In the recent NBER working paper, my co-author, Guillermo Ordoñez of the University of Pennsylvania, and I develop a model to examine the important role collateral plays in the economy. Where do safe assets come from? Empirical evidence suggests that the private sector creates more near riskless assets when the supply of government debt is low and reduces privately-created near riskless assets when the supply of government debt is high. Krishnamurthy and Vissing-Jorgensen (2012) show that the net supply of government debt is strongly negatively correlated with the net supply of private near-riskless debt.

The substitution between public and private safe debt is also shown by Krishnamurthy and Vissing-Jorgensen (2012) who document that changes in the supply of outstanding U.S. Treasuries have large effects on the yields of privately created assets. Gorton, Lewellen, and Metrick (2010) also find this relationship between government debt and privately produced substitutes. They document that the share of safe assets in the U.S. economy, including both U.S. Treasury debt and privately created near-riskless debt has remained constant as a percentage of all U.S. assets since 1952. Xie (2012) shows that the issuance of asset-backed securities tends to occur when the outstanding government debt is low and Sunderam (2012) documents the same phenomenon with respect to asset-backed commercial paper.

By “safe assets,” we mean government debt and privately created high quality debt, in particular, asset-backed securities. Such safe assets are used to collateralize repo, derivative positions, and are needed as collateral in clearing and settlement. See IMF (2012). Further, because they are ”information-insensitive” (in the nomenclature of Dang, Gorton, and Holmstrom (2012)), they are highly liquid and hence can store value without fear of capital losses in times of stress, a form of private money.

…continue reading: The Supply and Demand for Safe Assets

Given that the conference theme is macro-finance linkages, I thought I would try to lay out a corporate finance perspective on large-scale asset purchases (LSAPs). I have found this perspective helpful in thinking both about the general efficacy of LSAPs going forward, and about the differential effects of buying Treasury securities as opposed to mortgage-backed securities (MBS). But before I get started, please note the usual disclaimer: The thoughts that follow are my own and do not necessarily reflect the views of other members of the Federal Open Market Committee (FOMC). I should also mention that these comments echo some that I made in a speech at Brookings last month. [1] As I noted in that speech, I support the Committee’s decision to purchase mortgage-backed securities (MBS) at a rate of $40 billion per month, in tandem with the ongoing maturity extension program in Treasury securities, and its plan to continue with asset purchases if the Committee does not observe a substantial improvement in the outlook for the labor market.

…continue reading: Corporate Finance Perspective on Large-Scale Asset Purchases

I’d like to describe the framework I have been using to think about monetary policy in the current environment, focusing primarily on the role of large-scale asset purchases (LSAPs).

There is a considerable diversity of views within the FOMC, and among economists more generally, about the use of LSAPs and other nonconventional policy tools. This diversity is both inevitable and healthy given the unprecedented circumstances in which we find ourselves. To be clear on where I stand, I support the Committee’s decision of last month—namely, to initiate purchases of mortgage-backed securities (MBS) at a rate of $40 billion per month, in tandem with the ongoing maturity extension program (MEP) in Treasury securities, and to plan to continue with asset purchases if the Committee does not observe a substantial improvement in the outlook for the labor market. Given where we are, and what we know, I firmly believe that this decision was the right one.

In my comments, I will only briefly review the case for taking action, as that ground has been well covered in a number of other places, most notably in Chairman Bernanke’s recent Jackson Hole speech. Instead, I will explore in more detail the factors that make decisions about LSAPs so challenging. The Chairman discussed these challenges in his recent speech, saying: “Estimates of the effects of nontraditional policies on economic activity and inflation are uncertain, and the use of nontraditional policies involves costs beyond those generally associated with more-standard policies. Consequently, the bar for the use of nontraditional policies is higher than for traditional policies.”

…continue reading: Evaluating Large-Scale Asset Purchases

The SEC recently proposed Rule 127B to implement the prohibition under Section 621 of the Dodd-Frank Act on material conflicts of interest between securitization participants of an ABS and any investor in the ABS. The proposed rule includes exceptions for certain risk-mitigating hedging activities, liquidity commitments and bona fide market-making. The proposed rule is available here.

Key provisions of the rule include:

Conditions Required for Application of the Proposed Rule

• Covered Persons. The proposed rule would apply to an underwriter, placement agent, initial purchaser or sponsor, or any affiliate or subsidiary of such entity, of an ABS.
• Covered Products. The proposed rule would apply to any ABS, as such term is defined in section 3 of the Exchange Act, including, for the purpose of the rule, synthetic ABS. The definition of ABS provided in the Exchange Act is much broader than the definition of ABS in the Securities Act Regulation AB. Both registered offerings and private placements would be covered by the proposed rule.

