Sunday, March 16, 2008

TSLF: Is the government taking a risk?

In one of the latest blogospheric analyses of the Fed’s plans to accept private-label mortgage backed securities as collateral, James Hamilton concludes that the government is taking on a definite risk (specifically, although the Fed is the agent, it is really the Treasury’s risk, since the Fed’s profits are received by the Treasury) but that the risk is not a very large one. I wonder, though, if it’s appropriate to view the risk characteristics of the specific transactions in isolation without considering how they influence the Treasury’s other risks.

Modern portfolio theory teaches us that an asset that looks risky in isolation can actually decrease the risk of a portfolio. For example, if you have a portfolio that consists entirely of government bonds, and you take out some of the bonds and replace them with stocks, you have replaced a safer asset with a riskier one, and yet your portfolio overall is now less risky. In that context it is the correlation (or rather, lack thereof) between asset returns that is the issue, but in the case of the government itself, a more important issue is how transactions in one set of assets affect the value of other assets and liabilities.

In particular, the government’s most important asset, in real economic terms, is the expectation of tax revenues. Tax revenues depend mostly on incomes. In particular, revenues depend not on potential incomes but on actual incomes, so any expected gap between the two reduces the value of the government’s most important asset. The government’s most important liabilities are the securities it issues, most of which are denominated in nominal dollars and most of which do not contain a call provision. A worst case scenario for the government is a Japanese-style deflationary depression, in which the value of the government’s liabilities rises in real terms, while the value of its most important asset is eroded by an ongoing output gap.

Deflation might not have seemed like an issue before Friday’s CPI report, but now the risk cannot be so easily dismissed. Most of the positive inflation in recent months appears to be the result of rapidly rising commodity prices, which are volatile and could easily reverse direction. Meanwhile, the US labor market is weak, and the financial system – what’s left of it – is fragile. If, by taking on certain (relatively small, in the grand scheme of things) financial risks, the government is able to materially reduce the risk of a financial collapse and thereby reduce the risk of a deflationary depression, there is probably a net decline in the government’s total risk.

To put it a little differently, as James Hamilton says, “you don’t get something for nothing,” but, it seems to me, if the something that you get is clearly worth more to you than the something that you gave up, you kind of do get something for nothing. Don’t you?

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Anonymous Anonymous said...


Mon Mar 17, 09:05:00 AM EDT  
Anonymous Chris said...

Only if you believe modern portfolio theory.

Mon Mar 17, 11:05:00 AM EDT  
Anonymous mike said...

"if you have a portfolio that consists entirely of government bonds, and you take out some of the bonds and replace them with stocks, you have replaced a safer asset with a riskier one, and yet your portfolio overall is now less risky"

Never true. If the government bond is risk-free (0 beta), by replacing some of it with risky assets, all you've done is move along the red line (higher return + higher risk):

Mon Mar 17, 07:41:00 PM EDT  
Anonymous Anonymous said...


You are missing several factors such as investors risk tolerance, expected return, and rate of return needed to replace income upon retirement. 100% allocation into Government bonds in an inflationary environment can produce a negative rate of return when you factor in taxes and inflation. That's risk.

Tue Mar 18, 10:44:00 PM EDT  
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