Gotcha! (Willem Buiter’s Market Maker of the Last Resort Edition)

Willem Buiter ought to annoy me, and yet he doesn’t. While it is no doubt unconscious, he seems overly intent on impressing his readers with his intelligence, which is considerable; he wears his erudition on his sleeve. Yet he manages not to come off as an intellectual snob. While I’m not about to do an explication de text to prove it, he doesn’t give the impression that he is using his smarts for one-upmanship. You can be in his intellectual league too; he isn’t out to keep the membership down.

Buiter, currently a professor at the London School of Economics, has proposed along with Anne Sibert the notion that central bankers should act as markets markers of the last resort. The concept on the surface sound like a novel way to surmount the problem central bankers currently face, namely, that they find it difficult to create liquidity in the non-bank portion of the banking system (indeed, they are having trouble even in influencing Libor spreads, but that’s another topic).

However, some, yours truly included, have wondered how the central banks could set prices for instruments for which there isn’t a ready trading market (think those pesky Level 3 assets, the sort whose prices can’t readily be derived form assets that do have an active trading market). Those are the sort where the need is likely to be most acute.

Buiter proposes an answer in a current post:”Good news! Central banks don’t have to be smart to run auctions for illiquid securities without becoming moral hazard patsies” (I’m glad he’s worried about the right issues):

I will here just give a brief summary of these earlier scribblings on how central banks can organise auctions for loans against against illiquid collateral for which there isn’t a market price, without rewarding reckless lending and borrowing and thus encouraging a repeat of past excesses in the provision of credit.

Well-designed auctions will act as reservation price-revealing mechanisms for the central bank. The simplest auction is a reverse Dutch auction with the central bank as the only buyer. The central bank has to have a list of securities eligible for access to the auction. I would recommend the central bank only include simple structured investment products on the list, to provide incentives for private financial innovators to keep their wilder horses under control. It could also restrict access to the auction to sellers that are subject to a regulatory regime approved by the central bank. Unregulated financial institutions would have to try their luck with those regulated institutions that were successful obtaining liquidity from the auctions.

The central bank would have to decide for each auction an upper bound on the amount it is willing to purchase at the auction. It could do so by setting an upper bound either on the market value or on the notional or face value of the securities it is willing to purchases. Assume for the sake of argument it sets an upper limit of £10bn for the face value of the securities it is willing to buy. The central bank starts by offering to buy any amount up to £10bn at the lowest possible price, say, 1 penny for each pound sterling of face value. Assume £2bn worth of face value is sold at 1 penny. Next it offers to pay 2 pennies for each pound sterling worth of face value for up to £8bn worth of securities. If the cumulative sales at 1 penny and 2 pennies don’t add of to £10bn, there will at least be a third round, say, at three pennies for each pound sterling of face value. The auction continues until the pre-set upper limit, £10bn is reached, or until the price reaches 1 pound sterling for 1 pound sterling worth of face value.

In such a reverse Dutch auction, those desperately short of liquidity will offer to sell first, at very low prices. The less panicked would-be sellers hold out for higher prices, but risk missing out altogether.

The central bank would take the securities it had bought at the auction onto its balance sheet. If the markets for the securities bought at the auction by the central bank were to normalise later, the central bank could opt to sell the securities at that time. There is, however, no need to do so. The central bank can simply hold all the securities it buys at the auction until maturity. That way it never has to form a view on what they really are worth. There are advantages to never being liquidity constrained – the happy condition of the central bank.

The central bank would, of course, take credit risk onto its balance sheet if it buys private securities at the auction. The reverse Dutch auction with a monopolistic buyer is, however, so hard on the sellers, that the central bank could expect to make a profit out of the activity. Should it be hit by an unexpected wave of defaults on these securities, it would have to be recapitalised (bailed out) by the Treasury. This, of course, is also the situation the Bank of England faces today with its exposure to Northern Rock through the Liquidity Support Facility.

What is the fly in the ointment here? Buiter makes the mistake of assuming that you will have some depth of supply in instruments, that is, his discussion pre-supposes that if a central banker puts up a list of eligible securities, it will (in most cases) get multiple offers, assuring decent price formation.

But what he misses is the heterogeneity of instruments in the fixed income market, as an article in the Financial Times by Larry Tabb, “Transparency would muddy the waters in OTC market“, pointed out earlier this week:

…..there are approximately 7,000 equities listed on the US major markets, and while they may be valued differently, they represent a very simple concept: corporate fractional ownership.

Further, the average US equity trade (retail and institutional) is only 350 shares and has a nominal value of less than $20,000.

Compare that to the fixed-income markets.

While there are only about 250 US Treasury securities, there are more than 2.6m mortgage-backed securities, 100,000 US agency securities, 70,000 corporate securities and 30,000 asset-backed securities.

For mortgage-backed securities, each mortgage pool is very different from the others, differing by interest rate, mortgage type, geographic diversity, prepayment speed and outstanding principal balance.

Other fixed-income products (corporate, money market and municipal) have widely divergent characteristics as well.

Consider this: while there is still a comparatively small number of corporate securities relative to the other types, and these are the Level 2 type (they can usually be gridded from trading of more liquid issues by maturity, duration, rating, etc), they are still so illiquid that most investors create them synthetically using credit default swaps.

So how are central bankers going to choose among 2.6 million MBS issues and 30,000 ABS? Normally, you’d want to pick the most liquid (say the top 5%), but if you want to bring liquidity into an illiquid market, what would your decision rules be? And remember, per Tabb’s comment, these instruments are so diverse that price discovery in one in many cases won’t give you a lot of useful information about the others.

It’s possible there’s a solution, but Buiter needs to grapple more with the complexity of these instruments. The outline he has proposed isn’t yet sufficient.