What follows are the comments that I posted on Ajay Shah’s interesting blog post on understanding the global financial disturbance of 2007 and 2008.
Q1: Why was there a surge in demand for a yield pickup?
Ajay Shah is absolutely right in saying that monetary policy was loose, but then the question is why did it feed into asset prices rather than goods prices. It is the answer to this question that takes us to finance as opposed to economics. I often say that we must approach the study of finance with Ito’s Lemma in one hand and a copy of Kindleberger’s Manias, Panics and Crashes: A History of Financial Crises in the other.
Q2: Why did dodgy practices on home loan origination and securitisation flourish?
This is question 1 in a different form: greater tolerance for operational risk instead of market risk.
Q3: Why did liquidity collapse in key markets thus doing damage to Finance?
I would argue that liquidity collapses when prices are not allowed to fall. Why are the ABX contracts liquid? Because they have been allowed to undershoot. The ultimate providers of liquidity in any market are the value investors and they do not enter until prices have undershot.
On what Ajay Shah regards as the “well understood” questions, my answers are slightly different from his:
Why did a modest rate of default in a relatively small part of finance lead to such a crisis?
My answer: The real problem is not sub prime (which is only the canary in the mine), but falling real estate prices. Real estate is a huge part of finance. See also my earlier blog entry on real estate finance.
Did the Fed do right in rescuing Bear Stearns?
In my opinion, No.
First, as Kindleberger used to say, "A lender of last resort should exist, but his presence should be doubted." Even after LTCM, there could be doubts. After Bear Stearns, there can be none. This is a great tragedy.
Second, I can understand LOLR (lender of last resort), I can even understand outright nationalization (Northern Rock). I cannot understand buying a second loss credit linked note on $30 billion of hard to value securities.
See also my earlier blog entry on the rise of Mahathirism in the US and UK.
Why has the impact on the real economy of these events been relatively modest?
My answer: Canary in the mine again. I believe that this crisis has shown the power and utility of financial markets. Policy makers have had at least a year of lead time to deal with the problems in the real economy. Without mark to market and without liquid ABX markets, the crisis would have become evident only when mortgages actually defaulted. By then it would have been too late to act.
It is difficult to persuade people about this in today’s context, but even today it is true that with all their imperfections and tendency to malfunction during crises, financial markets are the closest thing that we have to the crystal ball that reveals the future. Everything else is backward looking.