Saturday, September 27, 2008

An Analysis of the Financial Crisis

University of Chicago economist Robert Shimer analyzes the financial crisis:
Let me explain what I think is happening in credit markets. This is my assessment, formed through numerous discussions with colleagues.... As everyone now knows, financial institutions hold significant assets that are backed by mortgage payments. Two years ago, many of those mortgage-backed securities (MBS) were rated AAA, very likely to yield a steady stream of payments with minimal risk of default. This made the assets liquid. If a financial institution needed cash, it could quickly sell these securities at a fair market price, the present value of the stream of payments. A buyer did not have to worry about the exact composition of the assets it purchased, because the stream of payments was safe.

When house prices started to decline, this had a bigger impact on some MBS than others, depending on the exact composition of mortgages that backed the security. Although MBS are complex financial instruments, their owners had a strong incentive to estimate how much those securities are worth. This is the crux of the problem. Now anyone who considers purchasing a MBS fears Akerlof's classic lemons problem. A buyer hopes that the seller is selling the security because it needs cash, but the buyer worries that the seller may simply be trying to unload its worst-performing assets. This asymmetric information ... makes the market illiquid. To buy a MBS in the current environment, you first need an independent assessment of the value of the security, which is time-consuming and costly. Put differently, the market price of MBS reflects buyers' belief that most securities that are offered for sale are low quality. This low price has been called the fire-sale price. The true value of the average MBS may in fact be much higher. This is the hold-to-maturity price.

The adverse selection problem then aggregates from individual securities to financial service institutions. Because of losses on their real estate investments, these firms are undercapitalized, some more so than others. Investors rightly fear that any firm that would like to issue new equity or debt is currently overvalued. Thus firms that attempt to recapitalize push down their market price. Likewise banks fear that any bank that wants to borrow from them is on the verge of bankruptcy and they refuse to lend. This is the same lemons problem, just at a larger scale. No firm that is tainted by mortgage holdings, even those that are fundamentally sound, can raise new capital.

With a theory of the problem, we can now ask whether the Paulson plan would solve it. My understanding is that the $700 billion would be used in a series of reverse auctions. In such an auction, the government would announce its intent to use some amount of money to purchase a particular class of security. Financial institutions would then compete by offering the most securities at the lowest price. I think we can agree that it is implausible that the government would be better than other buyers at determining the current value of the stream of payments from those securities. This gives financial institutions a strong incentive to sell the government their lowest quality securities at the highest possible price. Indeed, the government seems to want sellers to unload their worst assets so as to improve their balance sheet, so there really is no conflict of interest here.

This program does not solve the lemons problem. The government purchases a lot of lemons at an inflated price. This improves the balance sheet of the firms that can sell their worst securities. It also improves the balance sheet of firms that own better securities because the market price of those securities will increase. ... But this is fundamentally no different than giving taxpayers' money to owners, managers, and debt-holders of firms that made the worst decisions.


  1. Dear Senator/Congresman,
    I am writing because I am concerned the governement is rushing to bail out
    wall street and the credit markets. I view the current plans as a huge mistake
    and injustice to the american taxpayer.
    Wealth is not distroyed, it is mearly transferred from one individual to another,
    and market forces dictate this transfer. Someone has benefited from the crisis, and
    some have not. Wealth is continually created, because most people work
    and continually create that wealth. The credit markets are not scared for
    no reason. The financial markets are not scared for no reason. The value
    of mortgage assets have not declined for no reason. It is because loose credit
    inflated the asset value of mortgages for too long and is now unwinding, but
    that process is not necessarily over.
    The idea that the taxpayer will now buy toxic assets from the very people
    who created the problem and assume the liabilities for their horrible decisions
    will only serve to delay the process of this asset class bottoming, and extend
    the time needed to put this crisis behind us while putting the taxpayers at
    risk to loose big time.

    One would not go into a town with the plague and start to sell life insurance.

    The dire economic consequences predicted because of failure to act are no
    greater than interferring with normal market operation because interferring will extend
    the current economic downturn longer, although perhaps not as deeply as it could
    become for a brief time. The net over time is no improvement to the people and great risk.

    The true value of those assets will become what they may whatever the government

    In NO WAY should the government pay more than rock bottom prices for
    these securities. There is little chance the housing market will improve
    next week, the market is still going down and there is little, except by mortgaging our
    childrens future, the government can do about it except give it a short term boost without
    regard to the txpayers interests.

    A prudent investor would wait for the bottom to invest, not rush in as the knife falls.

    This bill asks the taxpayers to take a knife in the back.

    The recent market rally last Friday, inspite of dire economic and bank failure news is the most
    certain sign that wall street views this bailout as favorable to the finance indusry. What is favorable
    to one investor class usually comes at the expense of another... the taxpayer.

    The way the appropriations bills are becoming take it or leave it, and encumbering the
    nation in an unfair way with nearly insurmountable debt calls for a change
    of leadership.

    I'm mad as hell and NOT GOING TO TAKE IT ANYMORE!!!!!!!!!

  2. The crisis started in Thailand with the financial collapse of the Thai baht caused by the decision of the Thai government to float the baht, cutting its peg to the USD, after exhaustive efforts to support it in the face of a severe financial overextension that was in part real estate driven. At the time, Thailand had acquired a burden of foreign debt that made the country effectively bankrupt even before the collapse of its currency. As the crisis spread, most of Southeast Asia and Japan saw slumping currencies, devalued stock markets and other asset prices, and a precipitous rise in private debt.Though there has been general agreement on the existence of a crisis and its consequences, what is less clear were the causes of the crisis, as well as its scope and resolution. Indonesia, South Korea and Thailand were the countries most affected by the crisis. Hong Kong, Malaysia, Laos and the Philippines were also hurt by the slump. The People's Republic of China, India, Taiwan, Singapore, Brunei and Vietnam were less affected, although all suffered from a loss of demand and confidence throughout the region.
    Link Building

  3. Neither of you know what you are talking about.