as a result, you go out and buy $1,000 alligator skin boots, only to find that XYZ is bankrupt and unable to pay as promised. So, while there would be no cash loss, you could have relied on the payments and planned around them, causing you to incur obligations you can no longer afford ( TRUE ). Additionally, you could have reported the income in an accounting statement, and when the cash fails to appear, you would be forced to “write-down” the amount and take a paper loss ( TRUE ). However, the derivatives market is full of very bright people who have already considered counterparty risk, and the matter is dealt with through the dynamic posting of collateral over the life of the agreement, which limits each party’s ability to simply cut and run ( TRUE ). As a result, we will consider only cash losses and gains for the remainder of this article.

The Price Of Exposure To Risk

Although parties to a derivative contract do not “buy” anything in the traditional sense of exchanging cash for goods or services, they are expressing a desire to be exposed to certain risks ( THAT'S IT ). Since the exposure of each party to a derivative is equal in magnitude but opposite in sign, one party is expressing a desire for exposure to the occurrence of an event while the other is expressing a desire for exposure to the non-occurrence of that event ( TRUE ). There will be a price for exposure. That is, in order to convince someone to pay you $1 upon the occurrence of event E, that other person will ask for some percentage of $1, which we will call the fee ( PREMIUM ). Note that as expressed, the fee is fixed. So we are considering only those derivatives for which the contingent payout amounts are fixed at the outset of the transaction. For example, a credit default swap that calls for physical delivery fits into this category. As this fee increases, the payout shrinks for the party with positive exposure to the event ( TRUE ). For example, if the fee is $1 for every dollar of positive exposure, then even if the event occurs, the party with positive exposure’s payments will net to zero ( TRUE ).

This method of analysis makes it difficult to think in terms of a fee for positive exposure to the event not occurring (the other side of the trade) ( YOU KEEP THE FEES ). We reconcile this by assuming that only one payment is made under every contract, upon termination ( THAT'S IT ). For example, assume that A is positively exposed to E occurring and that B is negatively exposed to E occurring. Upon termination, either E occurred prior to termination or it did not. ( OKAY )

If E did occur, then B would pay to A, where F is the fee and N is the total amount of A’s exposure, which in the case of a swap would be the notional amount of the contract":

Under a typical CDS, the protection buyer, B, agrees to make regular payments (let’s say monthly) to the protection seller, D. The amount of the monthly payments, called the swap fee, will be a percentage of the notional amount of their agreement. The term notional amount is simply a label for an amount agreed upon by the parties, the significance of which will become clear as we move on. So what does B get in return for his generosity? That depends on the type of CDS, but for now we will assume that we are dealing with what is called physical delivery. Under physical delivery, if the reference entity defaults, D agrees to (i) accept delivery of certain bonds issued by the reference entity named in the CDS and (ii) pay the notional amount in cash to B. After a default, the agreement terminates and no one makes anymore payments. If default never occurs, the agreement terminates on some scheduled date. The reference entity could be any entity that has debt obligations, like AIG.

"If E did not occur, then A would pay . If E is the event “ABC defaults on its bonds,” then A and B have entered into a credit default swap where A is short ( DEFAULT ) on ABC bonds and B is long ( NO DEFAULT ). Thus, we can think in terms of a unified price for both sides of the trade and consider how the expected payout for each side of the trade changes as that price changes ( BASED UPON THE CHANCE OF DEFAULT ).

