The “other” imbalance and the financial crisis

Ricardo Caballero

Global imbalances have been suggested as the root cause of the global crisis. This column argues that another imbalance is the guilty party. The entire world had an insatiable demand for safe debt instruments that put an enormous pressure on the US financial system and its incentives. This structural problem can be alleviated if governments around the world explicitly absorb a larger share of the systemic risk.

One of the main economic villains before this crisis was the presence of large “global imbalances”, which refer to the massive and persistent current account deficits experienced by the US and financed by the periphery. The IMF, then in a desperate search for a new mandate that would justify its existence, had singled out these imbalances as a paramount risk for the global economy. That concern was shared by many around the world and was intellectually grounded on the devastating crises often experienced by emerging market economies that run chronic current account deficits (DeLong 2008). The main trigger of these crises is the abrupt macroeconomic adjustment needed to deal with a sudden reversal in the net capital inflows that supported the previous expansion and current account deficits (the so called “sudden stops”). The global concern was that the US would experience a similar fate, which unavoidably would drag the world economy into a deep recession.

Lessons to be learned when the "wrong" crisis happened

However, when the crisis finally did come, the mechanism did not at all resemble the feared sudden stop, as I argued recently in my Baffi Lecture at the Bank of Italy (Caballero 2009). Quite the opposite occurred. During the crisis, net capital inflows to the US were a stabilising rather than a destabilising force. The US as a whole never experienced, not even remotely, an external funding problem. This is an important observation to keep in mind as it hints that it is not the global imbalances per se, or at least not through their conventional mechanism, that should be our primary concern. I argue instead that the root imbalance was of a different kind – although not entirely unrelated to global imbalances.

The entire world had an insatiable demand for safe debt instruments – including foreign central banks and investors, but also many US financial institutions. This put enormous pressure on the US financial system and its incentives (Caballero and Krishnamurthy 2008). The financial sector was able to create micro-AAA assets from the securitisation of lower quality ones, but at the cost of exposing the system to a panic, which finally did take place. The crisis itself was the result of the interaction between the initial tremors in the financial industry created to supply safe assets, caused by the rise in subprime defaults, and the panic associated to the chaotic unravelling of this complex industry.

Safe-asset demand as the key factor

In this view, the surge of safe-asset demand was a key factor behind the rise in leverage and macroeconomic risk concentration in financial institutions in the US as well as the UK, Germany, and a few other developed economies. These institutions sought the profits generated from bridging the gap between this rise in demand and the expansion of its natural supply.

In all likelihood, the safe-asset shortage was also a central force behind the creation of highly complex financial instruments and linkages, which ultimately exposed the economy to panics triggered by Knightian uncertainty (Caballero and Krishnamurthy 2008, Caballero and Simsek 2009a,b).

This is not to say that the often emphasised regulatory and corporate governance weaknesses, misguided homeownership policies, and unscrupulous lenders played no role in creating the conditions for the surge in real estate prices and its eventual crash. Instead, these were mainly important in determining the minimum resistance path for the safe-assets imbalance to release its energy, rather than being the structural sources of the dramatic recent macroeconomic boom-bust cycle.

Role of global imbalances

Similarly, it is not to say that global imbalances did not play a role. Indeed, there is a connection between the safe-assets imbalance and the more visible global imbalances. The latter were caused by the funding countries’ demand for financial assets in excess of their ability to produce them (Caballero et al 2008a,b), but this gap is particularly acute for safe assets since emerging markets have very limited institutional capability to produce these assets. Thus, the excess demand for safe-assets from the periphery greatly added to the US economy’s own imbalance caused by a variety of collateral, regulatory, and mandated requirements for banks, mutual funds, insurance companies, and other financial institutions. This safe-asset excess demand was exacerbated by the NASDAQ crash, which re-alerted the rest of the world of the risks inherent to the equity market even in developed economies.

Internal-external axis versus the safe-risky axis

The point is that the gap to focus on is not along the external dimension we are so accustomed to, but along the safe-asset dimension. Shifting the focus provides a parsimonious account of many of the main events prior to, as well as during, the onset of the crisis – something the global (current account) imbalances view alone is unable to do.

New insight: How the pre-crisis mechanism worked

Within this perspective, the main pre-crisis mechanism worked as follows:

By 2001, as the demand for safe assets began to rise above what the US corporate sector and safe-mortgage-borrowers naturally could provide, financial institutions began to search for mechanisms to generate triple-A assets from previously untapped and riskier sources.

