Bankers debate asset pools and arbitrage

Banks may have to pool their troubled mortgage assets into giant special resolution vehicles in order to ring-fence past problems and help to restart the financial markets, some central bankers believe.

Such vehicles would be similar in some respects to the aborted “super-SIV” proposed by some US banks with Treasury backing last year. Governments could provide financial support if needed in return for a share in potential profits once the assets were liquidated.

This idea was one option circulating at the Jackson Hole symposium hosted by the Federal Reserve Bank of Kansas City.

Most of the policymakers present believe that market pricing of US mortgage-backed securities is far too low based on likely cash flow losses – and that this reflects an extreme liquidity risk premium.

But they do not know why investors with spare capital are not coming into the market to take advantage of the apparent profit opportunity, or what it will take to induce them to do so.

“We should all admit to be puzzled still – not by the fact of falling house prices or a financial crisis, but by its severity and longevity,” Peter Fisher, co-head of fixed income at the asset management group BlackRock and a former senior Fed official, told the conference.

Most central bankers think the answer lies in technical constraints on arbitrage. Hedge funds are unable to raise enough leverage from banks to go in and buy distressed assets on a large scale, and institutional investors see no need to buy now rather than wait for troubled holders to sell and depress prices further.

But some experts worry that these securities may not be fundamentally mispriced taking into account the small but not trivial possibility that the credit shock could yet cause a very deep global recession.

“We just do not know,” said Robert Dugger, a hedge fund partner, who said the financial crisis is best understood as part of a giant adjustment of global trade, savings and investment imbalances.

“When you think in current account terms, your mind opens to historic possibilities that may justify low asset prices quite apart from any liquidity sufficiency conditions.”

Much of the debate centred around causes of the crunch and how to make future crises less damaging.

Experts identified extensive flaws in subprime mortgage securitisation in the US, but also pointed to wider information and incentive problems inherent in the banking system.

There was widespread agreement that procyclicality is embedded in the supply side of the markets-based financial system, with rising asset values leading to more lending in a boom, and falling asset values leading to falling lending in a bust.

Raghuram Rajan, former chief economist at the International Monetary Fund, said banks in normal times should be required to take steps to ensure their recapitalisation in the event of system-wide losses – for instance, through buying insurance.

Central bankers agreed that they would have to pay more attention to measures of credit extension in future.

There was widespread interest in the idea that “macroprudential” regulation – financial regulation that focuses on system risk rather than firm-specific risk – could mitigate credit excesses in future.

But they disagreed on whether monetary policy should be used to lean against credit bubbles. Many central bankers appear wary of taking on an explicit responsibility for financial stability, fearing it could compromise their ability to focus on inflation.

Some policymakers were worried that there could be the wrong kind of regulatory response, and argued for finding ways to impose greater market discipline on risk-taking by banks.

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