Knightian Uncertainty and the TARP

Ricardo Caballero and Arvind Krishnamurthy argue that the presence of Knightian uncertainty in financial markets means that recapitalization of financial institutions must be massive in order to work, larger than is likely to be practical. However, another solution - government insurance - can reduce the size of the required capital injection:

Knightian uncertainty and its implications for the TARP, by Ricardo Caballero and Arvind Krishnamurthy, FT Economist's Forum: ...To paraphrase a recent Secretary of Defense, risk refers to situations where the unknowns are known, while uncertainty refers to situations where the unknowns are unknown. This distinction ... has significant implications for economic behaviour and policy prescriptions. There is extensive experimental evidence that economic agents faced with (Knightian) uncertainty become overly concerned with extreme, even if highly unlikely, negative events. ...

The main implication of rampant uncertainty for the TARP and its relatives, is that capital injections are not a particularly efficient way of dealing with the problem unless the government is willing to invest massive amounts of capital, probably much-much more than the current TARP. The reason is that Knightian uncertainty generates a sort of double- (or more) counting problem, where scarce capital is wasted insuring against impossible events.

A simple example makes the point: Suppose two investors, A and B, engage in a swap, and there are only two states of nature, X and Y. In state X, agent B pays $1 to agent A, and the opposite happens in state Y. Thus, only $1 is needed to honour the contract. To guarantee their obligations, each of A and B put up some capital. Since only $1 is needed to honour the contract, an efficient arrangement will call for A and B jointly to put up no more than $1. However, if our agents are Knightian, they will each be concerned with the scenario that their counterparty defaults on them and does not pay the dollar. That is, in the Knightian situation the swap trade can happen only if each of them has a unit of capital. The trade consumes two rather than the one unit of capital that is effectively needed.

Of course, real world transactions and scenarios are a lot more complex than this simple example, which is in itself part of the problem. In order to implement transactions that effectively require one unit of capital, the government needs to inject many units of capital into the financial system.

But there is a far more efficient solution, which is that the government takes over the role of the insurance markets ravaged by Knightian uncertainty. That is, in our example, the government uses one unit of its own capital and instead sells the insurance to the private parties at non-Knightian prices.

The Knightian uncertainty perspective also sheds light on some of the virtues of the now defunct asset-purchases programme of the original TARP. ... In such cases, removing the uncertainty-creating assets from the balance sheet of the financial institution reduces risk by multiples, and frees capital, more effectively than directly injecting equity capital.

Does this mean that there is no role for capital injections? Certainly not. Knightian uncertainty is not the only problem in financial markets, and capital injections are needed for conventional reasons. Our point is simply that these injections need to be supplemented by insurance contracts, unless the government is willing to increase the TARP by an order of magnitude...

Comments

[hari]

Is this more or less an argument for nationalizing financial (sector) instruments in order to overcome accumulated constraints over three decades or what?

[Mark]

Based on the past two years of data, we know with certainty that the risk valuation models were a) wrong and b) systematically understated risk. Therefore, were are not overly concerned but quite properly concerned about extreme negative events that are not impossible but are in fact unfolding. If I understand the argument of Caballero and Krishnamurthy correctly, all we need is an omniscient government agent who can dissolve the uncertainty about uncertainty to discover the value of the invaluable to insure the uninsurable.

[Premium Pricing]

GSE guarantees of mortgages are enticing foreign entities to buy them, but the price is that taxpayers make up for all defaults. Basically, insurance cost is being subsidized by the taxpayers. Extending these guarantees to all private debt would make the taxpayers responsible for all defaults in the private sector. Foreign entities would probably again buy private debt.

Switching to an insurance model might bring in premiums that would cover some/all of the default cost. The premium would have to be rolled into the cost of the loans (de facto higher interest rates). Charging lower than market rates for the insurance premiums would partially subsidize the cost with taxpayer funds. If the market truly is mis-pricing the insurance, charging properly priced premiums would be a free lunch that would entice foreign entities to buy private debt. However, if a mistake is made in pricing premiums, the taxpayers would be responsible for potentially fantastic default rates. Foreign confidence in full faith and credit might be put at risk, as private entities borrowed wantonly in response to the mis priced insurance premiums.

[Julio]

Wouldn't this argue for getting to the root of the rotten edifice and insuring the mortgages themselves?

Which could probably be done in a way that puts spendable money in the hands of homeowners, but that's another discussion.

[paine]

"But there is a far more efficient solution, which is that the government takes over the role of the insurance markets ravaged by Knightian uncertainty"

yes !!!!!