Subprime borrowers were next in line, but in order to produce safe assets from their loans, “banks” had to create complex instruments and conduits that relied on the law of large numbers and tranching of their liabilities.

Similar instruments were created from securitisation of all sorts of payment streams, ranging from auto to student loans (see Gorton and Souleles 2006).

Along the way, and reflecting the value associated with creating financial instruments from them, the price of real estate and other assets in short supply rose sharply.

A positive feedback loop was created, as the rapid appreciation of the underlying assets seemed to justify a large triple-A tranche for derivative CDOs and related products.

Credit rating agencies contributed to this loop, and so did greed and misguided homeownership policies, but most likely they were not the main structural causes behind the boom and bust that followed.

Systemic fragility of the new instruments

From a systemic point of view, this new found source of triple-A assets was much riskier than the traditional single-name highly rated bond. As Coval et al (2009) demonstrate, for a given unconditional probability of default, a highly rated tranche made of lower-quality underlying assets will tend to default, in fact it can (nearly) only default, during a systemic event. This means that, even if correctly rated as triple-A, the correlation between these complex assets distress and systemic distress is much higher than for simpler single-name bonds of equivalent rating.

The systemic fragility of these instruments became a source of systemic risk in itself once a significant share of them was kept within the financial system rather than sold to final investors.

Banks and their "special purpose vehicles" – attracted by the low capital requirement provided by the senior and super-senior tranches of structured products – kept them in their books (and issued short term triple-A liabilities to fund them), sometimes passing their (perceived) infinitesimal risk onto the monolines and insurance companies (AIG, in particular).

The recipe was copied by the main European financial centres (Acharya and Schnabl 2009).

Through this process, the core of the financial system became interconnected in increasingly complex ways and, as such, it developed vulnerability to a systemic event.

The straw that broke the back… and systemic panic

The triggering event was the crash in the real estate “bubble” and the rise in subprime mortgage defaults that followed it. But this cannot be all of it.

The global financial system went into cardiac arrest mode and was on the verge of imploding more than once. This seems hard to attribute to a relatively small shock that was well within the range of possible scenarios.

The real damage came from the unexpected and sudden freezing of the entire securitisation industry. Almost instantaneously, confidence vanished and the complexity which made possible the “multiplication of bread” during the boom, turned into a source of counterparty risk, both real and imaginary. Eventually, even senior and super-senior tranches were no longer perceived as invulnerable.

Making matters worse, banks had to bring back into their balance sheets more of this new risk from the now struggling ‘Structure Investment Vehicles’ and conduits (see Gorton 2008). Knightian uncertainty took over, and pervasive flights to quality plagued the financial system. Fear fed into more fear, causing reluctance to engage in financial transactions, even among the prime financial institutions.

Along the way the underlying structural deficit of safe assets worsened as the newly found source of triple-A assets from the securitisation industry dried up and the spike in perceived uncertainty further increased demand for these assets. Safe interest rates plummeted to record low levels.

Initially, the flight to quality was a boon for money market funds. They suddenly found themselves facing a herd of new clients.

To capture a large share of this demand expansion form these new clients who had a higher risk-tolerance than their usual clients, some money market funds began to invest in short-term commercial paper issued by the investment banks in distress.

This strategy backfired after Lehman’s collapse, when the Reserve Primary Fund “broke-the-buck” as a result of its losses associated with Lehman’s bankruptcy.

Perceived complexity reached a new level as even the supposedly safest private funds were no longer immune to contagion.

Widespread panic ensued and were it not for the massive and concerted intervention taken by governments around the world, the financial system would have imploded.

Global imbalances and sudden reversals nowhere to be seen

Global imbalances and their feared sudden reversal never played a significant role for the US during this deep crisis. In fact, the worse things became, the more domestic and foreign investors ran to US Treasuries for cover and treasury rates plummeted (and the dollar appreciated). Instead, the largest reallocation of funds matched the downgrade in perception of the safety of the newly created triple-A securitisation based assets.

Moreover, global imbalances per se were caused by large excess demand for financial assets more broadly (Bernanke 2007 and Caballero et al 2008b). This had as a main consequence (and still has) the recurrent emergence of bubbles (Caballero 2006 and Caballero et al 2008a). But it was not a source of systemic instability in the developed world until it began to drift toward safe assets. It was only then that the financial system became compromised, as it was a required input to the securitisation process. This drift was probably the result of the rise in risk awareness following the NASDAQ crash and the increase in the relative importance of global public savings in the demand for financial assets.

