Guiding seminar 5 (2020)

Question 1

The safe assets shortage conundrum

What is a safe asset? What are the characteristics of a safe asset?

Answer 1

A safe asset is a simple debt instrument that is expected to preserve its
value during adverse systemic events.

Safe assets’ characteristics implicit in the definition:
o Safe assets can be transacted without concern for adverse selection (information insensitivity)
o Safe assets have special value during economic crises (“simple” asset)
o Asset is safe if other expect it to be safe (strategic complementarity)

Question 2

The safe assets shortage conundrum

Who are the suppliers of safe assets?

Answer 2

Suppliers of safe assets:
o financial sector (e.g. short-term deposits in banks) 
o government (e.g. government bonds)

Question 3

The safe assets shortage conundrum

On what does the capacity of a country to produce safe assets depend on?

Answer 3

Capacity of a country to produce safe assets depends on:
o the level of financial development 
o constraints in the financial system 
o fiscal capacity of the sovereign 
o exchange rate and price stability 
advanced economies, mostly the US 
Supply of safe assets

Question 4

The safe assets shortage conundrum

What were the macroeconomic effects on safe asset shortage in 1990-2000 and 2007-2008?

Answer 4

1990s-2000s: safe asset shortage
i) stimulated the financial system to supply AAA-rated
securitized instruments;
ii)made it easy for fiscally weak countries (i.e. Greece) to issue debt at favorable yields
–>increased supply of pseudo-safe assets
——>reduced downward pressure on safe real rates
• 2007-2008: pseudo-safe assets lost their “safe” status
–> the supply of safe assets↓, demand for safe assets↑
—-> safe asset interest rate ↓ reaching its effective lower bound

With real safe rates unable to decrease further to clear markets, demand for safe assets remained too elevated and the economy had to slow down and operate below its potential (modern version of the paradox of thrift).

Question 5

The safe assets shortage conundrum

What is a safety trap? What are the main differences between a safety trap and a liquidy trap?

Answer 5

An acute shortage of safe assets creates a safety trap
• Differences from a liquidity trap:
o exit from a safety trap requires an increase in the supply of, or a reduction in the demand for, safe
assets, regardless of the demand and supply of other assets
o safety traps can be very persistent or even permanent despite the presence of long-lived assets,
because the risk premia attached to long-lived assets bound the value of these assets and the
associated wealth effects on aggregate demand

Question 6

The safe assets shortage conundrum

What is the global nature of the safety trap?

Answer 6

Global nature of the safety trap: the scarcity of safe assets in one country spreads to others via capital outflows, until safe rates are equalized across countries
–> the global safe interest rate drops and capital flows increase to restore equilibrium in global and
local safe asset markets. Once the zero lower bound for global interest rates is reached, global output
becomes the adjustment variable
–> interdependence of world economy (since countries can no longer use monetary policy to protect themselves from world capital flows)

Question 7

The safe assets shortage conundrum

What are the proposed solutions to restore the equilibrium of safe assets?

Answer 7

1. Exchange rate appreciation of the currencies of safe asset producers (increased real value of safe assets for non-currency holders). But it depresses net exports and potentially output for safe asset issuers.
2. Issuance of public debt –> increases supply of safe assets (government bonds)
3. Infrastructure investment (loans)–> boosts growth, increasing fiscal capacity –> maximum issuance of safe assets per unit of installed capital.
4. Production of private safe assets (still face systematic risks)
5. Reducing the (Net) demand for safe assets

Question 8

The safe assets shortage conundrum

On what 2 factors does the issuance of public debt depend on?

Answer 8

1. The fiscal capacity of the government to borrow

2. The risk that increased provision of public safe assets may crowd out the provision of private-sector safe assets.

Question 9

The safe assets shortage conundrum

What are the problems associated with the issuance of public debt?

Answer 9

1. Can core economies fulfill a growing demand?
   And not weaken their fiscal capacity by supplying too many safe assets?
2. If the safe asset scarcity disappears, the issuers face exploding and unsustainable debt dynamics
3. Potential coordination failure

Question 10

The safe assets shortage conundrum

What are the reasons why private safe assets are still risky? What is the solution to the problem?

Answer 10

Private safe assets are still vulnerable to systematic events and panic.
Solution: some form private-public partnership (providing a fiscal backstop for the severe tail risks of safe private assets, while monitoring collective moral hazard) (hard and inefficient).

