Opinion

Felix Salmon

Why the government shouldn’t insure securitized assets

By Felix Salmon
May 29, 2009

Ezra Klein does us all a favor this morning by spending 1,000 words or so summarizing a 20,000-word, 53-page paper by Yale’s Gary Gorton. Now to make it even shorter!

The key concept is the distinction between informationally-sensitive financial assets — assets which change in price when new information emerges — and informationally-insensitive financial assets — assets which don’t change in price when new information emerges. In the latter bucket we can include insured bank deposits, but bank deposits are insured only up to $250,000, and there are a lot of companies and other institutional investors who just want a safe place to park their cash and are also on the hunt for informationally-insensitive assets.

They found them — or thought they found them — in things like asset-backed commercial paper: they would hand over cash, and receive the senior tranches of securitized loans as collateral. When that happens, writes Gorton,

A ‘banking panic’ occurs when ‘informationally-insensitive’ debt becomes ‘informationally-sensitive’ due to a shock, in this case the shock to subprime mortgage values due to house prices falling.

Gorton’s solution to this problem is to involve the government in all manner of regulation — and insurance — of the securitization market, thereby making ABCP behave much like federally-insured bank deposits. I don’t like this solution at all, since it would send the contingent liabilities of the government into the stratosphere, and more importantly would ratify the demand for informationally-insensitive assets by creating trillions of dollars of new ones.

In my view of the crisis, it’s precisely the demand for informationally-insensitive assets which is the problem. And we need to get individuals, companies, and institutional investors out of the mindset that they can do an elegant little two-step around the inescapable fact that anybody with money to invest perforce must take a certain amount of risk. If you have a world where people are all looking for risk-free assets, you end up shunting all that risk into the tails. And the way to reduce tail risk is to get everybody to accept a small amount of risk on an everyday basis. We don’t need more informationally-insensitive assets, we need less of them.

Comments
6 comments so far | RSS Comments RSS

The other response to that proposal would be to run screaming into the night.

Or put it in bed bug terms – given that the US is experiencing a bed bug revival. We have a lot of bed bugs and we have two choices: accept them and make it easier for them to feed on our bodies at night or try to control if not eliminate them. I think most people would prefer option B.

Posted by jonathan | Report as abusive
 

I disagree. I did agree with almost all of Gorton’s views. For one thing, he agrees that we had, what I, in my sophisticated way, have been calling since September, a Calling Run, meant to connote a bank run like occurrence of getting to cash or safe investments. It’s been followed by a Proactivity Run and Savings Spree, thereby showing that my sophistication hasn’t increased.

The problem was Debt-Deflation or a Debt-Deflationary Spiral. I derived this view from Irving Fisher, assuming that, if he were alive, he’d acknowledge the parentage of my views. In any case, there are two solutions:

1) Bagehot’s Principles, meaning issuing a full government guarantee that necessitates, in order to work, an FDIC like agency that shuts down insolvent businesses without caring about their power or connections. This was my original view, and it’s like Gorton’s, and Felix dislikes it because of the guarantees.

Two points:

A: If you have a Lender of Last Resort, these guarantees might well be ineradicably implicit.
B: The point isn’t to have to spend the money, but simply allow enough confidence for a reasonable unwinding. Only a government has the resources for this, sad to say.

2) The other alternative is a split between Narrow/Limited Banking and Investment Concerns, which would be self-insured, while the Banks are government guaranteed, to the extent that they need to be.

Both are meant to stop major events like Calling Runs, not investors losing money. It seems to me that worrying about the particular investments verges on worrying about people losing money or trying to avoid recessions, which I consider impossible. We should focus on major events, not creating a perpetually spooked market.

I switched to Narrow Banking merely because I’ve experienced a crisis of faith in regulators as a class, although I agree that there are better and worse. I’m willing to become a believer again given a compelling scripture.

 

I don’t know much about finance and economics but it seems I’ve read that the proximate causes of this economic meltdown were mortgage CDIs with practically unknown asset values that were much higher than reality demands.
Helped along by the artificially inflated price of oil which is currently happening again with oil tankers anchored off our coasts waiting for the artificial shortages and increased demand to jack the price up yet again.
I don’t think anyone knows how to get us out of this Wall Street Casino mess with minimal damage since opinions abound. But while we\’re thrashing around, we need more regulation and better asset evaluations instead of fairy tale evaluations by unregulated mortgage salesmen, brokers, banks and commodity traders. We have created an economic system that beats gambling casinos hands down because the casinos are regulated whereas financial firms have been free to do practically anything they wish. Madoff may have broken a specific law but he was a minor player compared to the Wizards of Wall Street. It’s way beyond time to bring those people down to earth and a start would be to stop bailing them out with taxpayer money. But they have put us between a rock and hard place and many of them need to be in a hard place breaking up rocks. Rob a 7-11 of $10 with a toy pistol and you’re likely to do 15 years of hard time in the big house. Rob billions of dollars from taxpayers and other citizens and all the perpetrators get is a disapproving tsk, tsk, tsk. Yet another proof of an old saying: “Them that has the gold makes the rules.”

Posted by Ray | Report as abusive
 

An important thing to know about Gorton is that he was the main consultant to the unit at the AIG london office which developed the formula for insuring CDOs, CDOs squared, etc. Perhaps he mentions this somewhere in his article, but I highly doubt it.

Gorton has ZERO credibility writing about how the US should underwrite the mess for which he is PERSONALLY responsible.

Posted by emily | Report as abusive
 

Emily: Of course he mentions it in the paper.

Posted by vimothy | Report as abusive
 

Well we’ve been here before in near the start of the last century. Admittedly there are more extravagant financial instruments that control our economy now, but the underlying cause is the same – risk assessment. The government should insure securetised assets. Moreover their risk assessment will surely result in a fee which is beneficial to the tax payer while also essential to reinstill confidence in the market. The market is now forced to review their attitude to risk whether it’s through legislation or their own board. In fact further legislation at this time is just going to cause more problems at the consumer end of the market, through increased costs of the institutions. It’s times like this the short term of goverment is a real problem with inaction being seen as an election loser.

 

Post Your Comment

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/
  •