The last three or four decades have seen a remarkable evolution in the institutions that comprise the modern monetary system. The financial crisis of 2007-2009 is a wakeup call that we need a similar evolution in the analytical apparatus and theories that we use to understand that system. Produced and sponsored by the Institute for New Economic Thinking, this course is an attempt to begin the process of new economic thinking by reviving and updating some forgotten traditions in monetary thought that have become newly relevant. Three features of the new system are central. Most important, the intertwining of previously separate capital markets and money markets has produced a system with new dynamics as well as new vulnerabilities. The financial crisis revealed those vulnerabilities for all to see. The result was two years of desperate innovation by central banking authorities as they tried first this, and then that, in an effort to stem the collapse. Second, the global character of the crisis has revealed the global character of the system, which is something new in postwar history but not at all new from a longer time perspective. Central bank cooperation was key to stemming the collapse, and the details of that cooperation hint at the outlines of an emerging new international monetary order. Third, absolutely central to the crisis was the operation of key derivative contracts, most importantly credit default swaps and foreign exchange swaps. Modern money cannot be understood separately from modern finance, nor can modern monetary theory be constructed separately from modern financial theory. That's the reason this course places dealers, in both capital markets and money markets, at the very center of the picture, as profit-seeking suppliers of market liquidity to the new system of market-based credit.
Example: Negative Basis Trade and Liquidity Risk
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Economics of Money and Banking
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Banking as Advance Clearing, continued
In the modern economy, the price of risk is determined in swap markets that distinguish specific forms of risk, most importantly interest rate swaps and credit default swaps. The Treynor model can be adapted to understand how the price of risk is formed in dealer markets.
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Perry G MehrlingProfessor
Economics, Barnard College
Union Bank of Switzerland lost a lot of
money doing what it thought was a risk-less trade.
And then, they were forced by their bank regulator to
write a whole big report about how they managed to lose all this money.
And this is on the web, and everyone can read it and it is great.
It's very, very informative.
I have the URL in the notes here.
It would be a better world,
if the US securities regulators had required Citibank to write such a report.
Had required, you know,
all the banks that got some help from TARP,
to write such a report.
Explain to me how you managed to lose so much money.
Well, the Swiss regulators did this to UBS.
So, we know exactly what they were doing,
and we know how they got into trouble.
And here's what they were doing.
They were involved in arbitrage;
using credit default swaps.
They were dealing with corporate bonds.
They were dealing with mortgage-backed securities and
with CDO tranches of mortgage-backed securities,
but those things are very much like-- they're risky securities just like corporate bonds.
It noticed in effect,
that the spread S on the bond was not the
same as the cost of insuring against default on that bond,
or at least not the price that it could get that insurance from AIG.
So, what they did was to buy a AAA,
these were AAA to begin with.
AAA, CDO tranche.
So, this is AAA rated and the underlying securities behind this are mortgages,
subprime mortgages in some case,
but they've carved off all the-- they claim to have carved
off all of the credit risk and put it into low tranches.
And so what's left is rated AAA by Moody's and so forth.
And they bought those outright.
Their regulators in Europe said,
"I know it's rated AAA,
by this American company and-- but if you want to use this,
if you're a bank and you want to have this on
your balance sheet or you want to use this as collateral for borrowing,
which is what they did,
you have to, have to buy some insurance against it," which they did from AIG.
So-- and others, other people in this business too.
So, they bought a credit default swap.
So, that's like double insurance, you know.
They bought the highest tranche,
so there's all these lower tranches that are going
to absorb all the losses, that's the idea.
And then they bought insurance against that one too.
So it's like double up.
And then they did money market funding on this side.
Meaning, they used this security as
collateral for borrowing in the money market in
asset-backed commercial paper or repurchase agreements, one or the other.
Remember at the beginning of the lecture when I said my definition of
shadow banking is money market funding of capital market lending.
That's exactly what's going on here.
Money market funding of capital market lending.
This is a security here,
that trades in the capital market and has a price.
So, it was shadow banking in that sense,
but it was on the balance sheet of Union Bank of Switzerland.
