Tuesday, December 28, 2010

2010 Best of the Blog, V

. Tuesday, December 28, 2010

Readers: Over the next week or so we'll be re-posting some of our favorite posts from IPE@UNC from this year, interspersed with new content. Partially because blogging is so ephemeral, and some of our posts are worth revisiting. Partially because it's winter break and we've got eating, sleeping, and catching up on research to do. Nominations welcome.

From February 25, "A Little Light Game Theory (Greek Sovereign Debt Edition)":

A few days ago I saw Jeffrey Friedman extend his "Basel thesis" -- in which the risk-weighting scheme in the Basel Accords created the incentive structure that led to the subprime financial crisis -- to Greece's debt crisis:

So why did the bursting of the asset bubble in housing cause a banking crisis, freezing interbank lending and then bank lending into the "real" economy?

Because, according to the Basel thesis, Basel I bank-capital regulations, enhanced in 2001 in the United States by the Recourse Rule, encouraged banks worldwide and especially in the United States to leverage into asset-backed securities, including mortgage-backed securities, that were either government guaranteed (by Fan or Fred) or were privately issued but had an AA or AAA rating. How did the Basel rules encourage this? By giving such securities a 20 percent risk weight.

Translation: An AAA-rated mortgage backed security worth $100 required only $2 in bank capital at the 8 percent Basel rate for adequately capitalized banks. $100 x .08 x .20 (the 20 percent risk weight assigned to asset-backed securities by the Recourse Rule) = $2. By contrast, a commercial loan of $100 required $8 of bank capital, because Basel gave such loans a 100 percent risk weight. $100 x 8 percent x 1.00 = $8. Similarly, a $100 whole mortgage retained by the bank required $4 of capital, because the Basel risk weight for unsecuritized mortgages was 50 percent. With these risk weightings, securitized mortgage-backed debt offered significant capital relief.

Today's FT brings the news that "European financial institutions have $235 billion worth of claims on Greek debt, most of which is thought to be in government bonds." Why do they hold so much Greek government debt? Because the only category of bank asset treated more kindly by the Basel rules than asset-backed securities is government debt, which has a zero risk weight. I.e., no bank capital need be used to buy a government bond.

So today I was interested to read that some major banks are fanning the flames engulfing Greece:

Bets by some of the same banks that helped Greece shroud its mounting debts may actually now be pushing the nation closer to the brink of financial ruin. ...

As Greece’s financial condition has worsened, undermining the euro, the role of Goldman Sachs and other major banks in masking the true extent of the country’s problems has drawn criticism from European leaders. But even before that issue became apparent, a little-known company backed by Goldman, JP Morgan Chase and about a dozen other banks had created an index that enabled market players to bet on whether Greece and other European nations would go bust.

Last September, the company, the Markit Group of London, introduced the iTraxx SovX Western Europe index, which is based on such swaps and let traders gamble on Greece shortly before the crisis. Such derivatives have assumed an outsize role in Europe’s debt crisis, as traders focus on their daily gyrations. ...

A result, some traders say, is a vicious circle. As banks and others rush into these swaps, the cost of insuring Greece’s debt rises. Alarmed by that bearish signal, bond investors then shun Greek bonds, making it harder for the country to borrow. That, in turn, adds to the anxiety — and the whole thing starts over again.

How can we square this circle? If Friedman is right, then banks are highly leveraged in the sovereign debt of Greece (and other countries). Basel rules required a 0% right weight for any OECD sovereign debt, but not all sovereign debt paid the same yield. Some states, like Greece, are relatively more risky than others, like the U.S., but they all had the same risk weight. So banks looking for a bigger profit would plow funds into the riskier countries at a higher interest rate because yields were higher.

Why, then, would many of the same banks now do their best to increase the risk of a Greek default? If that happens, and Friedman is correct that many banks are leveraged to the hilt on Greek debt, then they lose a lot of money. They can't be trading on moral hazard, since if they believed that Greece will eventually be bailed out and their debts made whole they wouldn't waste money purchasing insurance (a.k.a. credit default swaps). So what's going on?

One explanation is that a need for hedging has created the equivalent of a bank run in CDS markets, and this is creating a self-fulfilling prophecy. Another is that this represents a classic Prisoner's Dilemma: in aggregate all banks would be better off if none of them bid up the prices of CDS on Greek debt and thus relaxed the credit constraints on Greece, but each individual bank is incentivized to defect and insure themselves against potential default. Banks in competition against each other cannot credibly commit to cooperate, so (Defect, Defect) is a dominant strategy for all banks exposed to Greek debt. This creates a run, which manifests itself in CDS markets, and leads to a sub-optimal outcome for all involved.

If this is the appropriate model, then there would seemingly be a role for outside players to influence the game. Germany, or the ECB, or the IMF, or even the US could step in and provide financing for Greece to roll over their debt, meet counterparty obligations, and loosen the constraints that Greece faces in credit markets. But this simply raises another Prisoner's Dilemma: how could a third party guarantor be sure that Greece will not defect from that agreement and continue in its fiscal profligacy? Again, the dominant strategy seems to be (Defect, Defect) unless Greece can somehow credibly commit to austerity in order to meet its obligations. Unfortunately, it doesn't appear that they can.

Maybe the EMU should play a Grim Trigger strategy: they'll provide financing for Greece in exchange for austerity. If Greece defects, then the EMU boots Greece out of the monetary union and they're on their own. That threat might be significant enough to escape the Prisoner's Dilemma if it's perceived as being credible.

Or maybe not. It's a mess. As Carlo Bastasin says over at Baseline Scenario: "You cannot imagine really solving the Greek imbalance without – at least somewhat – correcting the German imbalance." Germany does not want to correct its imbalance. So Greece is probably screwed.

(edited for correct attribution, 8:41)

UPDATE: Felix Salmon sees this as a simple hedge. He's probably right.


2010 Best of the Blog, V
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