[paine]

"The Knightian uncertainty perspective also sheds light on some of the virtues of the now defunct asset-purchases programme of the original TARP. ... In such cases, removing the uncertainty-creating assets from the balance sheet of the financial institution reduces risk by multiples, and frees capital, more effectively than directly injecting equity capital. "

too clever

the purchase price needs to be above market value
and given the lack of sound insurance
paid up by prior premia flows
what does this mean ???
but claw back and claw back uncertainty

ahh if it were insured all along .....

-----------

tarp to work would need to reduce
what some call " secondary uncertainty"

(ie uncertainty that is produced
by the particular institutional arrangements
of the existing system)

in this case "irrational secondary uncertainty "
but wouldn't this
require total balance sheet transparency ???

my guess such big T transparency
in the end could only be created
by a mandatory call
on
all outstanding toxic category securities

--enforced by uncle and funded by uncle---

[Anonymous]

This argument ignores the problem that many of the products we are talking about insuring are built on loans that were poorly underwritten. In other words the authors are proposing that the federal government insure loans that we have every reason to believe will go into default.

The whole problem that the private sector is facing is that the only way to deal with this situation efficiently is to go back and properly underwrite hundreds of thousands of loans that were never really underwritten. (I'm channeling Tanta here.) Of course, this is an expensive undertaking.

I don't understand how the government can go and offer insurance, unless it is first going to expend the resources to go back and evaluate one-by-one the quality of the underlying loans. In other words the main difference between the proposal that government just offer to buy all mortgages and this insurance proposal is that the insurance proposal will serve to hide the costs of the solution for a longer period of time -- and leave open the possibility of never correctly evaluating the underlying assets and thus of never correctly pricing the insurance product.

[paine]

"(I'm channeling Tanta here.) "

needn't she's more then enough pedestrian channel
for all of us

the whole point obviously
is to get uncle to eat the consequences
of bad private underwriting

okay so that got us here

now what
get out the claw ???

plenty of time to track these grifters down

but only after
uncle does the right thing
and eats up the whole problem
at its foundation
not the hierarchy of razzle dazzle
but the base
the securitized original mortgages themselves
in big toxic hunks
like the fearless cyclops he is

[Anonymous]

"the whole point obviously
is to get uncle to eat the consequences
of bad private underwriting"

Then why hide the truth -- that the government is going to pick up the tab for the financial system's mistakes -- by claiming that this is a matter of "insuring" assets.

I think words matter. If a bailout of the financial system is called insurance, we'll never escape the yahoos claiming that it was the government that mispriced the insurance, not the banks that didn't do their jobs.

[Mark]

Let's assume we can "track these grifters down." Do we have the legal basis for clawing back compensation? And if we do, can it make the taxpayer whole if trillions are lost? I'm not saying it can't be done, I just have a hard time imagining the legal system dealing with potential losses on this scale.

[paine]

do the notion of show trials
mean anything to ya mark ??

we yank these grifters in front
of the cameras by ones and threes
and nail em all up on their double crosses

will this get our toil produced trillions back ???

no

so
then why ??

well to fire up
our mostly honest
most of the time decent
votin majority

to convince em they've been screwed blued and tattooed
by these grifters and their ilk
and therfore
they as the vast ruling class
oughta see to it
the gubmint shifts back the tax burden
toward where it was headed in 1936 and
where it belongs now
on the sifter few

they best
get their elected agents in washington
to
begin soaking the rich
for "trillions "
in reparations
for the reagan-clinton-bush mega filtch

yes soaking em for the next 28 years
just like they've been
soaking amerika's
regular abiding folks
for the last 28 years

[calmo]

C&K argue that TARP is inadequately funded and/or CDS transactions need to be regulated with outrageousfearsome capital requirements is my takeaway.
The bite starts here (with my parenthetical chewing):The trade consumes (duzzit? by fees undisclosed? , duzzit take time this consumption? is there a waste product from this trade worth recycling? I submit "consumes" is extravagant and humbly submit "requires for this specific period".) two rather than the one unit of capital that is effectively needed (iff in the event of a default, yes?).
but quickly expands from ~twice the amount the transaction requires~ to "an order of magnitude more" wrt the current TARP payload...(pea-shooter -> cannon --crude econometrics).
But not all trades default. In fact the phenomenal practice for years proves that default is rare rather than common...and those capital requirements following the arithmetic here were not in fact needed...until recently.

The complexity of several trades by the same group of traders would seem to decrease the overall capital requirements --surely it does not follow the basic rules of arithmetic outlined here...what am I missing?