Munich Personal RePEc Archive

Conversion Theory II: the case for Recession Bonds

De Koning, Kees (2019): Conversion Theory II: the case for Recession Bonds.

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In a previous paper: “Conversion Theory: the key to understanding economic developments before and after the 2008 financial crisis”, the author stated that: * By 2007, U.S. subprime mortgages comprised 14% of outstanding mortgages, equivalent to $1.46 trillion. The securitized element was $1.1 trillion, which was about 15% of all outstanding mortgage backed securities ($7.3 trillion). * Over the period 2007-2014 21.228 million U.S. households were confronted with foreclosure proceedings out of the 51.234 million households who had a mortgage: 41.4% of all mortgage holders! * U.S Federal Government debt increased by $4.8 trillion between 2007-2010, while real GDP still shrank. This represented by far the fastest growth in debt compared to GDP over the last 50 years, from 62.9% Q4 2007 to 92.0% by Q4 2010. * Between May 2007 and October 2009, nearly 7 million U.S. individuals lost their jobs. New housing starts dropped from 2.273 million in January 2006 (annualized) to 478,000 by April 2009. Real median household income dropped from $59,534 by 2007 to $54,569 by 2012 or by 9.2%. The financial alchemy employed by bankers of the age entailed a conversion process, which turned long-term mortgage debt into daily tradable securities. The process failed for the simple reason that the risks posed by doubtful underlying debtors was transferred to investors, without clear provisions taken for such doubtful debtors. Liquidity disappeared when the curtain was pulled back and investors ran for the hills. The conversion method can also be applied to government debt in order to help overcome an economic recession. The method suggested is to create or convert a series of long-term bonds: Recession Bonds. Their defining characteristic is that the repayment of interest and some principal amount is halted during a recession period. A government can apply to the IMF to declare that a recession risk is imminent. Pay-outs of interest and some principal will be halted over the recession bonds until the recession is declared by the IMF to be over. Recession Bonds give a government the means to spend substantial additional amounts during a recession period without having to increase its borrowings. It is a cash flow transfer mechanism from financial investors to the real economy, benefitting consumer demand, wages and employment levels. This transfer mechanism also supports share prices. A version of financial alchemy but unlike the 2008 variety, the audience will not be repulsed if the curtain is pulled back!

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