So, it wasn't in any particular shadow,
it was right there sitting on their balance sheet.
When Citibank did things like this,
they put them in a separate little facility,
structured investment vehicles-- special-- SIV,
SIV stands for, I think special investment vehicle.
And it was off their balance sheet so you didn't see it.
But in UBS, you can see it.
It's right here.
And they thought they were in fine shape.
They thought they were doing something called a negative basis trade.
That's what they call it in their report, negative basis trade.
Which is to say that when you put this whole thing together,
you do this deal, you buy this thing, you insure this thing,
and then you borrow money against it here,
there's money left over.
There's money left over. And there's money left over today and
apparently every period from now till the life of this thing-- of the CDO tranche,
which is-- there's mortgages there's so there's 10,
20 years worth of this.
So, they took this money that was left over for the next 20 years,
and they said-- they booked that whole thing as profit today.
Every time they did a trade like this,
they said, "We now have 20 years worth of profit,
which we're going to book today and pay bonuses today,
on the basis of that profit."
They weren't the only ones who did this, a lot of people did this.
But then, what happened was,
there was-- began to be some little doubts,
little doubts about the value of this AAA CDO tranche.
It fluctuated in value just a little bit, just a little bit.
The credit default swap should have fluctuated in value the other way,
right, should have gone the other way.
That was all very fine and good but the problem was that this fall in
value caused problems for rolling over this funding,
because this is collateral for this funding.
Not this, the credit default swap is not collateral for the funding.
This was collateral for the funding.
So, they couldn't roll over their funding.
And when you can't roll over your funding,
what do you have to do?
You have to sell the underlying asset.
But if you sell the underlying asset,
that pushes the price down farther.
So you can see, you get into this kind of liquidity downward spiral thing that goes on.
Because they weren't the only one doing this trade,
there were other people doing this trade.
And by the time they were doing this trade,
they were no longer-- by the end,
they were no longer buying insurance from AIG,
which was a very solid insurer believe me.
But it charged a lot for this insurance and because it charged a lot eventually,
this was no longer a negative basis trade.
So, they started saying, "Well, you know what,
these things are so good that we won't actually insure the whole value,
we'll just insure against a 2% fluctuation.
And if it fluctuates more than that,
we will eat it ourselves."
So, we'll only buy insurance against moving from 100 to 98,
and if it moves below that,
we'll take the tail risk ourselves.
So when it moved below 98,
they had all that tail risk.
So this is the way.
So this is the important point to emphasize;
they were felt themselves to be taking no risk at all,
and they lost billions of dollars.
And it was because they had not-- they had
assumed that they would always be able to roll their funding,
and they were not able to roll their funding.
Yes.
While they still were getting CDS from AIG,
would it not have been in the best interest for both the short term lenders
and for UBS to renegotiate such that the CDS
could also be collateral for the [inaudible]?
Well, you might.
Okay, this is a good question.
So let me just repeat the question because I have a microphone.
You're saying, well wouldn't it have been in
their mutual interest for the people who were doing this funding to say,
"Why don't you give me this as collateral or
why don't you give me this package as collateral? "
Now, one reason possibly that you're imagining
that is because you're remembering the world of badgit,
where we had the bills and we had
the acceptance on the bills and they were attached to each other.
And here they're not attached to each other.
They're separate securities.
Maybe in some future world we will have that.
In this world, we did not because this money market funding is from a mutual fund.
Mutual fund that has regulations about what it can accept as collateral.
And certainly CDS is not something that it can accept as collateral.
It has to have a proper security.
There's a lot of regulations on the kinds of things that are acceptable.
So, this was just not on.
I mean, it might have been a good idea and it might still be a good idea.
In fact, you may have been-- one of
the things I proposed exactly when AIG was failing was,
what the government needs to do is to step in and write credit default swaps in
order--because I understood that credit default swaps are sort of like an acceptance,
and that that's what you need if you have a liquidity problem,
you need somebody to write acceptances and they didn't do that.
So, that's how they lost their money.
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