Question 11

The safe assets shortage conundrum

What are the two reasons why banks hold safe assets? And how could they be replaced?

Answer 11

1. To be able to intervene in foreign exchange markets if desired (involves hoarding of foreign safe assets–> inefficient insurance mechanism) –> could be partially replaced by more powerful global risk sharing arrangements (swap lines, reserve sharing agreements, etc).
2. As a result of quantitative easing policies, which involve the accumulation of domestic safe assets and occasionally riskier ones. –> CBs should not be hoarding safe assets beyond those who are required for the conduct of conventional monetary policy. –> Basel III criteria requires that financial institution hold safe assets on their balance sheets.

Question 12

Understanding the role of debt in the financial system

What is Pawning? Repo? What are the key differences?

Answer 12

Pawning the watch: 1) parties do not have to agree on the value of the watch → no need for price discovery 2) the broker will offer a price with a big enough haircut 3) the borrower keeps the right to redeem the watch at the same price later
• Repo - a repurchase agreement where a seller of a security agrees to buy it back from a
buyer (investor) at a higher price on a specified date.
• Functional difference between pawning and repo - in pawning the initiative comes from the borrower who has a need for liquidity, while in repo the initiative comes from someone with money who wants to park it safely by buying an asset in a repo

Question 13

Understanding the role of debt in the financial system

What are the differences between the stock and money markets?

Answer 13

Money markets are used by government and corporate entities as a means for borrowing and lending in the short term (provide liquidity by insuring information symmetry–> both parties have symmetric information about the collateral- e.g. pawn contract).

The stock market refers to the collection of markets and exchanges where the regular activities of buying, selling and issuance of shares of publicly held companies take place.

Stock market: risk sharing, price discovery, information sensitive, transparent, many exchages, volatile volume of trade and trading not urgent.
Money market: liquidity provision/ lending–> no need for price discovery and no need for transparency (opaque = transparent), few trades, trading urgent (for fast liquidity) and stable volume of trade.

Question 14

Understanding the role of debt in the financial system

What are the two main reasons why debt is an optimal contract?

Answer 14

1. Avoids a precise assestment of the collateral value at the time the contract is signed
2. Avoids the cost of price discovery whenever debt is paid in full

Question 15

Understanding the role of debt in the financial system

What are the three senses in which debt is information-insensitive?

Answer 15

1. Debt is information-insensitive to private information if it is deep in the money (otherwise migh pay the buyer to acquire information about underlying collateral of debt before buying it).
2. Debt is a contract –> do not care about the information acquisition, only care about the payoff.
3. Least sensitive to public information (debt is the best collateral).

Question 16

Understanding the role of debt in the financial system

When is debt more information-insensitive?

Answer 16

1. When collateral is less risky
2. When duration of debt is reduced
3. When FV of debt is reduced
4. When more collateral is added

Question 17

Understanding the role of debt in the financial system

Why woud anyone want opacity (lack of transparancy)?

Answer 17

Examples why transparency may be bad:
o During car auctions buyers are allowed to inspect cars only externally → provides increased speed of the
actions and reduces adverse selection (the value of cars is approximately the same across buyers)
o Money market mutual funds report the Net Asset Value (NAV) only quarterly and with a 1-month lag →
opacity gives MMMFs time to adjust to fluctuations in daily NAV and prevent investors from running
o Coarse bond ratings promote “commonality of beliefs” → result in reduced adverse selection
o Money is very opaque about the underlying collateral because no one knows exactly what backs up
government issued money → all the market participants are “symmetrically ignorant”, which is a blissful state in money markets
o During bubbles no one is likely to have private information about when prices will collapse → symmetric ignorance can make them a safe place to park money, at least for a short period of time

Question 18

Understanding the role of debt in the financial system

What are the consequences of debt and opacity (lack of transparency) in panics?

Answer 18

1. Everything that adds liquidity in good times pushes risk into the tail
2. Panics happen when information-insensitive debt becomes information-sensitive
3. There is enough uncertainty–> investors begin asking questions about the underlying collateral
4. No common belief about the value of debt even though before the panic investors had shared views on pricing
5. Fire sales, domino effect, interlinked balance sheets–> all contribute to the state of panic
6. Hard to understand what drives what

Question 19

Understanding the role of debt in the financial system

What is shadow banking?

