Wednesday, January 20, 2010

The global safe-asset imbalances and the sub-prime crisis

A large number of the explanations for the Great Recession have blamed the global imbalances - savings glut in the emerging economies and voracious appetite for debt in developed economies - and the (forced) need for their re-adjustment for creating the conditions of financial market instability that triggered off an economic recession.

However, as the crisis unfolded, instead of capital rushing away from the deficit laden US economy and dollar assets (if the aforementioned explanation were true), the capital flight was in the opposite direction. The US did not end up experiencing a deficit funding problem, as the global imbalance school would have predicted.

A more complete understanding of the crisis would have to look beyond the simple savings-deficit imbalance and explain the micro-dynamics of the capital flows. In this context, in earlier posts I had blogged about the role of demand for safe and liquid assets among emerging economy governments and investors (especially in light of their bitter experience with the currency crisis of the late nineties), which the domestic equity and debt markets could not satisfy.

Ricardo Caballero (the full paper here) attributes this phenomenon to another imbalance, one arising from an "insatiable global demand for safe debt instruments" which put great "pressure on the US financial system and its incentives". The bitter experience of the currency crisis of the late nineties and the relative lack of depth of their financial markets meant that the emerging economy markets could not meet the demand for safe assets and had to rely on external markets, of which the US markets were unquestionably superior and safer.

In fact, the demand for safe assets went beyond what was available even in Wall Street and other developed economy markets. The capital flight to safety and liquidity of US assets, and the resultant abundance of liquidity, therefore set in motion perverse incentives to re-package, securitize and sell riskier assets and payment streams as AAA-rated securities (with help from the rating agencies) by creating complex instruments that sought to hide the various risks. The largest re-allocation of funds (from the emerging to developed economies) matched the downgrade in perception of the safety of the newly created triple-A securitization based assets. He writes,

"The surge of safe-asset demand was a key factor behind the rise in leverage and macroeconomic risk concentration in financial institutions in the US as well as the UK, Germany, and a few other developed economies. These institutions sought the profits generated from bridging the gap between this rise in demand and the expansion of its natural supply... the safe-asset shortage was also a central force behind the creation of highly complex financial instruments and linkages, which ultimately exposed the economy to panics triggered by Knightian uncertainty.

This is not to say that the often emphasized regulatory and corporate governance weaknesses, misguided home-ownership policies, and unscrupulous lenders played no role in creating the conditions for the surge in real estate prices and its eventual crash. Instead, these were mainly important in determining the minimum resistance path for the safe-assets imbalance to release its energy, rather than being the structural sources of the dramatic recent macroeconomic boom-bust cycle."

And about how the various credit market mechanims worked to both trigger off and then amplify fear and panic to spread through the markets, he writes

"The triggering event was the crash in the real estate 'bubble' and the rise in subprime mortgage defaults that followed it... The global financial system went into cardiac arrest mode and was on the verge of imploding more than once. This seems hard to attribute to a relatively small shock that was well within the range of possible scenarios.

The real damage came from the unexpected and sudden freezing of the entire securitization industry. Almost instantaneously, confidence vanished and the complexity which made possible the 'multiplication of bread' during the boom, turned into a source of counter-party risk, both real and imaginary. Eventually, even senior and super-senior tranches were no longer perceived as invulnerable.

Making matters worse, banks had to bring back into their balance sheets more of this new risk from the now struggling ‘Structure Investment Vehicles’ and conduits. Knightian uncertainty took over, and pervasive flights to quality plagued the financial system. Fear fed into more fear, causing reluctance to engage in financial transactions, even among the prime financial institutions.

Along the way the underlying structural deficit of safe assets worsened as the newly found source of triple-A assets from the securitization industry dried up and the spike in perceived uncertainty further increased demand for these assets. Safe interest rates plummeted to record low levels.... Widespread panic ensued and were it not for the massive and concerted intervention taken by governments around the world, the financial system would have imploded."

He feels that addressing these issues would require governments to "explicitly bear a greater share of the systemic risk". This would in turn need the savings surplus countries to re-balance their portfolios toward riskier assets, apart from increasing the depth and breadth of their financial markets. The governments of the developed economies would have to either itself supply much of the triple-A assets or let the private sector take the lead role in supplying them with government support only during extreme systemic events.

Caballero argues that the most efficient approach would be a balance between government and private sector option, which would more effectively manage the systemic risk created through the private sector supplied triple-A rated securities. He writes,

"It is possible to preserve the good aspects of this process while finding a mechanism to relocate the systemic risk component generated by this asset-creation activity away from the banks and into private investors (for small and medium size shocks) and the government (for tail events). This transfer can be done on an ex ante basis and for a fair fee, which can incorporate any concerns with the size, complexity, and systemic exposure of specific financial institutions. There are many options to do so, all of which amount to some form of partially mandated governmental insurance provision to the financial sector against a systemic event."

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