Did Hedge Funds Help Stabilize the Mortgage Market? II

The intelligent and thoughtful Felix Salmon answers "no" to the question: Did Hedge Funds Help Stabilize the Mortgage Market?

His answer, if I am interpreting it right, is that hedge funds betting that mortgage-backed securities were overpriced did not help correct the excesses of irrational exuberant because there were not enough of them: not enough hedge funds, not enough investors to capitalize them, not enough derivatives to make deep pools for them toswin in. Thus hedge fund portfolio managers who went short MBS, Salmon argues, made fortunes to themselves, their bosses, and their investors, but did little to push MBS prices--and thus the incentives to make dodgy subprime loans-- to where they always should have been.

I think that Felix may be wrong because of one of the peculiar things about financial as opposed to other markets. In most markets--the one in which I am participating at the moment, for example, the market for bagels on the Q level of the Johns Hopkins University Library--buyers and sellers know what their valuations are. I know that after the red-eye my valuation of a whole-wheat bagels with a triple helping of cream cheese on it is well-nigh infinite. I compare the price to my stomach-driven valuation. I buy.

But finance is different. If your valuation is different from--say it is greater than--the valuation of smart people who know more than you do, you should not buy. You should change your valuation. In a normal situation you can read some but not necessarily a lot of information about what SPWKMtYD think off of the current market price. In this context, extra markets--options markets, other derivatives markets, et cetera--are potentially valuable as additional channels of information about what the smart, or at least the technically sophisticated, money is thinking.

This was Sandy Grossman's argument about 1987: that if portfolio insurance had been an actual market-traded option rather than a synthetic option synthesized by a dynamic trading strategy, peple would have understood the shape of the demand curve. I think his argument is a strong one. And it seems quite likely to me that it applies in this case as well.

Comments

[fairhavenhorn]

I think the problem can be more precisely described as the absence of a robust spot market. The ability to take delivery and use the spot market is part of what keeps more traditional derivatives markets in check.

[Charles Kinbote]

SPWKMtYD?

[Bunbury]

Which way round are you arguing?

1) The ABX provided, a la Grossman, the visibility missing in 1987 thus saving us from even greater catastrophe.

2) 1987 is being repeated because somehow we can't see some part of the demand curve.

3) The ABX provided, a la Grossman, the visibility missing in 1987 thus saving us from even greater catastrophe but 1987 is being repeated because somehow we can't see some part of the demand curve.

[Tim Worstall]

Umm, well, at the margin, of course Felix is wrong. Even only one person betting against the market flow will change that market price a little bit: might be a teensie weensie bit, but the effect will be there.

[Matt]

Reading this, I immediately looked to the number of bins used to classify bond ratings, about 16, or a four bit value. Right away the distortion is evident just by looking at Brad's last set of equations on monopolies.

More importantly, I would expect that the bond raters should distribute ratings over the ratings span like a normal curve. If not smoothly normal, then watch out.

[zeno2vonnegut]

Do hedge funds in general increase stability? For any particular hedge fund, profit opportunities rise with volatility.

[PaulC]

Q level? I've been away from Johns Hopkins way too long. As I remember, the levels ascended alphabetically as you went down. By Q level, you'd be fighting the Balrog for your bagels.

[randomeconstudent]

"Do hedge funds in general increase stability? For any particular hedge fund, profit opportunities rise with volatility."

They might do both-promote short term volatility but medium term stability by forcing assets back to fundamental values before the "long run". But they can only do either if they're really large enough to push prices.

[Ian Whitchurch]

"But finance is different. If your valuation is different from--say it is greater than--the valuation of smart people who know more than you do, you should not buy. You should change your valuation. In a normal situation you can read some but not necessarily a lot of information about what SPWKMtYD think off of the current market price. In this context, extra markets--options markets, other derivatives markets, et cetera--are potentially valuable as additional channels of information about what the smart, or at least the technically sophisticated, money is thinking."

Rationalisable expectations - Econometrica, 1984 around p1040.

Brad is exhorting a 'cheap information' strategy of rationalising that the smart money is right, rather than a Rational Expectations view of digging till you are satisfied that the marginal expenditure on getting new information exceeds the value of that information.

By following this strategy, as opposed to reading and following, say Tanta and the Mortgage Pig, you could have lost yourself a lot of money in the last bubble.

This strategy is also why bubbles happen - market participants copy each other, assuming that everyone else knows something that will rationalise the prices continuing to rise slash fall ... the Trend is your Friend, right ?

[christofay]

Well, Charlie Munger says there aren't 8,000 smart people on Wall Street. And I would take that for one reason things are so screwed up. And Ian points out the truism on Wall St it is right to be wrong together which is why being a contrarian works.

Consider Robert "CDS" Rubin being paid $10 million dollars a year then having to go to community college in the Fall of 2007 to try to learn what his firm was pushing. He just happened to be sleeping through the decade. When it is bail out time Robert Rip van Winkle Rubin gets the wake up call. Here is a market condition, the C suite doesn't understand what the firm is up to. Except at bonus time.

Prices should be screwy. CDOs are un-analyzable; there are thousands and thousands of moving parts. When they become squared and cubed the complexity rises an order of magnitude but at the same time the correlation with everything else becomes greater. Private label derivatives are designed to obfuscate

[Neal]

In the sea of finance hedge funds can operate as pirates, scavengers, salvager, ship breakers and and tramp steamers. In contrast to the main line ships that travel established routes between established markets, the hedge funds are more free form-- they are opportunistic, ruthless, find new markets, new routes and new cargoes, exploiting those portions of the world too specialized for the large ships of the line.

They are a part of the system, but they don't move the overall market the way the tankers, bulk carrier and container ships do. They can cause problems and take advantage of chaos. But their real advantage is that they are nimble and flexible--not that they are market-sized makers and movers.

[Ian Whitchurch]

Neil,

I'm not certain of that either. Before they blew up, Amaranth owned, what, 30% of gas deliverable in March 2007 in North America, right ?

Ian

[Frank Dean]

I think Felix Salmon may be right. Why? Delong et al: "Noise Trader Risk"

If I recall correctly, one of the results of that paper is that under certain plausible conditions, stupid people who think they're smart are significant players in the market, and the market doesn't drive enough of them into bankruptcy. The stupid and lucky are a large group that doesn't go away. The situation may be especially bad today, with the Federal Reserve financing firms that should be bankrupt, because they are also the firms needed by the financial system to maintain functioning markets.

[randomeconstudent]

In the noise trader risk paper, stupid investors end up influencing the market and not dying out because they actually make larger expected returns than the rational investors. Their mistake is in taking on too much risk relative to the reward they expect.

So I'm not sure that applies in this case since the mistake people are making here seems more in overestimating the mean rather than underestimating the variance.

In any event, I think the reason the information arguments don't go through here is that hedge funds go to great lengths to hide the positions they're taking. If you don't know what the SPWKMtYD are doing, then you can't infer what you should be doing from them. You might suppose that the market price is being determined by the SPWKMtYD, by this is only true if there are enough SPWKMtYD with enough money to move prices enough for people to figure out what's going on which brings us back to the beginning of the post.

[Neal]

Amaranth failed precisely because it couldn't control the market. It was busted on a weather bet.