Guiding Seminar 5 (2020) Flashcards
“The safe assets shortage conundrum” (Caballero, R., Emmanuel F., and Pierre-Olivier G.)
What is a “safe asset”?
Safe asset is a simple debt instrument that is expected to preserve its value during adverse systemic events - it is a good way of storing money (e.g. government bonds, short-term deposits)
“The safe assets shortage conundrum” (Caballero, R., Emmanuel F., and Pierre-Olivier G.)
What are the characteristics of a “safe asset”?
1) Safe assets can be transacted without concern for adverse selection (information insensitivity)
2) Safe assets have special value during economic crises (“simple” asset)
3) Safe asset is safe if others expect it to be safe
“The safe assets shortage conundrum” (Caballero, R., Emmanuel F., and Pierre-Olivier G.)
Who supplies safe assets?
Suppliers of safe assets:
• the financial sector (e.g. short-term deposits in banks)
• the government (e.g. government bonds)
“The safe assets shortage conundrum” (Caballero, R., Emmanuel F., and Pierre-Olivier G.)
On what does the capacity of a country to produce safe assets depend? Does it influence the availability of safe assets?
On:
• the LEVEL of financial DEVELOPMENT
• CONSTRAINTS in the financial system
• EXCHANGE RATE and PRICE STABILITY
For these reasons, the supply of safe assets has historically been concentrated in a small number
of advanced economies (supply problems)
“The safe assets shortage conundrum” (Caballero, R., Emmanuel F., and Pierre-Olivier G.)
Why does a shortage of safe assets exist?
Because supply is super scarce
“The safe assets shortage conundrum” (Caballero, R., Emmanuel F., and Pierre-Olivier G.)
Please, describe how the problem of shortage of safe assets tried to be solved during the 2000s? Did it work?
Safe asset shortage stimulated the financial system to supply MORE AAA-rated instruments and made it easy for fiscally weak countries to issue debt at seemingly favorable yields
On 2007-2008 these pseudo-safe assets lost their “safe” status, and people again jumped to the “true” safe assets (like German bonds), so the excessive demand pushed the interest rates to its effective lower bound and the economy had to slow down and
operate below its potential.
“The safe assets shortage conundrum” (Caballero, R., Emmanuel F., and Pierre-Olivier G.)
What does a severe shortage of safe assets create?
A severe shortage of safe assets creates a safety trap (supply)
“The safe assets shortage conundrum” (Caballero, R., Emmanuel F., and Pierre-Olivier G.)
What solutions do the authors provide to restore equilibrium in the safe assets market?
Solutions:
1) EXCHANGE RATE APPRECIATION of the currencies in which safe assets are denominated:
+++:
this increases the real value of these assets for non-’currency’ holders.
—:
this depresses net exports
2) ISSUANCE OF PUBLIC DEBT (supply of government bonds up).
+++:
an expansion in the supply of safe assets in core economies spreads across the world economy - production of safe assets anywhere expands output everywhere
—:
weaken country’s fiscal capacity by supplying too many safe assets
3) POOLING & TRENCHING investment among quasi-safe countries (supply up)
+++:
-creates a larger share of safe debt, increasing their fiscal capacity
—:
-stupid rating agencies pulling a la 2008 prank
4) PRODUCTION OF PRIVATE SAFE ASSETS (supply up)
+++:
-works if the public sector is unable to expand the production of safe assets (private safe assets: deposits at banks, commercial papers, money market funds, repos)
—:
-vulnerable to systemic events and panic
5) REDUCING DEMAND FOR SAFE ASSETS (central banks holding less safe assets - demand down)
+++:
it makes more sense for a central bank to engage to purchase riskier assets (e.g. mortgage-backed securities, equity shares)
—:
Banks cannot get rid of safe assets completely, because they need to guarantee stability, and no other way of guaranteeing stability except safe assets has not yet been done.
“The economics of structured finance” (Coval, J. D., Jakub J., and Erik S.)
What is structured finance?
Structured finance is a branch of finance that deals with financial lending instruments that work to mitigate serious risks related to complex assets (e.g. CDOs).
“The economics of structured finance” (Coval, J. D., Jakub J., and Erik S.)
When did the structured finance market become popular? Why did it become so popular?
When?
Expanded (more than tripled) from 2004 - 2007
Why did it become so popular?
1) CDOs offered ATTRACTIVE YIELDS in a period of low interest rates
2) CDOs were rated using the same scales as bonds (EASY TO COMPARE)
3) CDOs influenced strong ECONOMIC GROWTH and FEW DEFAULTS
4) CDOs were not regulated - they required MINIMUM CAPITAL REQUIREMENT
“The economics of structured finance” (Coval, J. D., Jakub J., and Erik S.)
What is pooling?
