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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:

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:

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