Expected Payout As A Function Of Price

As mentioned above, the contingent payouts to the parties are a function of the fee. This fee is in turn a function of each party’s subjective valuation of the probability that E will actually occur( IN THIS IT'S LIKE INSURANCE ACTUARIAL TABLES ). For example, if A thinks that E will occur with a probability of , then A will accept any fee less than .5 since A’s subjective expected payout under that assumption is . If B thinks that E will occur with a probability of , then B will accept any fee greater than .25 since his expected payout is . Thus, A and B have a bargaining range between .25 and .5. And because each perceives the trade to have a positive payout upon termination within that bargaining range, they will transact ( THEY BASE THEIR ACTUAL INVESTMENT ON THE PROBABILITY OF THE EVENT OCCURING IN THEIR OPINION ). Unfortunately for one of them, only one of them is correct ( THIS IS WHERE PEOPLE FEEL IT'S LIKE GAMBLING AND NOT LIKE INSURANCE ). After many such transactions occur, market participants might choose to report the fees at which they transact ( ON AN INDEX ). This allows C and D to reference the fee at which the A-B transaction occurred. This process repeats itself and eventually market prices will develop ( FORMING AN INDEX, AND, POSSIBLY, AN EXCHANGE ).

Assume that A and B think the probability of E occurring is and respectively. If A has positive exposure and B has negative, then in general the subjective expected payouts for A and B are and respectively. If we plot the expected payout as a function of F, we get the following:

The red line indicates the bargaining range. Thus, we can describe each participant’s expected payout in terms of the fee charged for exposure( TRUE ). This will allow us to compare the returns on fixed fee derivatives to other financial assets, and ultimately plot a demand curve for fixed fee derivatives as a function of their price ( TRUE )."

It is important to understand each point as he goes along, so that you can see that the investment has defined terms, and is thus Priceable and Saleable.

Why do I believe that this is so important? Because I do not believe that these investments are that complex. I believe that it is very easy to explain the purpose and risk of these investments, even to people who do not have the ability to understand how the CHANCE OR POSSIBILITY OF THE RISK is determined, which is where the real complexity is located.

Hence, I believe that Fraud, Negligence, Fiduciary Mismanagement, and Collusion, are the main problems associated with these investments in the real world. For example, the iffy nature of the models used to determine the Chance or Possibility of the Risk were known, and all that needed to be explained to a buyer is just that. The methods are iffy.

Stop looking at the investments for the cause of this crisis. It's a charade.

"What does an auto industry default cascade look like? "

Tracy Alloway on Alphaville with a post about why the Automakers would be bailed out through TARP:

"What does an auto industry default cascade look like? Like this, from Bank of America:

And that’s the reason why the US government may well be considering bailing out the country’s flailing auto industry using Tarp funds, according to the Wall Street Journal. It may even go so far as to request the second tranche of the Tarp to do so, according to the article.

Why the desperation determination to bail out what seems like a dying industry? BoA’s Jeffrey Rosenberg explains:
A GM default with no [government] support could lead to payment defaults by GM to its suppliers. The most concentrated of these, Axle, provides little of its sales outside of GM so a default by GM likely cascades into a default at Axle, but becomes limited there. However, consider the exposure of Lear. Here, a default of GM could significantly restrict the ability of Lear to supply Ford. If a payment default from GM lead to a default of Lear and an inability to supply Ford, that could impair Ford’s ability to provide payments to other suppliers. Next, with Ford as its major supplier, Visteon could face payment difficulties.

…

The systemic risk argument of a set of cascading payment defaults is borne out in the close linkages between suppliers and manufacturers. However, as we have argued before, Debtor-In-Possession (DIP) financing helps to forestall such a systemic risk outcome by allowing companies to continue to operate, and in this case, to continue to make payments to their suppliers, and avoid such an event.

By BoA’s reckoning, it would take about £30bn in DIP financing to save General Motors alone (about 2 times working capital plus a £10bn cushion).

Does that seem like a lot? Yes, but when you see graphs like the above you start to understand why the government is concerned about systemic risk.

Of note however, is how potential DIP financing would work. The Fed Reserve has, under “unusual and exigent conditions,” the ability to lend to corporations on a securitised basis — though the funding requires a bankruptcy so the Fed and Treasury can obtain senior claim on all assets. Back to BoA:
Repayment of the loan would contemplate a restructured GM achieving long term viability such that loan proceeds could be paid off over time, say 5-10 years, refinanced or sold to the private market under demonstrated viability several years out.

