As the mortgage bubble was expanding in the early 2000s, anyone with a pulse could get a nonconforming loan and buy a house, often one that was beyond their means. These mortgages were then bundled into securitized instruments known as mortgage-backed securities (MBS), just as individual eggs are bundled and sold by the dozen. Then complex financial derivatives such as collateralized debt obligations and credit default swaps were built on top of the MBS market.
The world of asset-backed securities can seem impenetrably complex at times, so to simplify things, let’s instead suppose you, along with a handful of others, are bidding on eggs. No one has any detailed information about the eggs, so everyone assumes that the eggs are worth $4 a dozen, and trade is brisk. Dozens of eggs are sold, even though some of the eggs turn out to be bad once cracked open.
But suppose that some people start to look more closely at boxes of eggs, and buy only the boxes with all good eggs. Other buyers now realize they are getting more bad eggs and start to pay less. As the market price falls to, say, $2, it becomes even more profitable to do the hard work to evaluate boxes of eggs. However, other buyers soon realize their disadvantage and may eventually stop buying eggs altogether. What had been a market with lots of eggs sold at good prices becomes a market with few boxes of eggs sold—only those able to get evaluated and, of those, only those found to be good. And the eggs that are sold are sold at low prices.
When sophisticated traders began rejecting the mortgage-backed securities most exposed to subprime borrowers, prices fell and less sophisticated buyers fled.
Such sudden changes in valuation are often part of the market volatility observed in new debt asset classes like asset-backed securities, according to research by Michael Fishman and Jonathan Parker, both professors of finance at the Kellogg School of Management. Unlike equity markets, where all participants can see the bids and offers for various stocks immediately, debt markets are more opaque and bonds are traded in large blocks.
In the MBS market, no one knew which MBS were better than others at first; trade was brisk, and prices were high. The buyers didn’t know what the assets and their future cash flows were really worth. Then, like the sophisticated egg buyers, sophisticated bond traders, such as those who actively managed bond funds, developed the expertise in valuation to distinguish the good MBS from the bad ones. When they began rejecting the MBS that were most exposed to subprime borrowers, prices fell, less sophisticated buyers fled, and the market collapsed.
“Instead of everything being priced based only on its rating, say AAA, sophisticated investors pick and choose which assets to buy, and those rejected by sophisticated investors are either traded at low prices or not traded at all. This is why volume dries up and the value crashes,” Parker explains. “For example, the Paulson fund famously entered the mortgage-backed security market, valued individual deals, and effectively bought the good ones and sold the bad ones. People eventually thought, ‘I can’t get into that market because I don’t have enough information to get in there.’ ”
Sophisticated traders who are able to value assets more precisely can bifurcate such a market by picking the best assets. This causes prices of the remaining, unpicked assets to decline, along with their average values. In the case of MBS in 2008, the derivative house of cards built atop it collapsed quickly, putting some of the world’s largest banks in mortal peril.
Are Crashes Inevitable?
This dynamic is difficult to reverse because it is hard to turn the information uncovered by one particular valuation into public information. Both sophisticated buyers and sellers have an incentive to conceal their knowledge gained from valuation. When good intelligence from valuation is tightly held, buyers can obtain lower prices for the good instruments, and sellers can obtain higher prices for the bad instruments from uninformed buyers. These buyers subsidize sophisticated buyers’ investments by purchasing the undesirable instruments. This creates a more liquid market than if everyone had access to the same valuation tools, which increases efficiency.
In the language of economics, the market equilibrium reached after valuation has been done can be “socially inefficient” because it bears the features of a financial crisis: trust declines as due diligence increases. Interest rate spreads rise, investment declines, and sophisticated investors make profits while unsophisticated investors leave the market.
“When the economy is going well, credit flows smoothly—you get credit checks, appraisal, all the standard stuff, and credit flows smoothly,” Fishman says. “In a valuation equilibrium, credit isn’t flowing smoothly.”
At some point, the necessary investment in valuation becomes socially inefficient even though it remains privately profitable. Compared with evaluating a single home loan, where it might cost $500 to $1000 to appraise the creditworthiness of a single buyer, valuing securitized instruments can be vastly more expensive.
“Investors have to invest a lot of resources in every borrower [in a pool of assets], but there’s a limit to what you can spend,” Fishman explains. “Suppose I thought that everybody else was spending way more money on credit checks, really learning about the creditworthiness of the borrowers. Then the cost of valuation—really serious checks—goes up substantially. You don’t want too many resources invested in who’s a better borrower and who’s worse.”
“You want credit to flow more smoothly than that,” Fishman continues. “You want to do the standard checks, but after ’08, nobody wanted to do any deal unless you wanted to do a lot of expensive valuation.”
The personal credit market operates in much the same way. When credit card companies issue cards, they keep perhaps half of them for themselves, then market the other half as a pool of securitized products. “If the investors thought that the credit card companies were doing deep analysis and keeping the good ones and pooling the bad ones, the market would disappear,” Fishman says. “So if the assignment is randomized, the market is more healthy.” A healthy market means greater access to credit.
The mortgage market meltdown of 2008 caused enormous and widespread financial damage, with global write-downs estimated by the IMF at $4 trillion. Regulators were called upon to crack down on the banks and ratings agencies that enabled the subprime mortgage explosion and to prevent such bubbles in the future. However, it is difficult to devise a policy that can maintain healthy debt markets while maintaining a socially efficient level of liquidity.
Fishman and Parker evaluated several policy prescriptions and found that some worked in the model but seemed risky in practice. Several others were nonstarters, such as monetary policy or quantitative easing designed to lower interest rates, which is actually counterproductive. It encourages a restricted market in which only well-informed investors participate. Subsidizing the payout of bad assets can expand the market and make it less profitable, but only at a cost to the government. Taxing investment in valuation works in theory but is impractical in the real world.
In Fishman and Parker’s model, the best policy requires commitment and potentially lots of funds, making it the role of the government. If the government judiciously committed to buy or insure fairly all assets at the no-valuation price, then it could deter the initial investment in valuation, ensuring that the market functioned efficiently. But Fishman and Parker note that this approach can go badly wrong if misapplied.
The direct government lending of the sort offered by Fannie Mae and Freddie Mac is an example of this policy, Fishman notes. The problem comes when markets become too reliant on it. Government support works best in times of crisis, because it can “push you out of crisis and back into normal times, but only if the crises aren’t too frequent. For government intervention to be effective, the crisis times have to be infrequent.”
So what policies might help prevent booms and busts in new asset classes and discourage the marketing of bad assets from the outset?
“That’s a tough one,” Fishman muses. “One solution is to have sellers or borrowers bear more of the costs if their asset or loan turns bad, such as having recourse in the case of mortgages.” Unfortunately, that can deter investment more generally. “They used to have debtors’ prisons that would deter financing bad projects, but it also deters financing good projects. The U.S. is viewed as a good place to invest because failure is not a disaster.”
The most efficient policy, the researchers suggest, would be to make debt markets more transparent so that valuation is more observable, as it is in equity markets. However, since both sellers and sophisticated buyers profit from hiding both the fact and the outcome of valuation, such a policy is incredibly hard to implement.
Although underwriting standards have tightened considerably since the 2008 crisis and MBS-backed derivatives have been largely unwound, the right policy prescription for preventing debt market booms and busts remains elusive. “Any policy that can deter bad lending can deter good lending too,” Fishman concludes.
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