Answer 19

[lending and other financial activities conducted by unregulated institutions or under unregulated conditions]

• The new model of ”originate to distribute” rather than “originate to hold”
• Shadow banking is highly scalable → designed to manufacture large amounts of high-quality assets, which are more widely acceptable
• State-contingent use of capital is more efficient than keeping mortgages on the books of originating banks

What drove the demand for new products and the growth of shadow banking?
• The global savings accumulation → foreign investors perceived the US financial system as a “safe
parking space” for money (global demand for safe assets)
• The US had sophisticated securitization technology that could activate and make better use of collateral (could manufacture a lot of AAA-rated securities provided there is available raw material)
• The US had a large pool of assets: housing (debt-free or underleveraged houses were potential
raw material for securitization )

Question 20

Understanding the role of debt in the financial system

What two faces do debt and institutions dealing with debt have?

Answer 20

1. A quiet one (liquidity and trust prevail because few
   questions need to be asked)
2. A turbulent one (a loss of confidence and a panic may break out)
   It is important not to let the recent crisis dominate the new designs → the quiet, liquid state is hugely valuable

Question 21

Understanding the role of debt in the financial system

What are the solutions for getting out of the crisis?

Answer 21

1. Crisis ends when confidence returns–> back to the “no questions asked” state, which involves:
   a) recapitalization of the banking system
   b) transparency without remedial action is a prescription for disaster
   c) the lack of specific information is the key element in the effectiveness of the message (e.g. Draghi’s words “We will do whatever it takes”)
   d) a detailed transparent plan to get out of the crisis might lead to a difference in opinions rather than to a convergence of views
2. Higher capital requirements and regular stress tests is the best road for now (in bad times it is better to be less transparent with stress tests).

Question 22

The Economics of Structured Finance

What were the reasons for structured market expansion?

Answer 22

1. Offered attractive yields in the period of low interest rates and AAA-ratings
2. Were rated using the same scales as bonds (easy to compare)
3. Strong economic growth and few defaults
4. Minimum capital requirement

Question 23

The Economics of Structured Finance

What is pooling? Tranching? Overcollateralization?

Answer 23

1. Pooling - a large collection of credit-sensitive assets is assembled in a portfolio (‘special purpose vehicle”)
2. Tranching - prioritized claims, known as tranches, are issued against the underlying collateral pool. The tranches are prioritized in how they absorb losses from the underlying portfolio.
   Overcollateralization - the degree of protection offered by the junior claims. It plays a crucial role in
   determining the credit rating for a more senior tranche, because it determines the largest portfolio
   loss that can be sustained before the senior claim is impaired.

Question 24

The Economics of Structured Finance

What was the key factor determining the ability to create tranches, which were safer than the underlying collateral?

Answer 24

Extent to which the defaults were correlated across the underlying assets.
Lower the default correlation in one tranche–> less likely that all assets default simultaniously –> safer the senior claims.

Question 25

The Economics of Structured Finance

What were the problematic features of CDOs?

Answer 25

1. Structure amplifies errors- when there are multiple rounds of structuring–> even minute errors at the level of underlying secutiry can dramatically after the ratings (especially CDO squared)
2. Credit rating only provided assestment of the risks of the security’s expected payoffs with no information about the correlation between the security and the market (diversifiable risks substituted for risks that are highly systematic)
3. Structured products are highly sensitive to:
   i) default probability and recovery value
   ii) correlation of defaults
   iii) the relation between payoffs and the economic states that the investors care about most

Question 26

The Economics of Structured Finance

What are credit ratings meant for? What was the problem with rating CDOs?

Answer 26

• Credit ratings are designed to measure the ability of issuers or entities to meet their future financial commitments, such as principal or interest payments.
• Previously, securities were assessed independently of each other, without considering the extent
to which defaults might be correlated. But to assign ratings to structured finance securities, the rating agencies were forced to assess the entire joint distribution of payoffs (!) for the underlying collateral pool.

Question 27

The Economics of Structured Finance

Why were there biased valuations for CDOs?