A 10-year bet that the US auto industry will recover? A rather big gamble for the government (and taxpayers) then."

The gamble that the Treasury Dept. doesn't want to take is with employment and production falling off a cliff. The actual economic sense of the bailout, without Political Economy thrown in, is minimal, and rests on a great deal of Wishful Thinking. I've given pretty stringent requirements for the bailout, which I doubt will be met, but I understand the fear underlying this bailout.

If you believe as I do, that the government not bailing out Lehman caused a crisis of faith in the government's willingness and ability to get us all out of this mess, then you can understand why this bailout is necessary. If you don't think that this is what the underlying assumption and context really is, then I can easily understand your being against this bailout.

"Crises like the current one are inherently unpredictable. "

Greg Mankiw makes a good point:

"Lessons from the Crisis As seen by Michael Spence.

Mike says a lot of smart stuff in this article. But this sentence seems to veer off in the wrong direction, or at the very least could be easily misinterpreted:

we need a commission of top industry professionals and academics to address the challenge of measuring and detecting systemic risk and provide the underpinning of an effective “early warning” system.

I see little hope of creating any kind of "early warning" system, if by that Mike means better forecasting. Crises like the current one are inherently unpredictable. If they were predictable, hedge funds and other money managers would not lose so much money during them."

This is a good point, but not dispositive.

"True, a few people were sounding an alarm in advance of the current crisis: Nouriel Roubini, in particular, comes to mind. And a few hedge funds have made money during the crisis. Yet that fact is not very meaningful. Given the diversity of opinion at any point in time, someone will always look right ex post. The key question is whether the event is reliably predictable ex ante.

Policymakers at the Fed and Treasury cannot do better than rely on the consensus judgment of experts, and a couple years ago the consensus opinion was not predicting anything like what is now occurring. To suggest a regulatory system that gives an "early warning" is like saying we need to find a better crystal ball. Good luck with that."

I think that there's a difference between an early warning system, and deciding what the early warning means. I can certainly think of early warning signs to alert us that we're in need of taking a serious inventory of our circumstances, but whether or not anyone would listen to it any more than any other commission or policy group or whatever is dubious. So, in that sense I agree.

"In my view, the key to regulatory reform is not trying to predict the future with more accuracy but, instead, making the system more robust so that the economy functions better when the unpredictable inevitably occurs. In other words, our focus needs to be not on what will happen but on what might happen."

I'm not sure about the difference between "will" and "might" here. I think that he means we shouldn't try to prevent anything, but be better at reacting to anything. But that can't be right. For one thing, the policies you put in place to react to a crisis are open to the same indeterminacy as trying to predict the exact crisis. You might well prepare for exactly the wrong thing. Also, some things can surely be prevented, so why not prevent them, if you can. True, it's hard to prove that you prevented something that didn't occur, but, it's certainly conceivable that an early warning system could prevent two or three crises, while a robust system fails miserably when the crisis actually occurs.

As an epistemological point, then, I don't see that he has drawn any kind of clear or determinative distinction. The solution is to take a look at both preventative measures and crisis management measures, and employ the most sensible mix of measures that we can agree on, knowing that, well, we don't really know exactly what will happen and when.

One note of major disagreement with Spence:

"Systemic risk escalates in the financial system when formerly uncorrelated risks shift and become highly correlated. When that happens, then insurance and diversification models fail. There are two striking aspects of the current crisis and its origins. One is that systemic risk built steadily in the system. The second is that this buildup went either unnoticed or was not acted upon. That means that it was not perceived by the majority of participants until it was too late. Financial innovation, intended to redistribute and reduce risk, appears mainly to have hidden it from view. An important challenge going forward is to better understand these dynamics as the analytical underpinning of an early warning system with respect to financial instability."

