The value of a risky loan is the value of a risk-free loan minus the value of the guarantee, which is the option that can be priced out, either as insurance or interest. The liquidity of private credit markets implies that lenders and borrowers guarantee each other’s solvency. The loss of mutual trust then explains the flight to cash or safe assets in times of crisis. Moreover, private credit markets attempt to create synthetic equivalents for governments’ risk-free debt. This action, however, takes as a basis for the liquidity of the private credit markets the insurance policies guaranteed by the government and thus defines this very liquidity as an equivalent for the ability to issue good collateral or to make risky collateral safer, which only governments can ultimately do. Governments write guarantees on the assets of banks that are short put options, which in turn means that governments write a put on short puts. But this should also make it possible to price out government guarantees on risky assets held by private parties, in reference to private risk premiums.
There are feedback loops here that arise because of the interdependence of banks and governments. If banks become weaker because of government guarantees, the value of government guarantees increases, while conversely, governments then become weaker, which in turn is feedback that banks have become weaker. These feedback loops are only intensified by the interconnectedness of shadow banking systems, central banks and insurance groups. And this means that the price of government guarantees of liquidity is not really measurable, even assuming that the expected default rate of private loans can be compared to the risk-free baseline of government debt. For private insurance of debt, credit default swaps are brought into play here, but they only cover the credit risk of the private sector. Nevertheless, as an approximation, the CDS prices are also supposed to apply to the CDS prices of guaranteed sovereign bonds. But this still falls far short of determining the amount of liquidity that the U.S. government made available to the markets after the 2008 financial crisis.
If private default risks for large parts of the private credit markets are backed by the government, then the interest rate spreads between government debt and private debt are far from reflecting the existence of formal and assumed government guarantees. Indeed, private lenders would then be paid an unnecessary insurance premium for debt that governments have long since insured. The biggest lenders, Wall Street banks, are encouraged by the certainty of government bailouts to undercharge the biggest borrowers, Wall Street hedge funds, for the risks they take. For the too big too fail policy, one estimates $30 trillion in 2008 for the 18 largest banks that were partly responsible for the crisis. This policy implies that lenders can issue a short put that is expected to yield no losses.
The nominal value of global derivatives markets was $683 trillion in 2008. Now, since 2008, the Fed has repeatedly issued neutral funding guarantees to this market. It has protected not only the banking sector, but also the shadow banking system, and even outside the United States. This provided 43 percent of all global credit in 2003, and its total liabilities were $25 trillion, twice that of the traditional banking sector. The Fed’s hedges were $3.6 trillion for global money markets and $2.6 trillion for global derivatives markets.
The political conciseness of government hedging is indicated by the rate between total debt in credit markets relative to gross domestic product. In 2016, the former amounted to $63.5 trillion in the U.S. and gross domestic product was $18.6 trillion – so the rate was 340 percent.
The flight to good collateral during financial crises increases demand for government-issued liquidity, while private-issued assets suddenly become less acceptable. In this situation of tighter credit and private financial instruments, there may also be a shortage of government-guaranteed liquidity, which is now in greater demand. It seems to be an illusion that newly created financial instruments are as liquid as the government’s bonds. Here, however, it is important to distinguish between liquidity and moneyness By this is meant that securities of any maturity can be highly liquid and stable in their prices, but only the shortest IOUs can really serve the demand for money quickly. Only these instruments are as liquid as government-issued money is.
For Meister, at this point, it is important to follow the interactions between the money markets, the shadow banking system and the sovereigns, especially the U.S., which provide good collateral to those, as well as the interactions between the capital markets and the money markets, which provide those with financial liquidity. In many cases, the shadow banking system today takes over the function of traditional banks by providing money to the financial markets. Money markets are based on the existence of safe and liquid collateral, such as U.S. Treasury bonds. These are considered safe because money is issued on them and no other collateral is required. But this is circular in that the bonds are considered intrinsically liquid in that they are instantaneously convertible to cash. The guarantee of a risk-free government bond for government-issued money, that is, the assurance of full liquidity, indicates a paradox of money markets in that cash pays no interest, but interest-paying bonds trade for cash.
Money itself is the most liquid asset that can be defined within the financial logic of capital because it is the only “thing” that fully satisfies the demand for funds for payments. Thus, it always indicates a premium of the money markets over assets, financial instruments and derivatives that just have to be redeemed in money. The premium that the dollar indicates in terms of U.S. government bonds, as the most liquid security especially in times of crisis, is measured by the excess of the value of the bonds that must be issued over the amount of money that can be lent against them, which is known as the haircut. The haircut of money markets, the discount rate at which risk-free bonds can be converted into cash, measures the difference between full liquidity and the ability to pay. The substitutability of cash for financial assets in money markets is a testament to the ability of institutions to produce new financial products, such as derivatives, in which value that has just been produced can be preserved and accumulated. By creating negotiable collateral, an illiquid thing or future state in the world can be transformed into an asset that can be priced out today because it can be pledged as collateral to create funds today. It has a price, which makes collateral convertible precisely into money.