Answer 27

1) overlap in geographic locations (higher-than-expected default correlations for mortgages)
2) errors in assumptions about default correlations and probabilities – turned out to be worse than expected
3) valuation based on wrong or not fully correct assumptions (constantly rising housing prices)
4) pricing of systematic risks in the same way as diversifiable ones
5) technical mistakes in the models

Question 28

The Economics of Structured Finance

Who is to blame for the fall of the structured finance market?

Answer 28

1. Credit rating agencies
   • Using wrong assumptions (constantly rising house prices)
   • Not taking into account systematic risk
   • Conflict of interest between issuer, who pays for the rating, and credit rating agency
   • Absence of historical data on default probabilities
2. Investors
   • Outsourcing their due diligence to rating agencies
   • Not taking into account the difference between credit rating for single-name securities and structured finance products
   • Fueling the growth of CDO market even understanding that it would eventually end (riding a bubble)
3. Regulations
   • Regulators tied bank capital requirements to ratings
   • The minimum capital requirements for banks set forth in Basel I and II - banks holding AAA-rated securities were required to hold only half as much capital as was required to support other investment-grade securities

Question 29

Credit Default Swaps and the Credit Crisis

What is a credit default swap (CDS)? What are the key differences between a CDS and an insurance contract?

Answer 29

• Plain vanilla CDS - an insurance contract against the cost of default of a company (which usually is an issuer of bonds).
• As with an insurance contract, you pay premiums over time. If a company does not default, you lose the premiums. If a company does default, CDS allows you to exchange the company’s bonds, which you hold, for the principal amount of these bonds or for a payment equal to the principal amount of the bonds minus
their current value at the time of default.

Two main differences from insurance contract:

1) you do not have to hold the bonds to buy a credit default swap on that bond (you do not need to own the underlying asset)
2) insurance contracts (mostly) are not traded; in contrast, credit default swapmcontracts do trade over the counter

Question 30

Credit Default Swaps and the Credit Crisis

What are the benefits and drawbacks of CDS?

Answer 30

+ Credit risk can reside with the investors who are best equipped to bear it
+ Separates the cost of funding and the credit risk–> greater transparency in the pricing of the credit
+ CDS better accesses a company’s credit risk than the bond market
+ CDS market often more liquid than the bond market
+ By buying CDS, investors have the same benefits in the event of default as if they had a short position in the bond

• Smaller incentives to monitor the loan (discoragous activism)
• Perverse incentives since do not own the underlying asset
• Lower regulatory capital requirements
• Web exposure–> failure of one institution leads to a failure of another
• Counterparty risk (since default is a discrete event it can lead to large jumps in the value of CDS contract)

Question 31

Credit Default Swaps and the Credit Crisis

What are the differences between OTC and exchange-traded CDSs?

Answer 31

OTC- tailor-made contracts with infinite variations, unknown exposure, provides a market for securities, which have low liquidity on the exchange, provides a market for new financial products –> enables innovation. Counterparty- dealers (rarely clearing houses).

Exchange- standardized in terms of size and maturity, transparency (trade prices are publicly available), not flexible in terms of volume, higher liquidity since more participants. Counterparty- clearing house always as an intermediary.

Question 32

Credit Default Swaps and the Credit Crisis

What are the clearing houses? What are its benefits and costs?

Answer 32

Clearing houses are the financial intermediaries (counterparties) when CDSs traded on exchange.

+ counterparty risk reduced (can manage and diversify risks associated with the failure of individual investors)
+ counterparty exposure reduced (if only one clearing house used, then it can net out all the dealer’s exposure)
+ can monitor the exposure of counterparties and prevent them from taking additional exposures

• must maintain sufficient resources and manage its risk to be able to honor the promises of the contracts
• not efficient at dealing with new or less liquid products
• limited resources to cope with failures

Question 33

Credit Default Swaps and the Credit Crisis

What did and what did not cause the crisis of 2007-2008?

Answer 33

Dramatic problems of the financial crisis were not caused by CDS nor by other derivatives.

The crisis was driven by 2 reasons:

1. Investors and financial institutions did not expect such a dramatic fall in real estate prices
2. Many financial institutions were operating with extremely high levels of leverage and invested heavily in subprime securitizations.

When events unfolded during crisis, CDS did bring losses and uncertainty to some institutions. But they also allowed others to hedge and reduce their exposure to the default of subprime mortgages and other securities.

