Thursday, 12 February 2009

Guaranteed to be no better

Just a quick post to record an opinion on the idea of dealing with banks' troubled assets by writing insurance against their most extreme losses, a solution which has been applied in the UK, and is being considered in the US and EU as an alternative to buying the troubled assets outright. So far, proposed troubled asset purchase schemes like the TARP have been stymied by the problem of valuing the assets, which are typically mortgage-based complex structured products, at the right level to induce the banks to sell them while avoiding losses to the taxpayer.

RebelEconomist has never tried to value structured products (as a fund manager, he always avoided them), but he would imagine that the key to realistic valuation of them is their left tail (extreme loss) risk, for two reasons. First, he suspects that the structuring was often designed to shape the securities' return distributions to minimise the probability of default as defined by the rating agencies, while accepting the maximum risk given default (not to mention accepting the maximum risk short of default too) as far as such risks attracted a return premium. In other words, structured products were built to arbitrage the naïve reliance of risk management on credit ratings. The left tail of their return distribution may well be very different from regular fixed income securities. Second, by definition returns in the tails of a return distribution are seldom observed, so the tails are the most uncertain parts of the distribution. And unfortunately, in securities involving credit risk, the left tail is typically long. It is the left tail of their return distributions where the difficulty of valuing structured products resides.

This view of the troubled asset valuation problem suggests that pricing insurance against their worst losses, which essentially means buying the left tail of the return distribution only, does not represent a significantly easier task, and that writing such guarantees is not necessarily a better deal for taxpayers than buying the assets. Guarantees look cheaper (ought to generate fee income up front, in fact) because they do not involve buying the bulk of the return distribution, over which the average return should be clearly positive and which will have a relatively well-defined value like a regular bond. The danger is that this minimal initial cost makes an insurance scheme enticing to politicians who can be seen to "do something" without asking voters to make an immediate tangible sacrifice, even if there is some attempt by the official accountants to estimate the expected outlay on the guarantees. Moreover, the fact that the cost arises later, as and when the guarantees are called upon, perhaps even under a different administration, reduces the government's incentive to drive a hard bargain on the fee.

RebelEconomist still believes that something like the PRAT scheme is the right approach.


Anonymous said...

A question for you: Ireland went down the guarantee route and is now nationalising. The UK went down the guarantee route and is now talking about nationalising. Why will the US be any different?

RebelEconomist said...


I assume that your question is partly rhetorical.

Actually, as you are probably aware, the nature of the guarantees is not the same in each case. The Irish and initial UK guarantees were of the banks' liabilities, aimed at forestalling runs on the banks. The guarantees now being proposed apply to the banks' assets, with the aim of limiting uncertainty about the banks' solvency (or perhaps in the US case, limiting the exposure of an aggregator buyer of the troubled assets).

In my view, state seizure of any bank that cannot service its liabilities is the ideal solution, because you neither want the continued existence of a zombie bank with (potentially) diluted shareholders inclined to "gamble for redemption", nor the disruption of bank closures and liquidations. I can see the disadvantages of state ownership of banks (inefficiency, crony lending etc), but it should not take long to recapitalise a nationalised bank, replace the failed managers, and re-float it.

For cultural reasons, the US may resist the nationalisation solution for longer than Ireland or the UK, but, as Krugman suggests, will eventually accept it when there seems to be no remaining alternative.

Anonymous said...

Thank you for your reply. My question was not intended to be rhetorical; apologies if it read that way.

RebelEconomist said...


An excellent point, which I just read in the comments on naked capitalism is the effect of SWF stakes in the banks - none I know of in Ireland, some in the UK and even more in the US. Such stakes, especially if they were taken in the early stages of the financial crisis with the tacit encouragement of the government concerned, must make it difficult to nationalise banks, especially with substantial losses to shareholders.

Anonymous said...

Thank you. On a related note, the recent investment in Barclays looks like it could preclude nationalisation (though Nomura downplayed that suggestion). The original story is here:

Divine Inerception said...


I would like to know more on Credit Arbitrage and what can be its implications if the scheme gets out of hand in this time of Recession?

Waiting for your reply

RebelEconomist said...


I am afraid I am not sure exactly what you mean by credit arbitrage. If you mean switching between debt of different issuers according to whether their returns are comensurate with risk, I suspect that, actually, there was not enough of this during the boom - ie risky debt was priced too high.

MW said...

DI: do you mean Cap[ital] structure arbitrage, i.e. relative value trades between different parts of the cap structure (e.g. the current Citi preferred/common "arbitrage")? If so, then I don't see any systemic implications of this style of trading.