Minibonds, Financial Crisis and Asymmetric information

This current American financial crisis has certainly affected the whole world.  Even in Singapore, the fallout from the DBS High Notes 5 as well as the minibonds have transformed many Singapore investors into risk averse people.  Personally, I have also seen my unit trusts investment in my CPF account losing money and I was telling myself that I am not going to trust any 3rd party agent to handle my money from now on.  Thus, I can certainly understand the basic danger of such crisis from the economic perspective, reinforced by Diamond et al in their AWSJ article here

As we see it, the real concern about the financial sector is that it is undercapitalized, both because of the losses it has sustained and because of the growing risk aversion of lenders. Undercapitalized financial institutions are forced to try to reduce their assets, and, of course, this means they will make fewer loans, even to the healthy portions of the economy. The credit crunch that inevitably will occur implies lower corporate investment, less commercial and residential construction, fewer students getting college degrees, and in general, a much slower pace of economic growth.

To put the above context from the economics perspective, banks serve as institutions to transform savings into investment.  For savers, we would like to earn as high a return as possible from our savings decisions.  We happily put our savings into banks like DBS, Citibank or Maybank under the belief that there is no way these banks can ever fail.  These banks can only give us that high return if they could earn a higher return by lending our savings to people who desires to borrow. 

However, if it turns out that the borrowers are constantly defaulting in loan payments, there is a chance that banks may eventually fail, leading to the standard Diamond-Dybvig bank runs that many of us studied. 

The minibonds episode has served to awaken Singaporeans everywhere that default risk is becoming less and less rare in our world now. I was reading the minibonds and the DBS High 5 notes episode with much interest. While I understand there might have been a case of imperfect information in the sense that many aunties/uncles/ah-peks thought the various relationship managers (henceforth RMs) were selling them fixed deposits equivalent, I think it is clearly unfair to lay the blame on the RMs entirely.

After all, the concept of "default risk" is common knowledge to every investor. Whenever we buy a bond, we should always understand that, if the company went bankrupt, we might lose our entire principal sum. Even if we were to open a savings account in any of the banks, it is understood that, if the bank were to "default", as in close down, we are only insured up till $20 000 in deposit, which I definitely believe should be increased. I guess the main problem is that we all believe that there is no way major banks can fail, an assumption that is clearly questionable at this present time. Remember, even Lehman Bros was given a credit rating of AA just a few months ago, who would have expected them to file for bankruptcy?

Perhaps I can illustrate with an example. Imagine if I were to offer you a bond that gives your 5% return on the condition that none of the major local banks in Singapore, that is DBS, OCBC and UOB would fail.  If any of the 3 banks were to fail, you might lose your entire principal amount.  Would you buy that bond?

Even at this time, I am sure there will be more than 50% of Singaporeans who will take up the offer.  After all, how many of us would seriously consider that possibility that any of those banks would fail?  I guess most of us would reason that there is no way our government will let that happen.  I am saying that the same reasoning probably also applied to our views towards Lehman Brothers. 

Okay enough of my own commentary.  Here is what I thought to be a very enlightening piece of commentary by Robert Shimer on the current American financial crisis.  Basically, its the classic problem of asymmetric information.  After careful reading through the "wall of text", I have added subheadings to make it easier to understand how the various paragraphs connect to one another.  Thanks to Greg Mankiw for the original pointer



Before the crisis: Mortgage backed assets were rated as very safe

Next, let me explain what I think is happening in credit markets. This is my assessment, formed through numerous discussions with colleagues, not necessarily the opinion of other signatories of the letter. As everyone now knows, financial institutions hold significant assets that are backed by mortgage payments. Two years ago, many of those mortgage-backed securities (MBS) were rated AAA, very likely to yield a steady stream of payments with minimal risk of default. </span>This made the assets liquid. If a financial institution needed cash, it could quickly sell these securities at a fair market price, the present value of the stream of payments. A buyer did not have to worry about the exact composition of the assets it purchased, because the stream of payments was safe.

After the crisis 1: Adverse selection means no one could sell these assets

When house prices started to decline, this had a bigger impact on some MBS than others, depending on the exact composition of mortgages that backed the security. Although MBS are complex financial instruments, their owners had a strong incentive to estimate how much those securities are worth. This is the crux of the problem. Now anyone who considers purchasing a MBS fears Akerlof's classic lemons problem. A buyer hopes that the seller is selling the security because it needs cash, but the buyer worries that the seller may simply be trying to unload its worst-performing assets. This asymmetric information this makes the market illiquid. To buy a MBS in the current environment, you first need an independent assessment of the value of the security, which is time-consuming and costly. Put differently, the market price of MBS reflects buyers' belief that most securities that are offered for sale are low quality. This low price has been called the fire-sale price. The true value of the average MBS may in fact be much higher. This is the hold-to-maturity price.

