We saw two recent commentaries by eminent economists advocating the use of indexed debt instruments.
Ken Rogoff, of Harvard’s Economics Department, was interviewed in the McKinsey Quarterly about the current Great Recession and what can be done about it. Among a number of other points about long-run structural reforms, he says that:
And then I’d say governments need to find ways to spark market innovation in indexing debt instruments. If we had housing loans indexed to, say, regional housing prices, as Bob Shiller has advocated, it would have helped a lot and provided better incentives to borrowers and lenders. If in 200 or 300 years, we’re experiencing fewer and milder financial crises, it will be because we figured out how to put some basic indexation clauses into debt that make it a little less vulnerable to systemic risk.
Jeffrey Frankel, at Harvard’s Kennedy School of Government, wrote an oped piece advocating action by the World Bank in a similar direction:
But some commodity exporters still seek ways to borrow that won’t expose them to excessive risk. Commodity bonds may offer a neat way to circumvent these risks. Exporters of any particular commodity should issue debt that is denominated in terms of the price of that commodity, rather than in dollars or any other currency. Jamaica, for example, would issue aluminum bonds; Nigeria would issue oil bonds; Sierra Leone would issue iron-ore bonds; and Mongolia would issue copper bonds. Investors would be able to buy Guatemala’s coffee bonds, Côte d’Ivoire’s cocoa bonds, Liberia’s rubber bonds, Mali’s cotton bonds, and Ghana’s gold bonds. The advantage of such bonds is that in the event of a decline in the world price of the underlying commodity, the debt-to-export ratio need not rise. The cost of debt service adjusts automatically, without the severe disruption that results from loss of confidence, crisis, debt restructuring, and so forth.
Both Rogoff and Frankel are well aware that calls for indexation of debt are not new. Indeed, Rogoff’s horizon for change is centuries, not years.
If these ideas are not new, and if the task of implementing them is likely to take centuries, we should ask what the difficulties are.
The biggest problem is that the world is complex, while the tools for hedging are too, too simple by several order of magnitude. It is an easy matter to build a simple model of a family, a company or a country exposed to a single specific risk, and then to design a financial instrument to hedge that risk. But the real world is more complex, and the hedge often doesn’t work quite as planned.
Back in the 1970s, MIT’s Franco Modigliani was studying the indexation of financial instruments to inflation, especially mortgages. In 1975, Federal Reserve of Boston published a conference series examining alternative mortgage designs. One version of the so-called Inflation-Proof Mortgage became the common design in Mexico. An implicit assumption of this design is that housing prices move closely with the general inflation rate. However, in the early 1990s, a dramatic drop in housing prices occurred despite strong inflation, causing many of these mortgages to be underwater—the amount owed was higher than the value of the home. Delinquencies rose dramatically in 1993, from 4% to more than 30%. The problem continued into the ultimate devaluation of the peso in 1994 and thereafter. Ultimately, the government was forced to step in to restructure loans as well as the banks. See this study for the details.
The Mexican experience with inflation proof mortgages is a rich variation on the classic problem in hedging: basis risk.
Basis risk arises when the investor wants to hedge against risk X, but the financial market offers a security tied to risk Y, a different variable. For example, airlines seek to hedge the price of jet fuel, but the most liquid futures market contract is for crude oil, which is a related but still different commodity. If the variables X and Y are closely correlated, then the investor can buy a security tied to risk Y and capture a partial hedge of risk X. It is a partial hedge because the correlation is not perfect. Furthermore, correlation is a simple metric that portrays how variables relate to each on average, and there is a great danger in relying too much on average relations to manage contingencies. Correlation can vary unexpectedly, and variables can wonder away from their average behavior. In general, basis risk forces the investor to hedge less. That is, if the investor owns 1 unit of risk X, then it is optimal to sell less than 1 unit of financial asset Y. Were the investor to sell a full 1 unit of risk Y, it is possible the investor will have added to his or her total risk instead of reducing it. Basis risk is a well known and severe limitation on the value of hedging.
The Mexican experience is like basis risk because the home buyer faces many, many risks determining the ultimate economic value of the purchase/investment, while any mortgage design indexes payments to financial variables that only partially correlate to the ultimate economic value of the purchase/investment. So an indexed mortgage has basis risk. Properly structured, it may be better than no indexing, but it is equally important to see the limitations. Overestimating the success of an index in hedging all of the risk will conceal the size of the true remaining risk and lead to overleveraging.
Commodity bonds face a similar limitation. We agree they can be valuable—we modeled their contribution to a company’s value more than two decades ago—but their benefits can also be oversold. Basis risk is huge. Commodity production doesn’t operate on autopilot. Producers have many decisions to make about capital investments and operating decisions. These will be conditioned by many, many variables in addition to the price of the commodity being produced. For example, the costs of inputs will be key, too. These extra variables produce basis risk, and this limits the value of indexing debt to the commodity price. Ideally debt should be indexed to the full complex of variables, but that’s not possible. Recognizing this means scaling back our expectations about the contribution that indexing provides.
If we turn our attention away from theoretical models of hedging and look to what companies actually do, we find that the vast majority of financial hedging is tied to very, very short maturity instruments. For example, in the largest commodity futures market, crude oil, approximately 95% of all hedging is done using futures contracts with a maturity less than three years. Nearly 50% of all hedging is done using futures contracts with a maturity of 3 months and less. That is a huge skew. Clearly this distribution does not match the maturities of actual exposures of companies. One reason is basis risk. Companies are far more conservative about putting on hedges than is recommended by oversimplified theoretical models.
There is less basis risk involved in hedging short maturity exposures, since the structure of these exposures can be described with greater reliability. Therefore, short maturity exposures can be hedged more completely. The longer the maturity, the more a number of other variables enter into the equation. A simple hedge of the oil price has a lot more basis risk in it.This effect is much more significant than many people understand. It goes a long way to explaining the limitation of all sorts of hedging schemes. Reality is just much more complex than these schemes acknowledge.