Sunday, 21 August 2011

The Worrisome Analogy at the Heart of the Theory on Information-Insensitive Debt

Now for Part 4 on Gary Gorton's theory about information-insensitive debt, in which we begin by dusting off our SAT analogy skills.



Retail banking : deposit insurance :: Shadow banking : x



"X" is, of course, the kind of insurance that will save the day when there's another run on the shadow banks, as we saw during the financial crisis. Deposit insurance is a neat innovation that traces back to 1934; it eliminated runs on commercial banks in times of panic. It also made deposits at a bank "information-insensitive" debt -- the value of your $1,000 at Fidelity and Security Trust is secure, even if the CEO absconds to Tahiti with $10 million in a duffel bag.



Before solving for "x" -- or, better, asking whether we should even try to solve for "x" -- let's look at how shadow banking works.



SOME BANKING TAKES PLACE “IN THE SHADOWS”



Retail banking is for you, me, Aunt Edna. Shadow banking is for the giants in the financial system, who have large amounts of cash to park -- typically money market mutual funds, insurers, pension funds. They make “deposits” and “earn” interest through a process that involves something called a repurchase (repo) agreement.



Here's an example of how that works.



A pension fund spends $100 million to "purchase" AAA asset-backed securities from JPMorgan. As part of the deal, JPMorgan agrees to buy back these securities, after a short period of time -- overnight, or maybe a week or two. The pension fund will receive a small amount of interest (a fraction of 1%, as the lending is so short term). If JPMorgan goes insolvent, the pension fund holds those securities as collateral. They can be sold and (theoretically) the pension fund recovers all its money.



Now consider what happens with retail banking with a $100 deposit if the bank becomes insolvent. The FDIC makes the investor whole, paying the $100. Similarly, the pension fund in our example really wants its $100 million returned and doesn't want to deal with those collateral securities, which may not really fetch $100 million on the open market if they happen to be complex products, especially in times of stress.



So what happens in the repo market during a "bank run"? Nervous depositors -- like this pension fund -- demand greater and greater haircuts on securities they “purchase.” In other words, instead of “depositing” $100 million and accepting say $102 million of securities, they may demand much more collateral: $110 million, $120 million. Haircuts on asset-backed securities may go from zero to 40 percent (as they did in the crisis). This has the effect of sucking 40 percent of that $100 million out of the shadow banking market.



Spread this effect around, and the impact is similar to that of a bank run.



SO WHAT WOULD ‘DEPOSIT INSURANCE’ IN THE SHADOW BANKING SYSTEM GUARANTEE?



Here’s a big problem, for those who see insuring shadow banking "deposits" as the obvious solution to bank runs: This kind of banking has a wrinkle that's not found with its retail counterpart. In the shadow system, to guarantee a depositor’s $100 million, you essentially would have to say, “Whatever the actual value of that security you bought in a repo agreement, we’ll buy it back for $100 million.”



Think about this. If you deposit $100 in a commercial bank, the FDIC says you’ll get that $100 back -- which seems fair; you have deposited a fiat currency, and you receive the same amount of that fungible currency in return. But this differs hugely from what the shadow banking system would be guaranteeing: that you would be made whole no matter what the true value of the security that you hold as collateral.



Why is this problematic (other than for the obvious reason that the security, especially if thinly traded and "marked to model," could be mispriced -- and that this tendency to mispricing will be exacerbated because of the very existence of the insurance)?



WHY RETAIL AND SHADOW BANKING ARE WORLDS APART



Well, significant differences exist between retail and shadow banking systems.



"Deposit insurance" for commercial banking means: You're insuring that a depositor of money (common currency) will receive that money back. The bank involved is usually not too risk-loving, not too large, not too interconnected, and not too complex -- plus its commercial banking activities are regulated.



"Deposit insurance" for shadow banking means: You're insuring that a depositor of money (common currency) will receive that money back. The bank involved is usually risk-loving (often an investment bank), large, highly interconnected and complex -- plus its shadow banking activities are unregulated.



Being large and highly interconnected implies that when a bank in the shadow system gets in trouble, others will soon be at risk and the amount of "deposit insurance" ultimately needed may be very high (and the FDIC model won't work, where a team of examiners takes over the bank on Friday and sorts out things so the institution can re-open on Monday -- Lehman, which was enmeshed in the shadow banking system, is still painfully crawling through bankruptcy, almost three years later, even spawning its own periodical: Lehman Brothers Bankruptcy News).



THE CHALLENGE OF PICKING “INFORMATION-INSENSITIVE” DEBT WORTHY OF BEING INSURED



Enormous problems arise when it comes to how securities will be chosen to be insured in the shadow banking system. It's comparatively easy in retail banking. The FDIC insures dollar claims. Dollar claims are in money, or fungible currency.



But in shadow banking, how will securities be selected that will qualify as "information-insensitive" collateral worthy of insuring? Will government regulators be involved in picking and/or rating them? If so, why does anyone think our regulators have the expertise to assess asset-backed securities (one form of information-insensitive debt prevalent in shadow banking) that S&P and Moody's failed miserably to understand properly during the financial crisis?



Who determines how much of this insured information-insensitive debt is appropriate? Who pays for this "insurance" and how? And, if the debt is insured to market value, that will pervert the price at which it trades (Q: What would you pay for a security that is insured for however much you pay for it? A: Potentially, the sky’s the limit.).



And if the debt is insured to market value minus a haircut, who sets the haircut? How is the haircut adjusted if that debt class grows riskier? And, even with a haircut, insurance will tend to push the price higher as traders discover ways to game the system (Here's a scenario: X buys Security C for $100, its true price. Security C, which is classified as "information-insensitive" debt, is insured up to 90 percent of its market value. X sells Security A to Y for $200, who later sells it back to X for $210. Y makes $10 and X now possesses a security that's insured to $189 -- a great game for everyone but the insurer of the debt.)



Also what precautions will be taken to ensure that financial institutions don't start smuggling in junk disguised as quality securities, trying to get them classified as "information-insensitive debt" -- the designation of which will immediately boost the value of the assets?



Next: Is “sensitivity to information” really the way investors analyze debt?