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September 26, 2008
Did the market fail? Or did the response fail?
Sure, investment-worthy organizations can’t raise funds in the market today and that indicates a failure. But let’s think of the market as a patient and consider what the patient has been saying in the months leading up to the crises.
An example of the patient showing a symptom is the “TED spread” (the difference between the rate banks use to lend to one another and a risk-free rate). From August 2007, it has been growing dramatically – sending a clear message that financiers weren’t very comfortable lending to one another. Banks also became less willing to offer alternative mortgages, as they were having a hard time finding interested investors. They began to assess risk differently on all types of mortgages.
So, perhaps the market did not fail. But rather the regulatory system failed to react appropriately to the rational conclusion the market came to at the end of last year: it was a problem of valuation. The pricing of mortgage risk became difficult as housing prices kept slipping. As an investor it was hard, if not impossible, to price some of the bundled mortgage products in an environment in which there was no housing price stability.
If you buy my theory that the patient’s illness was a valuation problem, what should have been the role, if any, for the government at that time? The Fed slashed the fed funds rate a whopping 325 basis points from September 2007 to January 2008. But it didn’t seem to stem the tide of bad economic news.
In 2007, former Governor Mishkin wrote a very interesting paper on the topic of Monetary Transmission (the process by which monetary policy affects the real economy) and the Housing Sector. He wrote:
Uncertainty about housing-related monetary transmission argues for humility on the part of monetary policy makers regarding our understanding of the monetary transmission mechanism generally and the appropriate settings of monetary policy instruments.
You can link to the entire paper here. What are your thoughts on our patient?
Posted by Cindy at September 26, 2008 11:40 PM
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Comments
the very definition of market failure is asymetrical information...in the case of the TED Spread banks had private information that the public did not...most banks knew, in my opinion, more about their abilty to repay a loan than their counterparts. it is my opinion, therefore, that the market failed as all costs were not accounted for.
Posted by: Mike Fladlien at September 27, 2008 3:42 PM
868863 I am probably writing to the wrong e-address but don't know how to proceed otherwise: It is shameful that the CEO's of AIG were able to go to a California resort and spend $400,000 on a week-end get-away derived from "bail-out" funds and rescue package that was released by the Federal Reserve. They should be required to pay it back, or they should be prosecuted. This is precisely the kind of unethical behavious in our country, that brought us to this sorry state. Please direct this thought to the proper venue. Thank you
Posted by: carolyn swan at October 9, 2008 10:58 PM
868863 I am probably writing to the wrong e-address but don't know how to proceed otherwise: It is shameful that the CEO's of AIG were able to go to a California resort and spend $400,000 on a week-end get-away derived from "bail-out" funds and rescue package that was released by the Federal Reserve. They should be required to pay it back, or they should be prosecuted. This is precisely the kind of unethical behavious in our country, that brought us to this sorry state. Please direct this thought to the proper venue. Thank you
Posted by: carolyn swan at October 9, 2008 11:00 PM
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