After the crisis 2: Even banks who are not exposed to MBS could not raise new capital

The adverse selection problem then aggregates from individual securities to financial service institutions. Because of losses on their real estate investments, these firms are undercapitalized, some more so than others. Investors rightly fear that any firm that would like to issue new equity or debt is currently overvalued. Thus firms that attempt to recapitalize push down their market price. Likewise banks fear that any bank that wants to borrow from them is on the verge of bankruptcy and they refuse to lend. This is the same lemons problem, just at a larger scale. No firm that is tainted by mortgage holdings, even those that are fundamentally sound, can raise new capital.

Would the Paulson plan solve the crisis?

With a theory of the problem, we can now ask whether the Paulson plan would solve it. My understanding is that the $700 billion would be used in a series of reverse auctions. In such an auction, the government would announce its intent to use some amount of money to purchase a particular class of security. Financial institutions would then compete by offering the most securities at the lowest price. I think we can agree that it is implausible that the government would be better than other buyers at determining the current value of the stream of payments from those securities. This gives financial institutions a strong incentive to sell the government their lowest quality securities at the highest possible price. Indeed, the government seems to want sellers to unload their worst assets so as to improve their balance sheet, so there really is no conflict of interest here.

This program does not solve the lemons problem. The government purchases a lot of lemons at an inflated price. This improves the balance sheet of the firms that can sell their worst securities. It also improves the balance sheet of firms that own better securities because the market price of those securities will increase. (Of course, it cannot increase too much, or no one would sell to the government. They would wait to sell at the higher market price. I have not worked out the equilibrium of an auction with an option to resell later. It seems complicated.) But this is fundamentally no different than giving taxpayers' money to owners, managers, and debt-holders of firms that made the worst decisions.

How government can solve the adverse selection problem better than the free market.

The government does have one way tool at its disposal that would allow it to directly address the lemons problem. The clear advantage that a government has over the private sector is its ability to force individuals to participate in mechanisms that cross-subsidize other participants. This ability to coerce can be critical in markets with adverse selection. In this instance, the government could force all financial service firms to raise capital, as proposed by my colleagues Douglas Diamond, Steve Kaplan, Anil Kashyap, Raghuram Rajan, and Richard Thaler in today's Wall Street Journal Asia. This mandate would eliminate the lemons problem. Along the way, the scrutiny from potential buyers might help uncover which firms are in fact insolvent.

Other types of coercion might have similar effects, but superficially seem less appealing. For example, the government could force all owners of MBS to sell them to the government at the expected hold-to-maturity price. This would again be a subsidy to the owners of bad MBS, but now at the expense of the owners of good MBS rather than the taxpayer. Since there is no currently no market for those securities, it is conceivable that everyone would gain from the increase in liquidity. Still,I would imagine that the unforeseen costs of such an extraordinary action would outweigh its benefits and I suspect that market participants would agree.

Government actions need to prevent moral hazard

What else can the government do? First, it can establish stable rules and play by them. Holding out the possibility of distributing vast sums of money in an unspecified manner does not help market participants value the securities or value the firms. Second, it can prevent panics, i.e. Diamond-Dybvig bank runs. This is what it did when it offered insurance for money market mutual funds, an important source of funding in the commercial paper market. So far, that market appears to be holding up. Third, it can reduce the risk that its current actions encourage future misbehavior. We have already seen evidence of moral hazard in these markets, for example in AIG's decision to turn down a $8 billion offer from J.C. Flowers during the weekend before AIG collapsed.

The connection to the Asian Financial Crisis

In closing, let me mention one other issue that I take very seriously. I recognize that this might not matter much to my Congressman, but in my view it may be the most important issue for global welfare. The U.S. has long been a beacon of free markets. When economic conditions turn sour in Argentina or Indonesia, we give very clear instructions on what to do: balance the budget, cut government employment, maintain free trade and the rule of law, and do not prop up failing enterprises. Opponents of free markets argue that this advice benefits international financiers, not the domestic market. I have always believed (at least since I began to understand economics) that the U.S. approach was correct. But when the U.S. ignores its own advice in this situation, it reduces the credibility of this stance. Rewriting the rules of the game at this stage will therefore have serious ramifications not only for people in this country but for the future of global capitalism. The social cost of that is far, far greater than $700 billion.