“I don’t know of any economist who doesn’t believe that better functioning capital markets in which assets can be traded are a good idea.”
-Lawrence Summers

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There are Markets, and then there are markets. I am less sure that Larry Summers understands the differences between the two. That’s why I almost called this post “The Star Wars Collectibles Hedge Fund.”

Summers is part of a group whose ideology is that Markets are a solution to many of our economic woes. I don’t necessarily disagree with this, except on the definition of what a market is. Indeed, what many economists and free market zealots call “Markets” are somewhat misleading. A place where people come together to buy and sell goods is a small “m” market — a bazaar or flea market — and may not be ideal for what some people expect from capital “M” Markets. Consider purposes of price discovery, information transmission, transaction efficiencies that are less than ideal in markets where the goods are non-uniform, information is expensive or time consuming to obtain, where transactions are infrequent, and where expertise is rare. (I’ve made many of the same point regarding prediction markets, also).

And that pretty much describes the RMBS and CDO markets. Its is one of the primary reasons why there was no exit when toxic securitized paper needed to be dumped.

The major Markets — Equities, Fixed Income, Commodities, Futures, Options and Currencies — have on a daily basis billions of transactions worth trillions of dollars. They are broad, deep, liquid. You can sell any of these assets, in size, instantaneously.

And this points out why the decision to buy any size in RMBS, CDOs and even CDS was so problematic. The commercial and investment banks and funds that chose to invest in these “financial products” –  difficult to value, thinly traded, non-uniform — was the root of the problem. That they happened to be so poorly constructed is almost besides the point. Its the non-existent market place for these hold-to-maturity securities. If you are looking for the underlying cause of why some arcane accounting rule is an issue, this is it.

This is why smart funds don’t buy beanie babies or Star Wars collectibles. Its hard to to justify the risk of owning hard to value, thinly traded, very difficult to sell items.

The banks made a poor decision: “Let’s bypass the broad, deeply traded traditional markets and instead create new markets for new products.” Not only that, but they dove headfirst into these markets in huge size. No one should be surprised that the net result was a flawed system of garbage paper, with too little room at the exits in case of emergency.

And while I recently wrote Paul Krugman was wrong about securitization, he got closer to the truth when he criticized the deification of markets.

Buying billions of dollars of securities when there is no easy exit, no liquidity, and no transparency is near the top of the list of really dumb things the banks did.

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Previously:
Paul Krugman is Wrong About Securitization (March 28th, 2009)

http://www.ritholtz.com/blog/2009/03/krugman-is-wrong-about-securitization/

Understanding the Significance of Mark-to-Market Accounting (October 2008)

http://www.ritholtz.com/blog/2008/10/understanding-the-significance-of-mark-to-market-accounting/

Source:
Summers fires back at Krugman for ‘hocus-pocus’ column
Michael O’Brien
The Hill, March 23, 2009

http://briefingroom.thehill.com/2009/03/23/summers-fires-back-at-krugman-for-hocus-pocus-column/

The Market Mystique
PAUL KRUGMAN
NYT, March 26, 2009

http://www.nytimes.com/2009/03/27/opinion/27krugman.html

Category: Bailouts, Credit, Currency, Derivatives, Markets

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

23 Responses to “Can There Be Market Solutions With No Real Markets?”

  1. JustinTheSkeptic says:

    I knew the Mother Fing Banks were lying! Just didn’t have enough background to put my finger on it:

    http://www.nakedcapitalism.com/2009/03/guest-post-banks-were-profitable-in.html

  2. VoiceFromTheWilderness says:

    Markets are the solution to all our problems. The Market is incorrectly pricing select assets, their True Value is markedly different from what the Market is pricing them at.

    So, in order to have a market solution, we have to take a trillion dollars separate it from it’s creators by force majeur and give it, at a loss, to the ‘the market’.

    I can assure you we are all waiting with breathless anticipation for the glorious return of the ‘economic miracle’, and while we wait singing hymns to the ability of the public to believe the self serving double think that has become an entrance exam into public discourse.

  3. danm says:

    I’m just wondering if it won’t be a bond market for a while…

    If deflation: don’t need equities to make gains.

    If inflation: rates will go up and crush many more players. So less investors than today will have money. Multiples will be crushed along with the earnings. Government intervention can only grow. Then why bother owning equities when bonds can offer double digit returns and government keeps on backing them up.

