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Remember the Global Financial Crisis?! – Safe Assets and the Global Savings Glut

Shadow Banking

“Runnable debt” is effectively “money”, and it comes in many forms.

In its simplest form, such debt was produced by banks in the form of demand deposits.

 

Safe Assets

What Are Safe Assets?

Information Insensitivity

  • No incentive to produce information about the asset
  • Can also think of this as “no adverse selection”
  • Not the same thing as “risk free” — this is tricky!

Includes

  • Currency
  • Government bonds of stable countries
  • Insured deposits in banks

Excludes

  • Stocks
  • Private debt of third parties
  • Government bonds of unstable countries

 

Why do we need safe assets?

Investments

  • Investment portfolio for consumers, institutions, and other capital pools

Transactions

  • Collateral for financial transactions

These are the same functions we often ascribe to traditional money

 

The Global Savings Glut Hypothesis

Between 2003 and 2007, short-term interest rates in the United States increased, which would normally also increase long-term rates.

That didn’t happen. Ten-year rates stayed about the same.

Ben Bernanke proposed that one cause of this “conundrum” was a “global savings glut” (GSG) from emerging-market and commodity rich countries with large current-account surpluses.

 

Supply of Safe Assets

  • Precious metals
  • Debt and currency of stable countries: U.S., U.K., Germany

By 2007, we were running out of U.S. securities for to serve as safe assets.

  • Insured deposits in commercial banks can act like safe assets… but there aren’t enough insured bank deposits.

When there is excess demand for something, we can expect somebody to try to make it.

 

“Manufacturing” Safe Assets

  • The key principle is to use only part of an asset as collateral.
  • A house is purchased for $1 million in cash. How safe would a security be that is based on getting at least $1,000 on that property? How much work would you need to do to figure that out?
  • A large tech company has a market capitalization of $100 billion in equity, with zero debt.
  • How safe would be the first $1 million of debt? The key here is to set the debt to value ratio low enough that nobody has an incentive to analyze default probabilities.

This is not the same thing as “default is impossible”!

Why do it this way?

Agency Risk

  • Risk that bank’s management makes a mistake and harms the rest of their business operations
  • But since these assets don’t require maintenance – they just collect cash payments –you don’t need the bank’s management to be involved any longer

Market Risk

  • If the value of the assets fall far enough, the special purpose vehicle has unique bankruptcy rules which are much cheaper than usual bankruptcy costs

 

Special thanks to Timothy F. Geithner (Lecturer in Management, Yale SOM, Former U.S. Secretary of the Treasury, Yale School of Management) and Andrew Metrick (Michael H. Jordan Professor of Finance and Management, Yale School of Management)

 

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Remember the Global Financial Crisis?!

What is a Financial Crisis?

  • Almost all wealth is embodied in long-lived assets that pay off slowly over time.
  • Some fraction of that wealth is needed to back short-term safe assets used in transactions (“money”).
  • Collectively, we cannot all convert our long-term assets to money at the same time.
  • A “panic” happens when enough people get nervous and try to convert.
  • A “financial crisis” occurs when a panic (or fear of panic) affects the functioning of the financial system.

 

Why Study the Global Financial Crisis?

  • It is an important part of history, by far the most important economic event since the 1930s, and crucial for understanding the world that followed.
  • It could happen again.
  • We would like to prevent it from happening again.
  • If it happens again, we need to be prepared to fight the fire together.

 

Asset Bubbles

  • “This time is different …” (Reinhart and Rogoff, 2008).
  • Prior to all financial crises, there is a large increase in the price of at least one asset class. When this price later falls, we retroactively label the original increase to be a “bubble”.
  • In the Global Financial Crisis, the bubble was in housing.
  • Housing bubbles have been associated with every major financial crisis since WWII.

 

New Kinds of Money

  • Through most of the history of civilization, our monetary needs were met primarily by metal-based currencies.
  • The rise of the modern state has allowed for sovereign-backed “fiat” money.
  • But … even stable governments have limits and the demand for money can exceed the supply of metal and sustainable fiat money.
  • Additional monies are then “manufactured” by the financial system, using private debt backed by collateral.
  • The history of financial crises is a tour through sad stories of new monies gone bad.

 

The Anatomy of a Modern Panic

  • For hundreds of years, panics were easy to spot: depositors would “run” to banks to exchange their banknotes for gold, or to remove their deposits.
  • The Global Financial Crisis was different, with the panics occurring out of public sight, in the non-bank part of the financial sector. This area of the financial system is often called the “shadow banking” system.
  • To fully understand the Global Financial Crisis and the efforts required to fight the panic, it is important to understand the mechanics of this modern system.

 

Fighting the Panic

  • Going into the Global Financial Crisis, governments all over the world were underprepared, with the available tools built for fighting an old-fashioned bank run, not a modern crisis.
  • To fight this crisis, these tools – emergency lending, guarantees, capital injections – were extended to creative new uses.
  • The evidence shows that this panic-fighting was a success, but this success came at the cost of political backlash, in some cases reduced our firefighting capabilities for the next crisis.

 

Special thanks to Timothy F. Geithner (Lecturer in Management, Yale SOM, Former U.S. Secretary of the Treasury, Yale School of Management) and Andrew Metrick (Michael H. Jordan Professor of Finance and Management, Yale School of Management)