Discussion of “Can Cross-Border
Financial Markets Create Good
Collateral in a Crisis?”by M. Saito, S. Suzuki, and T. Yamada
Maurice Obstfeld
IMES Annual Research ConferenceBank of Japan, Tokyo, May 26, 2010

The Motivation• Financial crises create a scarcity of generally
acceptable collateral.
• Governments may lend cash on riskycollateral.
• Or they may swap good for risky collateral
to avoid public balance-sheet growth.
• Can markets endogenously create enoughcollateral?

The Formal Model• Two countries, complete markets for contingentclaims.
• In addition, Lucas-tree equity is held.
• Bonds must be collateralized by equity.
• Equity short sales must be collateralized by bonds.
• Only one Lucas tree in world, perfectly correlatedwith world aggregate labor output.
• Idea: Here, equity provides no diversification oflabor-income risk. Functions purely as (positive ornegative) collateral.

Key Constraint[ p(zt+1) + d(zt+1)]θ (s ) ≥ −a(s , s ), ∀s .
ttt +1t +1• When a < 0, this states that equity holdings
must suffice to collateralize contingentdebts.
• When θ < 0, this states that scheduled bondreceipts must suffice to collateralize shortequity position.

Results and Realism of the Model• Main result is that ex post trades in debt andequity may approximate complete-markets
allocation.
• The model requires tiny ratios of dividends tolabor income – in first example, 0.001!
• This plus focus on very large “catastrophic” laborincome declines leads to binding collateral
constraints—failure of full risk sharing.
• But in truth share of capital and othercollateralizable assets (such as land) much bigger.

Results and Realism (cont’d)• In actual crises, assets once viewed as safe collateral(e.g., MBS) become suspect.
• Demand for collateral also rises.
• As a result, credit collapses; fire-sale dynamics.
• International risk sharing fails in aggregate even foreveryday shocks – this model can’t explain why.
• My interpretation of the model: As an allegory of
how markets can exploit arbitrage opportunities toreduce impact of financial constraints.
• Basic idea is very clever!

The Basic Idea
• Due to collateral constraints onleverage/short positions, stochastic discountfactors may not correspond to ArrowDebreu prices q(st , st+1 ).
• E.g., if country 1 would like to issue morebonds for state st+1 but its equity collateral is
too low in st+1 , planned consumption forstate st+1 will exceed Euler-equation level.

The Basic Idea (cont’d)• We may also have deviations of equity pricefrom fundamentals, the authors claim.
• Equities overvalued, they argue, when acountry’s bond holdings constrain its shortsales of Lucas trees.
• In that case:p ( z ) > ∑ q ( s , s ) ⎡⎣ p ( z ) + d ( z ) ⎤⎦.
t +1tttsfst +1t +1t +1

The Basic Idea (cont’d)• Suppose country 1 is hit by a big idiosyncratic
negative shock to labor income.
• It can short trees, consume a bit of theproceeds, and use the rest to buy a bond profilethat collateralizes its short position:∑ q(s , sts t +1 f s tt +1t)a (s , st +1)=t
t +1t +1t +1t⎡⎤q(s,s)
p(z)
d(z)
p(z).
+<∑⎣
⎦

s t +1 f s t

The Basic Idea (cont’d)• In its turn, country 2 goes long in equity andissues bonds (“supplies safe collateral”) tocountry 1.
• Country 1 consumption thus cushioned.
• Country 2 smoothes its relative consumption
gain, which is permanent.
• Mechanism works even for persistent shocks.
• Does country 2 collateral constraint bind?

Why Can Stocks be Overvalued?
• Equity overvaluation critical. Its cause?
• “[T]he damaged country cannot make enoughshort positions in Lucas trees due to bindingsolvency constraints…. The nondamaged
country that intends to spread relative gains
over time is not interested in making shortpositions in Lucas trees at all.”Cause of Overvaluation• But … why should the lucky country wish tobuy overpriced Lucas trees?
• Given prices, will this country not prefer tospread its relative consumption gain over timeby buying rather than selling bonds?
• Perhaps the nondamaged country is so collateralconstrained that it view bonds as even more
overpriced.
• I would like to see more about the foreignincentives that support the equilibrium.

Final Thoughts• Curious that in the model, it is precisely in acrisis that equities are overvalued!
• Numerical results on the percentage,
persistence of equity overvaluation?
• Like a giant hedge fund, the damaged
country seems to exploit a small arbitrage
opportunity through a huge short sale.

Final Thoughts (cont’d)• Some intuitive discussion of how price-dividend ratios
respond to shocks?
• In light of the Rietz-Barro disaster theory of the equity
premium (perhaps disappearing), some morediscussion of implied model premia?
• If governments distribute bonds and raise lump-sumtaxes, risk sharing can be enhanced in this world.
Departure from Ricardian equivalence if government
can reduce human wealth with an equal increase incollateralizable financial wealth.

Final Thoughts (finalized)• I have not commented on many aspects ofthe paper, such as the reformulation of themarket allocation as a welfare maximization
following Negishi (1960).
• The numerical solution is demanding.
• All in all, impressive technical achievement.
• All in all, stimulating insight about thechannels for international risk sharing.