See, I don't buy that financial innovation was intended to reduce risk. It was quite clearly meant to increase risk, in the hopes of higher returns. Lowering capital requirements, avoiding regulations that are intended to dampen risk, selling products to people unable to afford them under any reasonable scenario, are in no meaningful sense capable of lessening risk.

They were intended to redistribute and hide risk, but not in the way Mr. Spence says. And this is my main disagreement with Prof. Mankiw; namely, one can imagine an oversight group that examines all products that transfer risk to third parties or magnify risk. Since that is why they will, in fact, be created, it is not inconceivable that they can be monitored or, if deemed necessary, regulated. If they can be created by human comprehension, then they can be understood by human comprehension as well. This is actually a version of the fact that whatever can be meant can be understood.

"it is ready to begin clearing CDS contracts as soon as it receives regulatory approval"

From Bloomberg, Fed to control clearinghouse for CDS market:

"Nov. 11 (Bloomberg) -- The Federal Reserve is working on a plan that would give it authority to regulate the clearing of trades for the $33 trillion credit-default swap market, according to people with knowledge of the proposal.

The Fed, the U.S. Securities and Exchange Commission, the Treasury Department and the Commodity Futures Trading Commission are discussing a memorandum of understanding that lays out oversight of clearinghouses that would become the central counterparty to credit-default swap trades, said the people who asked not to be named because the discussions are private.

The SEC and CFTC would also share trading information under the plan, the people said.

``The main concern is systemic risk and that's much more in the Fed's wheelhouse than the SEC or CFTC,'' said Craig Pirrong, a finance professor at the University of Houston who studies futures markets. ``The Fed is the natural place for it to go.''

The Fed has been pushing the industry to form a clearinghouse that would absorb losses should a market maker fail. Regulators stepped up their efforts after the failure of Lehman Brothers Holdings Inc. in September and the near-collapse of American International Group Inc. The New York Fed has been meeting with groups including CME Group Inc., Intercontinental Exchange Inc. and NYSE Euronext to press them to accelerate their progress."

The two items that interest me are:

1) The concentration on systemic risk ( Yes )

2) Industry absorb losses ( Yes, if I understand this )

More On Reverse Auctions

Via Greg Mankiw again, a good argument against reverse auctions and TARP by Vernon L. Smith:

"Auction designers should immediately note that we are talking about a market with one buyer and many sellers of a hodge-podge of items. The mechanism that will be used is a "reverse auction" -- with sellers competitively submitting asking prices to sell Treasury a heterogeneous mix of good, some sour, apples and oranges whose content is better known to sellers than the Treasury.

Treasury expertise is in auctioning Treasury securities of a given maturity to multiple competing buyers: say $10 billion worth of six-month bills, or two-year notes. In either case every bill (or note) is identical to every other one. The only uncertainty is the final clearing price and Treasury is assured that it will get the best price.

Treasury has no expertise in this ridiculous new venture. (Auction houses such as Christie's and Sotheby's have no problem with heterogeneous items. They auction them singly or in small assemblies to multiple buyers, who assess the items and make bids that reflect best estimates of true value.)

Treasury action should focus on providing capital to individual banks and mortgage companies in return for debt, convertible bonds and equity and warrants to be negotiated. This is dangerous enough for the taxpayer, but here Mr. Paulson has previous experience. (The model was demonstrated recently when Treasury and the FDIC assisted J.P. Morgan's takeover of Washington Mutual.) Then let companies do any necessary piecemeal paper asset auctions, while Treasury holds managers accountable. This is feasible at least, if hardly risk-free for taxpayers.

This procedure will confront financial systemic risk, and allow prices to emerge competitively that will encourage the all important return of bargain hunting buyers.

Would the procedure work? I don't know. But it does focus on the knowledge that markets are capable of bringing to the table. The bailout does not."

I've never liked this idea and put it on my post about the problems of TARP.