  4. “…while we wait singing hymns to the ability of the public to believe the self serving double think that has become an entrance exam into public discourse.”–VFTW, above

    no doubt.
    ~~

    “The banks made a poor decision: “Let’s bypass the broad, deeply traded traditional markets and instead create new markets for new products.” Not only that, but they dove headfirst into these markets in huge size. No one should be surprised that the net result was a flawed system of garbage paper, with too little room at the exits in case of emergency.”

    I think we’ll find, sooner or later, that there was ‘no exit strategy’ b/c this was a ‘one-way’ Play..
    too many, on Wall St., are too smart, for these actions to be, merely, “unintended consequences”..

    and, yes, save me the “Network-effect reinforcing complexity driven by incentivived actions of atomized players HS”

  5. danm says:

    On top of that, I’m thinking of all the boomers/retirees who will be going from 65%-75% equities to 35-25% over the next few years… because that is what portfolio management theory has been recommending forever.

    I don’t care what everyone says, not many 65 year olds can cope with the volatility in equities.

    I think the market is going to become a bond market because we are going to need a bond market.

  6. Marcus Aurelius says:

    Justin,

    “Mother Fing” would be a great name for a band.

  7. MA,

    that’s a good point, could be a novel name for an ‘advice’-column, as well..

    and, play, ala ANF ‘spoof-Ts’

  8. M.G. in Progress says:

    Few months ago I posted that there are markets and free markets. There was no notion of real markets (against fake ones?).

    http://mgiannini.blogspot.com/2009/01/markets-and-free-markets.html

    Now I realize that there markets, free markets, real markets, fake markets and BAZAR…

  9. Marcus Aurelius says:

    M.G:

    There are also traveling snake-oil salesmen and carnival hucksters in search of markets/victims/rubes. Lydia Pinkham’s medicine cures everything!

    Fron Wikipedia:

    The Ballad of Lydia Pinkham

    Let us sing of Lydia Pinkham
    The benefactress of the human race.
    She invented a vegetable compound,
    And now all papers print her face.

    Mrs. Jones she had no children,
    And she loved them very dear.
    So she took three bottles of Pinkham’s
    Now she has twins every year.

    Peter Whelan, he was sad
    Because he only had one nut
    Till he took some of Lydia’s compound
    Now they grow in clusters ’round his butt.

    Mrs. Smith had nursing problems
    Had nursing problems, she didn’t know how.
    But after drinking a bottle of compound
    They had to milk her like a cow.

    Mrs. Johnson has kidney trouble
    Had kidney trouble, she could not pee.
    But after drinking a bottle of compound
    They had to pipe her to the sea.

  10. wally says:

    Another consideration about ‘free markets’ is that government has now substituted itself for actual free market credit ratings by providing artificial guarantees. This may make the stats look good for a while… but at some point the government must back out… and it will find out what FDR found in 1937 – that no underlying cure happens while the problem is masked.
    We’re in for a long one here… maybe made longer by excessive “help” from the government.

  11. Stuart says:

    Can there be market solutions with Geithner and Summers defending the gates of the status quo.

  12. philipat says:

    I’m shocked. All these securities were rated AAA so how could you say such things? Which brings us back to another issue which seems to be dropping well belwo the radar again?

  13. SWMOD52 says:

    “I don’t know of any economist who doesn’t believe that better functioning capital markets in which assets can be traded are a good idea.”

    What?

  14. JasonF says:

    No, the Market solution worked just fine: those companies were crushed by the Market for their stupidity, and, as you write about very well (I read your great blog every day), by not letting the Market crush their stock- and bond-holders too, we’ll simply increase moral hazard to make it even more difficult for the Market to do it’s job in the future.

    In the even larger Market for politicians (votes instead of dollars) we’ll hopefully see those responsible for Freddie, Fannie, lax SEC enforcement, etc. get crushed too (voted out of office).

    And in the even larger Marketplace of ideas and culture we’ll hopefully see both Democrat and Republican economists/politicians get horsewhipped for the harm they’ve caused the public through lax Fed policy, gigantic state and federal deficits, our multi-trillion dollar “Keynesian experiment” of the next ten years, and the Ponzi schemes of Social Security, Medicare and Medicaid of the next 30 years.

    The horrible thing is how much Main Street is going to suffer, but unfortunately that is a Market process too, it might be called Reality Bites Back: you can’t create wealth simply by having politicians sign a piece of paper or by having the Fed crank up the presses.