For Meister, the Black/Scholes formula is not only a way to price derivatives, but also a technology to create synthetic public debt from other forms of private capital. This is about risk-free financial assets, about CDOs, for example, creating synthetic AAA collateral that can be recycled as good collateral and used in place of government bonds to lend money. But this does not guarantee that there is a robust private and liquid market in which such risk-free debt can be traded, with the same stability as government bond trading.
For Meister, the Black/Scholes model was also empirically true because sovereigns guaranteed the liquidity of AAA-rated collateral. Of course, this can be doubted because, although accumulated wealth could be priced out via options, this just led to the collapse of markets and the use of sovereigns. For Meister, however, the Black/Scholes model is politically contingent. It does not say that public and private debt are identical; rather, the swap between them contains a guarantee that can itself be priced out by means of the model, and also shows that this implicit price, which exists to maintain the liquidity of markets, was actually paid. However, the financial crisis accentuated the difference between government bonds and all other assets that can be used as collateral.
When investors burn the private assets, there is an increasing demand for government bonds, which in turn increases the supply of good collateral that can be bought or sold to generate funds. U.S. Treasuries serve this function in money markets by pricing out the difference between cash and the safest collateral that can be traded for money. It is money markets that keep financial markets liquid today. Meister wonders at this point whether there is a financial value in preserving the financial system qua bailout that can then be priced in the price of an asset – a macro-economic put. This is not a matter of calculating the cost to the government, which in turn was $29 trillion for the Fed from 2007 to 2010. The importance of issuing government bonds, and thus debt, today is not primarily the Keynesian motivation of fiscal and monetary policy, as Modern Money Theory also assumes, but the production of a supply of safe collaterals demanded by money markets, on which, in turn, financial markets are built. This could also mean that the government becomes a factory of collateral production for the shadow banking system. In this scenario, Treasuries do for market-based finance what central banks do for bank-based finance by creating underlying assets that increase the growth of liabilities in the shadow markets. The government eventually becomes a shadow central bank. Although the state has privatized banks and corporations and left macroeconomic governance to independent central banks, its role in finance has grown. Sovereign debt became the cornerstone of the modern financial system, serving as a benchmark for pricing out assets to hedge positions in income markets and producing insurance for the creation of credit through the shadow banking system. Meister assumes government financial dominance as the asymmetric support for falling asset prices.
If governments can borrow money at zero interest in financial markets to issue even more safe collateral, then they increase their importance. The role of governments in simultaneously issuing government bonds and the currency used to pay for them has put them in the position of a dealer in the shadow banking system, where currencies and bonds are exchanged, what Meister calls the dealer of last resort. The financial sector today has no doubt that the liquidity of asset markets is guaranteed by governments trading their very debt, which in turn is backed by the currencies they can produce themselves, for privately issued debt that would otherwise become illiquid. The state does not borrow more to spend more, as Keynes still saw it; rather, its austerity policy is to spend less in order to borrow more cheaply, since the issuance of debt is in the interest of the state, regardless of any need to spend more money.
For Meister, the point is to show that when sovereigns restore systemic liquidity and reduce the spread of differential liquidity, it boils down to the fact that the liability for the asset price case is the same when a put is sold. The government’s ability to do so can be priced out as a financial asset, an option that sells for a price.
Meister again says that the Black/Scholes model applies to the price of a call that is built into a hypothetical portfolio of assets that must have a return equivalent to all future amounts of a risk-free government bond. In addition, risk-free AAA collateral can be produced to price out riskier assets. There should be no liquidity premium for holding a private risk-free portfolio as an alternative to holding a government bond. And yet such a premium can be calculated. One assumes that governments may be unwilling to swap their bonds with private assets at par, but that this risk can be priced today as the amount to require the government to swap its bonds with AAA collateral at par.
Meister assumes that the amount provided during the post-2008 recession could indeed have been priced out, but that leaves open the question of to whom the amount should have been paid. In any case, the illiquidity of capital markets destroys the present benefits of past injustice. At the same time, understanding historical justice as the illiquidity of capital markets is a real option that distinguishes real democracy from a mere technology for producing consensus. The monetary value of U.S. asset market guarantees as the price of a put option sold was $9 trillion in 2008.
check also part, 1, 2 and 3
Foto: Bernhard Weber