Pooling - an action when a large collection of credit-sensitive assets is assembled in one special portfolio
“The economics of structured finance” (Coval, J. D., Jakub J., and Erik S.)
What is tranching?
Tranching - prioritized claims which are issued against the underlying collateral pool.
The tranches are prioritized in how they absorb losses from the underlying portfolio. Junior tranches take the biggest hit.
“The economics of structured finance” (Coval, J. D., Jakub J., and Erik S.)
What is overcollateralization?
Overcollateralization - the degree of protection offered by the junior claims.
Overcollateralization shows the largest portfolio loss that can be handled before the senior claim gets hit. (what is the probability of even seniors getting nothing?)
“The economics of structured finance” (Coval, J. D., Jakub J., and Erik S.)
Please, name a few positive features of a CDO!
1) As the pool of assets is big, a progressively larger fraction of the issued tranches can end up with higher credit ratings than the average rating of the underlying
pool of assets. (supposedly safety up :))
2) CDOs diversify away individual risk. (safety up)
3) CDO2 can be created by having even more tranches with high credit ratings (safety up)
4) the underlying asset default correlation in non-crisis
periods is miniscule
“The economics of structured finance” (Coval, J. D., Jakub J., and Erik S.)
Please, name a few problematic features of a CDO!
1) with multiple rounds of structuring (when CDO becomes CDO2), even slight changes in default
probabilities and correlations can have a substantial impact on the expected payoffs and ratings
2) credit rating does not portray information about the correlation between the security and the market at different states of the economy
3) CDOs have a large and multiplied amount of systematic/market risk (any big market movements are deadly)
4) CDO’s do not offer their investors large enough of a yield spread to compensate them for
the actual systematic risks they bear
“The economics of structured finance” (Coval, J. D., Jakub J., and Erik S.)
How were CDO ratings designed? Should it have followed the bond rating scheme? Why/why not?
CDO ratings are designed to:
-measure the ability of issuers or entities to meet their future financial commitments (e.g. safety of the investment), such as principal or interest payments.
In the bond market, securities are assessed independently of each other, therefore considering security correlations in terms of defaults/unexpected events was not needed.
In the CDO market, again, each CDO pool was assessed independently. However, an individual bond is NOT equal to an individual CDO pool - a CDO pool consists of thousands of different debts, all of which could have been extremely correlated, but this was not checked -
agencies were forced to assess only the entire JOINT distribution of payoffs (!) for the underlying collateral
pool.
“The economics of structured finance” (Coval, J. D., Jakub J., and Erik S.)
Please, name some reasons why the CDO rating models were biased!
1) there was an overlap in geographic locations (actual correlations between mortgages were higher)
2) there were errors in assumptions about default probabilities and recovery values (again, due to overlooking correlation problems)
3) valuation was based on wrong or not fully correct assumptions (the market was not efficient at the time but on a housing market bubble)
4) the return for bearing systematic risk was undervalued and incorrectly calculated
“The economics of structured finance” (Coval, J. D., Jakub J., and Erik S.)
Who can be blamed for making these CDO rating faulty?
1) CREDIT RATING AGENCIES who:
- –used wrong assumptions in models;
- –did not consider systemic risk
- –were engaged in conflicts of interest (CDO issuers and rating agencies had personal relationships that influenced biased decisions, aka “pls give me a good rating”)
- –did not identify the importance of default probability data
2) INVESTORS who:
- –did not do their due diligence when looking at rating agencies
- –did not consider the difference between credit ratings for single-name securities vs structured finance products
- –fueled the growth of CDO market even if they understood that it would eventually end
3) REGULATORS
—who canceled or eased every possible regulation in the financial markets from 2004-07
—who tied bank capital requirements to ratings – banks holding AAA-rated securities were required to hold only half as much capital as was required to support other
investment-grade securities, so AAA-rated securities were in demand if the bank wanted to stay strongly levered.
Exchange-traded funds 101 for economists
Lettau, Martin, Madhavan, 2018
Which one - ETF or mutual fund - interacts directly with the capital markets
Mutual Fund. ETF does not interact with capital markets directly. ETF manager is in legal contract with Authorized Participant (large financial institutions who interacts with the market instead of them)
Exchange-traded funds 101 for economists
Lettau, Martin, Madhavan, 2018
At what prices shares trade for ETFs?
Trades occur at MARKET determined PRICES
Exchange-traded funds 101 for economists
Lettau, Martin, Madhavan, 2018
At what prices shares trade for mutual funds?
Trades occur at the end of the day at NET ASSET VALUE (NAV)
Exchange-traded funds 101 for economists
Lettau, Martin, Madhavan, 2018
Describe and compare transaction costs for ETFs vs. mutual funds
ETF - externalized (because of no interaction with the capital markets) -> reduced transaction costs
Mutual Fund - Investors bear transaction costs incurred by participants
