Comments for the GSB Global Financial Markets forum, Sep 25, 2007

John H. Cochrane

Graudate School of Business, University of Chicago

I want to mention some good things about the current situation, some interesting and unusual aspects of Fed policy, a view of some things that went wrong, and a warning against quick fixes.

The good:  In the 1930’s a bunch of mortgages went bad. Local banks held the mortgages. The banks ran, and local depositors bore the losses.  In the 1980s, another bunch of loans went bad. Deposit insurance stopped runs, but US taxpayers ended up bearing the losses. This time, the losses are being borne by… German hedge funds! This is great. Deep-pocket, long term investors around the globe are exactly who should be bearing the risks -- and earning the rewards -- of financial innovation.

Fed policy is very interesting, but not for the reasons most people think it is. Whatever caused and will cure the credit situation, 50 basis points in the price banks pay to borrow reserves from each other overnight is essentially meaningless.

The fact that we have an interest rate target in the first place is much more significant. The policy “come and get it at 5 ¼ %” led already to massive increases in reserves. The “come and get it” is much more important than the 5 ¼  or 4 ¾  %. (The rate matters more for long-term inflation and macroeconomic issues, but that’s not why we’re here tonight.)

It’s even more significant that the Fed opened the discount window, and is lending money for long periods (30 days) and with mortgages, not treasuries, as collateral. This action puts money directly in the hands of people who can buy illiquid securities. Banks fueled by reserves may not have been willing to turn around and repo mortgages. The “real bills doctrine” has returned, for better or for worse.

The problem so far is really a “liquidity crunch,” and a “risk-management crisis,” not a true “credit crunch” or “solvency crisis.”  Not even that many subprime mortgages are actually in default.  Instead, sparked by problems in the subprime are, investors are reevaluating many assets, trying to separate out those that are just illiquid from those that really are not worth much.  During such a period it’s hard to sell large quantities of anything, as other investors worry that a large sale reflects bad news.

This sort of thing has been going on for centuries. The freezing-up of sovereign debt markets after the 1998 Russian bond default is just one recent example. Contracts, institutions, and risk management strategies should all recognize that events like these happen. They do, but not well enough.  

Some mortgage-backed securities are funded by short-term “asset-backed” commercial paper.  It’s not a mystery that rolling over short riskfree debt to fund long illiquid assets is a risky business, so banks provided backup lines of credit.  The trouble came when many of these backup commitments had to be exercised at the same time. That’s a source of the huge demand for bank borrowing that the Fed has been accommodating.

Hedge funds should be a better intermediary, since their investors face lockups and should understand that the funds hold illiquid assets. But hedge fund investors, and the funds themselves, tried to pull out quickly as markets dried up this summer, and got in trouble when this proved hard to do.

What went wrong? First, I think there is a common misunderstanding of individual vs. market liquidity. Just because you can sell a security easily today doesn’t mean you’ll be able to sell it easily when you, and everyone else, wants to. This is a failure to think of “state-contingency” in finance lingo, or to recognize that the important risks are “correlated.”  A parachute sounds like a good risk-management plan, but not if there are 10 parachutes and 50 passengers.  The Fed gave us 40 parachutes at the last moment, but that’s a bad design going forward.

Second, I think that many hedge funds are reaping the rewards of overzealous marketing. Suppose they told their investors, “we earn a small premium for holding illiquid assets. Every now and then, markets for these assets will freeze up and you’ll see mark-to-market losses.” There might be a lot less panic; investors might even want to double up and go bargain hunting in the crisis. Instead, many funds told their investors “we have magic alpha.” Investors who bought on that basis are right to jump at the first loss. Of course, it’s hard to get investors to pay 2+20 for my story!  Many  hedge funds also deluded themselves that they could stem losses by selling on the way down. MBA finance 101: A stop-loss order is not a free put option.

Things could be made much worse by quick ill-advised regulation. Every regulation has its downside, which needs at least to be considered.  

There is a lot of concern about the “transparency” and “complexity” of structured mortgage products, and calls for their regulation. Transparency sounds good, but it can be the enemy of liquidity. If each mortgage pool were completely “transparent,” then each one would be a different security, and they would be much harder to buy and sell. Their liquidity comes from a willingness to ignore their differences, after the worst credit risks have been tranched out.

Similarly, it’s clear that some originators stretched the standards. There are calls to force originators to bear more risk, to make them care more about the quality of their loans. But remember that in the 1930s, when originators – banks – bore the risks, the ability and expertise to make new loans and refinance old loans evaporated along with the banks. Imagine the mess we’d be in if all the mortgage originators were now bust, not a bunch of overseas hedge funds. The separation of risk-bearing and origination is exactly what keeps losses from becoming a systemic problem.

Most of all, caveat emptor -- these are a matters for buyers and sellers, not regulators. Nobody else gets hurt if you buy a lousy mortgage pool. The government does not need to write a new rule every time someone buys a rotten tomato. Investors will demand the right transparency, complexity, and risk-sharing or monitoring of mortgage pools. That is, unless they get bailed out and learn to count on that instead!

The history of the mortgage market is a grand story of bringing credit to people who need it, upon the removal of layer after layer well-intended but counterproductive “protective” regulation.