What is to be done?

One approach to addressing these issues prospectively would be for governments to explicitly bear a greater share of the systemic risk. There are two prongs within this approach.

On one hand, the surplus countries (those that on net demand financial assets) could rebalance their portfolios toward riskier assets.

On the other hand, the asset-producer countries have essentially two polar options (and a continuum in between): either the government takes care of supplying much of the triple-A assets, or it lets the private sector take the lead role with government support only during extreme systemic events.



If the governments in asset-producing countries were to do it directly, then they would have to issue bonds beyond their fiscal needs, which in turn would require them to buy risky assets themselves. From the point of view of a balanced allocation of risks across the world, this option appears to be dominated by one in which sovereigns in surplus countries (e.g. China) choose to demand riskier assets themselves.

The public-private option

A more cumbersome but more promising avenue is to foster a public-private option within asset-producing countries. The reason this is an option at all is that the main failure during the crisis was not in the private sector’s ability to create triple-A assets through complex financial engineering, but in the systemic vulnerability created by this process.

It is possible to preserve the good aspects of this process while finding a mechanism to relocate the systemic risk component generated by this asset-creation activity away from the banks and into private investors (for small and medium size shocks) and the government (for tail events). This transfer can be done on an ex ante basis and for a fair fee, which can incorporate any concerns with the size, complexity, and systemic exposure of specific financial institutions. There are many options to do so, all of which amount to some form of partially mandated governmental insurance provision to the financial sector against a systemic event.

References

Acharya, Viral V. and Philipp Schnabl (2009). “How Banks Played the Leverage ‘Game’”, Chapter 2 in Acharya, Viral V. and Matthew Richardson, eds., Restoring Financial Stability: How to Repair a Failed System, New York University Stern School of Business,John Wiley & Sons.

Caballero, Ricardo (2009). “The Paolo Baffi Lecture”, delivered at the Bank of Italy on December 10th.

Caballero, Ricardo J. and Alp Simsek (2009a). “Complexity and Financial Panics.” MIT mimeo, June.

Caballero, Ricardo J. and Alp Simsek (2009b). “Fire Sales in a Model of Complexity.” MIT mimeo, July.

Caballero, Ricardo J. and Arvind Krishnamurthy (2008). “Knightian uncertainty and its implications for the TARP,” Financial Times Economists’ Forum, November 24

Caballero, Ricardo J. and Arvind Krishnamurthy, 2008a. “Collective Risk Management ina Flight to Quality Episode.” Journal of Finance, Vol. 63, Issue 5, October.

Caballero, Ricardo J. (2006). “On the Macroeconomics of Asset Shortages.” In The Role of Money: Money and Monetary Policy in the Twenty‐First Century The Fourth European Central Banking Conference 9‐10 November, Andreas Beyer and Lucrezia Reichlin, editors. Pages 272‐283.

Caballero, Ricardo J. (2009a). “Dow Boost and a (Nearly) Private Sector Solution to the Crisis.” VoxEU.org, February 22.

Caballero, Ricardo J. (2009b). “A Global Perspective on the Great Financial Insurance Run: Causes, Consequences, and Solutions.” MIT mimeo, January 20.

Caballero, Ricardo J., Emmanuel Farhi and Pierre‐Olivier Gourinchas, (2008a). “Financial Crash, Commodity Prices, and Global Imbalances.” Brookings Papers on Economic Activity, Fall, pp 1‐55.

Caballero, Ricardo J., Emmanuel Farhi and Pierre‐Olivier Gourinchas, (2008b). “An Equilibrium Model of 'Global Imbalances' and Low Interest Rates.” American Economic Review, 98:1, pgs 358‐393.

Coval, Joshua D., Jakub W. Jurek and Erik Stafford. (2009). “The Economics of Structured Finance.” Journal of Economic Perspectives, Vol. 23, No. 1, Winter

DeLong, J. Bradford (2008). “The wrong financial crisis”, VoxEU.org, 10 October.

Gorton, Gary B. (2008). “The Panic of 2007.” In Maintaining the Stability in a Changing Financial System. Proceedings of the 2008 Jackson Hole Conference, Federal Reserve Bank of Kansas City.

Gorton, Gary B., and Nicholas Souleles. (2006). “Special Purpose Vehicles and Securitization.” In The Risks of Financial Institutions, edited by Rene Stulz and Mark Carey. University of Chicago Press.