    So the capital-M “Market” is still working as always, it’s just that some feedback loops take years or decades to go through their cycles. It’s not that the Market isn’t a modern Deity, it’s that this Deity is unfortunately very very harsh in enforcing its rules.

    Barry, I know that you’ve got an agenda to combat naive Market Catholicism out there, and I don’t disagree with it, but right now there is the danger of an over-reaction in the opposite direction being fueled by populist rage which threatens our long-term freedom and prosperity, and sometimes your blog contributes to it when your finer critiques can be easily misconstrued as a rejection of the fundamental long-term value of free market capitalism for human welfare. People can mistake your critique of the details of today’s particular laws or events as arguments against capitalism as such. So I hope you keep your critiques and commentary going, it’s great stuff and very healthy, but sometimes reaffirming the value of free market capitalism (broadly defined) would be beneficial too.

    ~~~

    BR: Jason, That’s a fair point. I am not the cheerleading type, and try not to wax rhapsodic about things I believe are obvious.

    That said, I pointed out over the weekend that I thought Krugman’s critique of securitization was misguided:

    Paul Krugman is Wrong About Securitization (March 28th, 2009)
    http://www.ritholtz.com/blog/2009/03/krugman-is-wrong-about-securitization/

  15. Steven Bowles says:

    The banks buy hard to value and illiquid assets every day – its their function. Assets such as personal loans, mortgages and corporate loans have always been accounted for at amortised cost under ‘loans and receivables’. All our problems stem from allowing banks to treat what should be ‘hold to maturity’ assets as trading assets and thus marked-to-market. Unless an item is level 1 or level 2 (mark to market or mark to model) then it should by law be accounted for as a loan and receivable. No chance of a quick profit and so no motivation to get involved in CDO tranches etc. would never have allowed the bubble to build in the first place.

  16. Moss says:

    Deification indeed. Where is Mother Theresa when you need her?

    BR: Would be good to begin looking at the various instruments being bandied about for the ‘market’ of some of the PPIP assets. I hear PIMCO, Legg Mason, Blackrock and others talking up the various funds they plan to introduce for general public consumption.

  17. gringcorp says:

    Which makes me wonder why the investment banks were, and I believe are still, pouring huge amounts of effort into establishing “dark pools” (scare quotes warranted) where large institutions can trade securities without any wider scrutiny

  18. Mannwich says:

    Oh, they believe in “free markets” alright. They just don’t like it when their team loses at their own game and so they change the rules midstream to ensure that doesn’t happen.

  19. tz says:

    They did NOT “create new markets” for the sometimes collectible securities. They could have created an exchange. Last time around the “market” for junk bonds was Milken’s desk in California. When there is no public exchange or something similar (Even food is sold at grocers and cars at dealers), there is no “market”, just a series of unique private contracts.

    They could price them as they wanted, value them as they wanted. They were placed more than sold or auctioned.

    Mises noted the key function of a market is price discovery. The more free and open the market, the better the price information.

    What it should have read is “We can create a private cartel where we set prices on individual non-fungible instruments and collect huge fees”.

    There are shares in things like oil and natural gas trusts and all the wells are different. Instead of a MBS, they could have created an ETF with a ticker, or even standardized packages (e.g. some number of 30 year fixed X% mortgages) which would trade on an exchange, but then it wouldn’t be a cartel.

  20. flipspiceland says:

    “Banks” didn’t do anything. But the senior mangement, all the vps, the mortgage originators within those banks did. Their incentives were geared to make these transactions, offload the debt for cash and do it again.

    They were not stupid, these people. It was intentional, it was very lucrative for a long time, and those who have walked off into the sunset with gigantic fortunes knew precisely what they were doing.

  21. Benedict@Large says:

    It seems to me that the problem is not in “Mark to Market” accounting, but rather that these institutions did not price in illiquidity when these instruments were initially booked. Now that their illiquidity has forced itself to the forefront, they cry loudly that there is an accounting problem, when in reality the real problem (“irrational exuberance”) was there but unrecognized on day one. In other words, they fucked up.

  22. howard0339 says:

    Next we get to see what the various government “inspectors” identify as
    “systemic risk.” Talk about in the eye of the beholder…..

  23. [...] Barry Ritholtz makes the point that valuing toxic assets is not just part of the problem, it is THE problem for which the Fed and Treasury have no good solution: There are Markets, and then there are markets. I am less sure that Larry Summers understands the differences between the two. … [...]