Saturday, August 18, 2007

Commenting on this now

Take last week’s tumbles in world stock markets. These raise four puzzles. First, why should the threat of default on some US sub-prime mortgages – loans to high-risk, poorer customers – be such a big deal? Conventional economics says risk should be split up into small bits and sold off to those people most willing and able to take it; all that jargon about collateralised debt obligations describes how this is done. Spread over trillions of dollars of assets, losses of even billions of dollars should be little problem. As recently as March, Ben Bernanke, the chairman of the Federal Reserve, said: “The impact on the broader economy and financial markets of the problems in the sub-prime market seems likely to be contained.” Last week at least, stock markets thought he was wrong. Why?
Because they weren't following so-called conventional economics- they took the risk and packaged it up into larger chunks. Secondly, the stock market is (or appears to be) generally more volatile than reality.

Secondly, there’s a timing problem: why should stock markets worry about the problem now? The risks of sub-prime lending have been known for months; stock markets fell (albeit temporarily) in February for just this reason. Basic economics – the idea that the market is efficient – says that information should be immediately embodied in share prices. It shouldn’t take so long for sub-prime problems to hit prices.
I suspect human psychology has more to do with this than the sum-prime "meltdown". If I, investor, see trouble on the horizon, I am going to dump some of my riskier assets regardless of their exposure to sub-prime. On a macro scale, bad stocks get worse, good stocks get better (note the 12 month S&P500, still nicely up, but showing a lot of volatility). Skittish investors dump their bad stocks, lowering the price, making those an attractive buy for other investors. The market IS efficient, but neither perfectly efficient nor instantaneously efficient. News is released/discovered in dribs and drabs, and the investor has to work on extrapolation/instinct/fear/arrogance in the interim periods of information vacuum.

The third puzzle came on Thursday, in the market’s reaction to the injection of €95 billion into the banking system by the European Central Bank. Investors could have thought: “There’s more money around. This is great for shares.” But they didn’t. They thought: “The ECB’s bailing out banks – things must be even worse than we knew” and shares fell as a result. Why did the latter reaction dominate?
Because the stock market is irrational? Because the banks don't really need cash, they are merely suffering from lowered returns on their investments and higher costs from foreclosures? Because it takes time for the cash to have its intended effect? Similarly, the rate lowering at the Fed's discount window wasn't really the story, it was a change in rules that made it impactful. The fed is letting borrower banks keep money for 30 days instead of the overnight timeframe. The rate change injects money, but the rule change allows companies more borrowing options meaning they can operate more efficiently. So well managed, strong companies can be better.

The fourth puzzle, deepened by yesterday’s recovery in prices, is: why are shares so volatile? The past few weeks have reminded us of what Robert Shiller, of Yale University, established back in 1981, that shares move much more than their “value” – the discounted present value of future dividends – would warrant.
Bear market(s) in some sectors, bull markets in others. There is more to the market than chart reading and p/e ratios.

From the comments:
The reason for weird reactions to behavior of the media and central banks is not a product of the market but a product of intervention in the market. Evil central banks are in a dizzying process of attempting to adjust the economic behavior of billions of people through the mechanism of creating more or less money. (Note that they are always creating money.)
If that's true, why did the addition of 90 billion euros have no effect? If the actions of the central bank were in fact all-powerful (and as legend has it, distortive), /something/ would have happened.


At Sunday, August 19, 2007 11:46:00 AM CDT, Anonymous SR said...

The NYT makes the argument that the people who bought the mortgage backed bonds didn't know what they were buying (and only looked at the yields)

At Monday, August 20, 2007 10:28:00 PM CDT, Blogger gregchap said...

Isn't that always the case at the top of a bubble (sorry: pre-correction)? Every idiot thinks he's a genius for "discovering" the easy buck?

Let's not all forget that the banks all underwrote these loans. Some brokers surely inflated (or outright lied) about their borrowers' ability to repay, but ultimately, the banks loaned the money anyway.

At Tuesday, August 21, 2007 9:07:00 PM CDT, Blogger cljo said...

Well hello. Finally getting around to commenting on this. Overall, I agree with with you, GC. But, as usual, from a different perspective.

First, I think they were following so-called "conventional economics" by repackaging and spreading the risk. But I think, like many Wall Street fuck ups, there psychology did not allow them to think it would fail. The abundance of cheap money around told them they could just buy there way out. Or Ben. B would.

Nice piece of research looking up the S&P. This takes me back again to my criticism of The Fed and Jim Cramer's freakout. Who did The Fed save? Goldman Sachs, Bear Sterns, etc. What did it create? Moral hazard.

The stock market is irrational, or at least woefully underinformed. Everyone should struggle through Nassim Taleb's Fooled by Randomness. I hate his style, like his ideas.

I was not aware of the change in Discount Window terms. That certainly is significant and creates an interesting new policy tool. I wonder if they have done that before.

Never read charts or p/e ratios. You're either in an index fund or wrong.

I think the actions of the central bank do have powerful macro effects (see present day Zimbabwe), but you were right to call out that comment. The craziness started before the Fed acted. Now was the craziness a long-term effect of Fed actions over the years? To some degree, maybe.

At Tuesday, August 21, 2007 9:10:00 PM CDT, Blogger cljo said...

And in response to SR's NYT story: I would just say, yet again, if that is the case (traders were not looking at the risk profile of bonds) then they should have been left to suffer like everyone else. Now, if the underwriters did lie (as GC notes is a possibility) then that is another problem.

At Tuesday, August 21, 2007 9:19:00 PM CDT, Blogger gc said...

"Never read charts or p/e ratios. You're either in an index fund or wrong."

Nice. Are you saying having 50% of my assets in a passbook savings account and the other 50% in CapitolOne isn't proper diversification?

And thank you for reasoned comments; it always classes up the joint.

At Tuesday, August 21, 2007 9:23:00 PM CDT, Blogger gc said...

Also heard a statistic on the radio, and I apologize that I'm generalizing, but it was basically that banks wrote a slightly higher percentage of the bad paper than the brokers did. Something like each was responsible for half of the foreclosures, but their proportion of the market is different.


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