Government backed insurance of extreme systemic risk

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1 Government backed insurance of extreme systemic risk Kathleen McElvogue (Independent Financial Consultant) and Alistair Milne (Cass Business School) 15 th December, 2008 This is a global credit crisis, from Iceland to Australia, affecting most countries in between. So to deal with this credit crisis, global teamwork is a prerequisite. The recent G20 Summit was a good start. The next G20 Summit will be held in London, on April 2 nd 2009 and should be a target date for debate and implementation of this proposal of government backed credit insurance for extreme systemic risk. Prior to the G20 Summit each country can begin to examine closely this proposal and see how it can be implemented in their own economic environment. Banks globally, have to take responsibility to communicate with each other, to get their heads together to see how they can benefit from open dialogue and consider how to consolidate their market position. In the UK, the Treasury could begin to discuss with knowledgeable market participants, ways in which to set up a framework for this government backed systemic credit insurance, prior to the G20 Summit. Introduction Governments worldwide have recapitalised their banks, but this has not been enough to persuade banks to lend again. Despite large interest rate reductions the supply of credit to households and corporations continues to fall. A view now gaining ground is that in order for banks to have the confidence to increase their lending, they need further support in the form of a government backed insurance against extreme systemic losses. Recent US government interventions have moved in this direction, with the insurance of $306bn of Citigroup assets, the provision of open-ended capital support to Fannie Mae and Freddie Mac and the Federal Reserve purchase of Credit Default Swap (CDS) contracts from AIG. In the UK the Crosby report has recommended government backed insurance for extreme losses on senior mortgage backed securities. While this idea, further government support for banks in the form of guarantees against extreme losses, is moving to the top of the policy agenda, there are questions. How can it be made to work in practice? Who should benefit? What will be the practical impact? The purpose of this document is to provide some answers to these questions. 1

2 Economic issues In recent weeks a number of researchers and policy makers have been exploring ideas of this kind. Perhaps the most detailed economic case is made in a recent paper by Perry Mehrling (Barnard College, Columbia University, New York) and Alistair Milne (Cass Business School, City University, London). They propose government backed insurance against extreme systemic credit losses, operating on a general not selective basis, and used in slightly different forms, both to combat the current crisis and to prevent its recurrence (see hyperlink below) They propose government backed credit insurance, provided for a fee, putting a price floor under the AAA rated senior tranches of mortgage backed and other structured securities. They estimate that banks currently hold about $3.5 trillion of this highly rated paper, out of a total global market for structured securities of $7 trillion. This is much bigger than sub prime, while the entire U.S. home mortgage market is around $11 trillion, the sub prime part of that market is at only $1.3 trillion. There is a huge demand for such structured credit insurance. Banks worldwide acquired far too much senior structured credit, financed short term, thinking there would always be a liquid market for these securities and hence that they need not be concerned about maturity mismatch. Insurance will allow them to obtain renewed access to short term funding in the markets and assure them that this access is permanent not temporary. Monoline insurers and the insurance conglomerate AIG wrote at least $700bn of CDS contracts to protect holders of this highly rated paper against loss, but this protection has been undermined by the financial difficulties experienced by the providers. The insurance was underpriced and the insurers were insufficiently capitalised to protect against the kind of systemic credit shock we are now experiencing. This has worsened the problem of maturity mismatch on bank balance sheets and is a major cause of the current pressures on bank balance sheets. Governments should now do this job of providing insurance against extreme losses. Why? First because it costs very little, government is already on the hook for these losses (they will have to cover the losses anyway since in such an extreme systemic outcome bank capital will be exhausted). Second because without insurance against such extreme risk, banks will continue to lack the confidence to lend. Third no one else other than government can provide this systemic risk insurance. This is very different from loan guarantees advocated by some (e.g. the UK Conservative Party). Loan guarantees are a considerable intrusion into bank loan and business decisions. The taxpayer takes on risks that should and can be carried by bank shareholders. The public sector will have to make susbstantial payouts on at least some of these guarantees. Without extensive and costly monitoring, loans may be made under guarantees schemes that should not be made in the first place. 2