Question 34

Credit Default Swaps and the Credit Crisis

What were the benefits and drawbacks of CDS during the crisis?

Answer 34

When events unfolded during the crisis, CDS did bring losses and uncertainty to some institutions. But they also allowed others to hedge and reduce their exposure to the default of subprime mortgages and other securities.
While the derivatives’ market (such as CDS) is often blamed for being too large, it might have
benefited the financial system if it was even larger (and more robust)→ more useful information
about the development of the market, the opportunity to hedge and, therefore, minimize the
effects of a crash.

Question 35

Exchange-Traded Funds 101 for Economists

What are the key differences between ETFs and mutual funds?

Answer 35

ETFs do not interact with capital markets directly, ETF manager is in a legal contract with “authorized participants” (usually large financial institutions), who interact with the market–> no transactions in the underlying securities -> reduced transaction costs. The authorized participants typically lock in profits intraday–> price discovery & more liquid (can buy/sell shares intraday). Trades occur at a market-determined price. Investors can short shares, lend shares and buy on margin.

Mutual funds interact directly with capital markets, investors trade the fund directly and transaction costs occur at the end of the day and at net asset value, holdings are listed quarterly–> less transparency, investors cannot short shares, lend shares or buy on margin.

Question 36

Exchange-Traded Funds 101 for Economists

What are the potential issues dor ETFs?

Answer 36

1. Investors might have poor financial knowledge to distinguish between the types of ETFs (levered funds or based on unsecured debt)
2. Intraday liquidity can cause “too much” trading–> investors who trade actively suffer lower returns than those who trade less.
3. The proliferation (growth) of indices pose challenges for ordinary investors

Question 37

Exchange-Traded Funds 101 for Economists

What are the types of ETFs?

Answer 37

1. Equity ETFs (dominate the landscape- 78% of exchange-traded products)- based on market capitalization, sector ETFs (track benchmark for a sector) and factor/ smart beta ETFs (focusing on factors to beat the market- e.g. size factor)
2. Fixed income ETFs (portfolios of investment grade and government bonds)
3. Commodity ETFs (often viewed as a hedge against inflation or a source of diversification).

Question 38

Exchange-Traded Funds 101 for Economists

What are the reasons for the recent growth in bond ETFs?

Answer 38

• Bond ETFs are traded intraday on electronic exchanges – convenient
• Offer higher transparency - bid/ask quotes are readily available
• Offer greater liquidity and diversification

Question 39

Exchange-Traded Funds 101 for Economists

What is the risk of exchange-traded funds?

Answer 39

When an ETF closes, its price should converge to its NAV and underlying assets may be returned in
kind (so, it seems to be safe)
However, in the case of exchange-traded unsecured debt obligations issued by Lehman Brothers in
2008, there were no underlying assets to be returned to investors when the bank declare bankruptcy
–> Investors need to distinguish between various exchange-traded products

Question 40

Exchange-Traded Funds 101 for Economists

What is the risk of the short selling of ETFs? Risk of securities lending by ETFs?

Answer 40

• Short selling of ETFs:
May cause bankruptcy of the fund if done simultaneously by many investors. Yet, this scenario is
remote since an attempt to redeem shares by a party who does not posses shares will fail to settle.
• Securities lending by ETFs:
May pose a threat to investors but it is very unlikely due to the presence of different safeguards on
lending of securities by ETFs.

Question 41

Exchange-Traded Funds 101 for Economists

Describe liquidity and flash crash risk in the ETFs

Answer 41

• Flash Crash:
ETFs were represented among the securities most affected with prices diverging from their NAVs – could cause the Flash Crash, yet most likely flash events are not driven by structural problems with ETFs.
• Liquidity mismatch
Liquidity in the primary market, where the underlying securities trade, refers to the ability of Authorized Participants (APs) to acquire the underlying assets and transfer them to the ETF. The chance that an AP steps away in a crisis may pose a systematic risk. Yet, if a particular AP stops its activities, remaining APs continue providing liquidity can be a problem only for small ETFs which have few APs.

Question 42

Exchange-Traded Funds 101 for Economists

What impact does an ETF have on the underlying markets?

Answer 42

The impact of a “basket” security on liquidity and distortion of prices of the underlying market is unclear
In practical terms, the relative scale of index investing is still small (20% of global equities)