…continue reading: SEC Proposes Rule 127B to Implement Section 621 of the Dodd-Frank Act

On August 31, 2011, the SEC issued (i) a concept release (the “Derivatives Concept Release”) soliciting public comment on the use of derivatives by registered investment companies under the Investment Company Act of 1940 (the “ICA”); (ii) an advance notice of proposed rulemaking on the treatment of asset-backed issuers under the ICA (the “Proposed Rule”); and (iii) a concept release (the “Mortgage Concept Release”) seeking public comment regarding the ICA status of companies engaged in the business of acquiring mortgages and mortgage-related instruments.

A brief summary of key topics in each release is below.

…continue reading: SEC Concept Release on Use of Derivatives by Investment Companies

Next, we will consider re-proposing rules outlining the requirements for an issuer of asset-backed securities to be able to use shelf registration.

Today’s actions partially re-propose a set of rules the Commission proposed in April 2010 that would significantly revise the regulatory regime for asset backed securities. Among other things, the 2010 proposals were designed to increase transparency and to improve the quality of securities that are offered through the shelf registration process.

Subsequent to our proposal, Congress — through the Dodd-Frank Act — sought to address some of the same concerns and we have reevaluated the proposals in light of those provisions. The proposals today also take into consideration suggestions from commenters on the April proposal.

Today the staff is recommending that we re-propose shelf eligibility requirements for ABS issuers and seek additional comment on certain parts of our April 2010 proposal.

As we consider a final set of rules, we will look to the rules we proposed in 2010 as well as the revisions to those proposals we are considering today.

…continue reading: Shelf-Eligibility Requirements for Asset-Backed Securities

What should be done about the private money market? It is widely recognized that this market was at the center of the recent financial crisis. Indeed, very nearly the entire emergency response to the financial crisis was aimed at stabilizing this market. Yet recent and proposed reform measures have done little to address this market squarely.

It is important to be precise about terminology. The term “private money market” refers to the multi-trillion dollar market for short-term IOUs that are neither issued by nor guaranteed by the federal government. This market includes repurchase agreements (“repo”), asset-backed commercial paper (“ABCP”), uninsured deposit obligations, and so-called Eurodollar obligations of foreign banks. It also includes the “shares” of money market mutual funds. (Contrary to widespread belief, commercial paper issued by non-financial firms is only a tiny fraction of the private money market—on the order of 2%. That is to say, the private money market is dominated by financial issuers, not commercial or industrial ones.)

…continue reading: What Should Be Done About the Private Money Market?

Looking back to the fall of 2007, it is clear from SEC filings that significant financial company losses resulted from proprietary positions booked in trading accounts. More specifically, a large amount of trading losses came from holdings of mortgage-backed and asset-backed bonds that had been afforded high credit ratings (e.g., AAA) by Nationally Recognized Statistical Rating Organizations (NRSROs). Rapid mark-to-market losses on these and other trading positions contributed significantly to the financial crisis and ultimately led legislators to develop the Volcker Rule, section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

With the Volcker Rule, legislators aim to reduce banking entity exposure to proprietary trading and thereby enhance bank’s ability to maintain their more traditional functions during market crises. The Rule, depending on how it is interpreted and enforced by regulators, has the potential to significantly change the scope and scale of proprietary trading within federally insured depositories and their affiliates.

This article discusses the relevant background of the Volcker Rule trading restrictions and offers insights on likely regulatory interpretations and banking entity responses. Specifically, the article addresses the designation of customer-initiated trades, increased expectations related to trading risk systems and limits, and the identification of material conflicts of interest.

The original article can be found at the following link on NERA’s website: http://www.nera.com/67_7328.htm.

In late 2010, a number of banks with mortgage servicing operations declared moratoriums or suspensions on some aspects of foreclosure proceedings, a move that appears to have been prompted by revelations about the banks’ alleged substandard foreclosure practices. By mid-October 2010, it was reported that the Office of the Comptroller of the Currency and the attorneys general of all 50 states were launching investigations into issues surrounding the mortgage foreclosures.

…continue reading: Foreclosure Suspensions and Other Mortgage Disputes

The rule before us is designed to implement a requirement of the Dodd-Frank Act to strengthen the process by which asset-backed securities are offered. [1] I fear that today’s proposal does not implement this Congressional intent. Instead, this proposal will frustrate investor protection by endorsing an “anything goes” approach for issuers reviewing assets underlying an asset-backed security because it sets no minimal standards.

Leading up to the financial crisis, underwriters and others involved in offering asset-backed securities had, and I quote Professor John Coffee’s Senate Testimony, “decreased their investment in due diligence, making only a cursory effort by 2006.” [2] Because market participants approached due diligence as just a formality, there was a significant erosion in market discipline by those involved. [3] As just one example, it has been reported that by 2005, outside due diligence firms hired by securitizers to conduct asset reviews were only evaluating 5 percent of the loans in the underlying mortgage pools. [4]

…continue reading: Reviewing Asset-Backed Securities – Investors Deserve Better