Monday, November 17, 2008

Clearing the fog

This is a guest post by Rabee Tourky, Professor of Economics at the University of Queensland

In a previous post on this blog I began describing how to my mind the market failure associated with the financial crisis has to do with market incompleteness. That is, we found ourselves in a situation in which one could not use the available securities to diversify away from certain risk.

I'll take the opportunity to refine, in a loose way, my market incompleteness argument.

First, I'll specifically address the apparent failure of the efficient markets hypothesis with regard to the securitization of default instruments; basically these were not markets in the sense understood by economists. Second, I'll conjecture a transmission mechanism in which market incompleteness, associated with a sudden collapse of the span of existing assets, affects non-financial firms; basically the mechanism is driven by a failure of the Modigliani-Miller theorem.

It is now becoming apparent that the markets for securities associated with credit default instruments was not a market in the usual sense, and not a market in which one expects prices to convey meaningful information. These assets were priced to models (inspired by relatively recent works of Darrel Duffie, I guess) and not to market. Further, these securities were essentially not traded. In the words of Susan Wachter of Wharton:
What's new this time is that unlike the securitization of the past, the securitization is tranching of risk in very complicated CDO's, CLO's, SIV's instruments which do not trade. So we do not have market discipline. Although the price of the loan may be varied by risk, the price of the mortgage instrument and the securitization of the mortgage instrument, these securities did not trade. Therefore, there wasn't a market discipline to price the risk and give the signal that these were extraordinarily risky instruments. They were marked to model, not to market. There were lots of fees up front across the board. But the ultimate risk was unknown, because in fact they weren't priced to the risk.
Let me now turn to the second point.

Imagine a sudden collapse in the span of available financial assets. How does this affect the real economy?

To understand this let's recall the Modigliani-Miller theorem, which in a very general setting tells us that the debt-equity ratios of firms do not affect their values. Of course, we know the Modigliani-Miller theorem could fail when there are possibilities of bankruptcy and under certain tax regimes. However, it is likely that what we are seeing now is the failure of the Modigliani-Miller theorem because of a sudden collapse in the span of available financial securities.

The idea, as far as I know formalized by Piero Gottardi in a 1995 article in Economic Theory, is that when there are any type of derivative securities over the shares of a firm, a change in the capital structure of a firm will modify both the real equilibrium allocation and the value of the firm. This is because "payoff of the derivative securities is affected in a non-linear way by changes in the firm's financial policy; thus the set of the agents' insurance opportunities is also modified".

In summary, there was an ineffective market for default securities that collapsed because these securities were not priced in a market setting. This sudden change in the span of financial securities meant that there was an abrupt change in the relationship between firm capital structure and value. Many firms were faced with an unforeseen need to change their capital structure and much of what we see now is a result of this shift of firm capital structures.

Much of the turbulence in relative assets prices will subside when this shift in firm capital structures is completed. We will also know when the financial crisis has resolved itself when this process is complete and when it becomes apparent that firm capital structure has become as irrelevant to firm value as it was prior to the crisis.

In this regard, at this stage government policy should be two pronged. First, helping establishing appropriate clearing mechanisms for default securities so that they are priced by markets; this involves standardization and a measure of regulation. Second, trying to facilitate the capital structure transitions that most firms are currently engaged in. One idea is to guarantee matching government-debt based funding for new equity based funding.

Addendum (inserted by Harry Clarke)

These two papers by Frank Milne, Bank of Montreal Professor of Economics and Finance at Queen’s University, make points similar to those made by Professor Tourky.

The first is a policy oriented piece:

http://www.cdhowe.org/pdf/commentary_269.pdf

The second is a more technical paper that sets out the failure of liquidity modelling in the Arrow-Debreu model that underlies derivative and risk management models:

http://jdi.econ.queensu.ca/Working_Papers/Milne%20-%20Credit%20Crises%20RM%20and%20Liquidity%20Modelling%20JDI%20final%20Sept%2022.pdf

6 comments:

hc said...

Rabee,

This is a hard post for the non-specialist. Are you saying that firms took on more debt to equity and that this affected the bankruptcy potential of these firms but that that was not reflected in the market valuation of derivative contracts drawn on the firms although it did affect the firm's underlying market value?

If so I don't see why not.

More simply I still don't understand why savy investment managers bought securitised bundles of mortgages at excessive prices.

rabee said...

Sorry I guess that I was talking to various economists trying to figure out how what we are seeing fits in the (microeconomics) frameworks that we understand.

The debt/equity problem is more pronounced now than it was before the collapse of Lehman and associated markets. My argument is that the MM theorem held (more or less) before the financial crisis and that it doesn't hold now.

Firms that made prudent financing decisions before the crisis found that they were compelled to change the way they are financed after the crisis.

There's probably an increase in probability of bankruptcy for firms holding high debt to equity (once the crisis began).

But it's not simply about an increase in the probability of bankruptcy.

The basic message is that even firms that are very unlikely to go bankrupt are now facing a situation where the way they chose to finance their corporation before the crisis is affecting the value of their firms after the crisis and that they need to change their finacing regime.

You see there are various kinds of debt/equity financing that a firm can obtain. My argument has more to do with the rich class of financing that was available and that is presently not available; some of which has disappeared.

The idea is that now the choice of financing affects derivatives on the firms shares in a non linear way which in turn affects firm value in a non-linear way.

My thinking is also being formed by this working paper: Link
Certain kinds of lending is on the increase while other kinds are going down.


As to why investment managers bought securitised bundles at excessive prices before the crisis; well I don't know. I guess ratings regimes could have contributed. But what is clear is that had these securities been traded in a clearing house market prices would have reflected their risk.

The important question here is does the efficient markets hypothesis need a clearing house with a market maker and clear pricing rules?

Observa said...

'The important question here is does the efficient markets hypothesis need a clearing house with a market maker and clear pricing rules?'

It only needs money that represents real claims on production rather than funny money ones. Deliberately targetting 2-3% inflation is really legalised theft, assuming that target is actually being realised. If however monetary expansion is going into that legalised theft AND fuelling asset prices, the true scale of theft may be hidden for many years. That is essentially our problem now. The massive theft has been uncovered and there's no efficient way of making all the accessories to the crime pay. Often we are accessories and victims at the same time which compounds the problem and rules out any simple solutions.

Markets are trying to reduce the excessive monetary claims on production right now, you'll notice, but that is being resisted by monetary authorities that think they know better. In that regard Govts and bureaucracies do have a vested interest in trying to minimise their pain and losses by any means possible, even at the expense of future taxpayers.

Confidence in claims on production vis a vis real forgone consumption, reward for same and risk and innovation are as fragile as complex production structures and you break that at your peril. It's broken now and all the kings horses and all the kings men can't put Humpty together again. He has to heal naturally over a long convalescence now.

observa said...

Basically rabee the Austrians were right all along and Keynesians are a silly bunch of headless chooks now. We don't need more regulation(we've never had so much anyway) just the soundness of money and the soundness of the real economy that coexists with it. Getting back there is a long hard haul but ultimately it's the money supply stoopids!

You have to laugh at the quintessential Keynesian Paulson now. He's been reduced to propping up consumer credit in a futile attempt to stop consumption crashing around his ears. Consumer credit is of course the epitome of funny money but these Keynesian drug addicts just can't help themselves. Time to go cold turkey fellers.

rabee said...

Harry,

Here is a paper that raises questions about the "credit crunch" mechanism for the way the financial crisis is affecting the real economy. Apparently, there is no credit crunch: Link (referenced in the paper I earlier linked to)

It's compelling. The credit market is fine yet we see dramatic changes in the ways firms finance their operations.

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