3 The idea of systemic credit risk insurance is different, it is for banks to keep most of the risk of their lending, passing onto government only the extreme tail of risk, the tail of losses that would emerge only were we to have a repeat of the US great depression of the 1930s. With this government support they can then start lending again and the threat of a new great depression is removed. So as long as the systemic risk insurance is provided globally and comprehensively then, because the global slump is avoided, there is no call on the insurance. In fact government, by charging appropriately, can make a profit on the transaction. Practical implementation There is much yet to be done on the practical details. The key is insuring only good quality but illiquid and hence undervalued structured assets (the idea is not to insure the most toxic assets, such as the re-structured ABS-CDO tranches that have collapsed from AAA to BB or less). Taking the Citigroup rescue as a model, it might be appropriate to set up insurance special purpose vehicles (SPVs) with government equity funding. This vehicle could write CDS protection on a large variety of structured credit assets. There could be further tranches of preference capital in these vehicles, at very low risk of loss, provided for example by sovereign wealth funds, pension or insurance companies. This could be an ideal way of bringing into the scheme all sources of long term capital. Initially, such insurance would focus on mortgage backed securities and could then later be extended to other structured exposures such as portfolios of leveraged loans (but with relatively large excess); or on pools of committed lines of credit to AA rated and better companies, with a differential fee for unused and drawn down credit or used to write an index. It is key to see that this insurance is provided on a comprehensive global basis, not piecemeal to a few companies in a few countries. So, in contrast to the way insurance was provided to Citigroup, insurance would be offered on the structured asset and other portfolios of all banks. The take-up would probably have to be optional, but given current low market prices for most structured and loan assets there should be little difficulty in persuading the large majority of banks to exercise this option. An important practical detail is to make the insurance transferable whenever a structured bond is sold to another investor. This is a desirable feature because it directly restores liquidity to secondary markets for these bonds. To be fully effective the insurance should be comprehensive, it should be offered on existing senior structured credit securities and in a modified form on corporate bonds and loans that cannot be so easily securitised. It should be offered on existing exposures and on new lending and security issues. Further practical issues arise when insuring newly issued bonds, loans and structured securities. In this case there has to be an effective assessment of the underlying credit 3

4 quality. One possibility is to involve the credit rating agencies in this task, although their work would have to be subject to oversight given, the weaknesses of their ratings of many structured credits. A further important practical point is that, to be fully effective in eliminating the strains on bank balance sheets, the insurance should be comprehensive. It should apply to most catgories of structured assets. Impact The immediate impact of a globally co-ordinated, government banked scheme for insuring against extreme systemic credit risk would be on the secondary markets for trading credit. Our discussions with market practitioners indicate that this would be greatly welcomed and result in an immediate positive impact on the pricing and trading of bonds, structured credits and syndicated and leveraged loans. There will also be an impact on the credit default swap market, since CDS are used directly for hedging mark to market risk on existing structured credits and corporate bonds. In particular the presence of government backed insurance against extreme credit risk will make it possible for private insurers e.g. credit derivative product companies to provide their own insurance against more moderate losses (in effect the government is acting as a re-insurer to accept the catastrophe element of the insurance, a practice common in buildings insurance especially in areas susceptible to flooding or storm damage). A further impact, provided the insurance is available on new issues, will be to help revive the new issue market for structured credit and mortgage backed securities, a market which is currently closed and a major constraint on bank funding. The greater liquidity in both primary and secondary markets for structured credits will have an immediate further impact on money markets. Large money market funds will once again accept mortgage backed and other structured securities as collateral and this will allow their funds to flow back into the money markets. Banks, with greater liquidity restored to the money markets, and the opportunity to raise long term funds from the renewed issue of bonds and mortgage backed securities, will no longer be restrained from lending because of pressing concerns about future funding. The wider economic benefits will be greater availability of both corporate and household lending, restoration of economic activity and finally the benefit of greater tax revenues. 4

5 Role of the central bank This proposal raises several questions about the role of the central bank. Suppose this policy is followed, what are the respective roles of the central bank and of government in providing systemic credit risk insurance? Can the job be done using the central bank balance sheet alone? Do existing central bank policies (the Bank of England special liquidity scheme, the acceptance of senior mortgage backed securities as collateral for central bank lending) not already amount to systemic credit risk insurance, making a new initiative redundant? The central bank is ideally placed to provide short term financing for bank holdings of senior structured credit. The Bank of England special liquidity scheme (extended and expanded in October to a total of 200bn) allows banks to swap senior structured credit assets for Treasury bills and so obtain ready, short term funding in the market. The Federal Reserve offers its banks a similar asset swap facility. The Bank of England, in common with all the other major central banks, accepts senior structured and mortgage backed securities as collateral in much of its repo lending. These measures are extremely valuable, preventing the extreme maturity mismatch on many bank balance sheets leading to inability to fulfil payment obligations. But these are regarded by both central banks and the banks themselves as temporary arrangements. They do not assure banks that short term funding will always be available to them in the future. Hence, there is a need for a programme of permanent long term government backed insurance. Central banks may play an additional role in supporting credit markets. In the short term, as policy interest rates fall to their zero-lower bound, central banks then acquire the freedom to create additional reserves. This freedom can be used to support a programme of CDS underwriting of senior structured credits, for contracts denominated in their own currency. The advantage central banks have is that unlike private providers of structured credit insurance they have the ability to create new reserves to meet margin payments, which reduces the possibility of them experiencing a liquidity crisis from writing CDS protection, such as brought down AIG and many monoline insurers. Thus the central bank may play a key further short term role in supporting credit markets. However, in order for the central banks to sell these CDS positions back to the private sector as the economy recovers, the long term government backed credit insurance will need to be in place. 5