I came across this Bengt Holmstrom note he presented at Kansas Fed Symposium 2008 as a discussant. The paper is absolutely brilliant. I can’t extract the content of the paper so one has to read it. However, I would just point to key contributions of the paper.
The paper looks at 2 questions- in what sense were mortgage backed securities responsible for the crisis? Why did this market grow so big?
The paper talks about fundamental nature of two types of financial markets – money markets and equity markets. He says in money markets (and interbank/repo markets) the key is trust and one cannot do continuous credit assessment. The counterparties here are expected to be solvent and the market is low on information. There is hardly any scope for adverse selection here. Hence, if problems develop here, as in counterparty is insolvent etc, it leads to numerous problems. In these markets you are rolling out and reversing transactions continuously; and one hitch devastates the system
However, in equity markets we see the opposite. It thrives on adverse selection and is highly information sensitive. Here one does not need to trade if he doesn’t agree with the price and can wait. Unlike money markets where one has to manage liquidity position on a continuous fashion, this compulsion isn’t in equity markets.
In sum, equity markets thrive on information asymmetry, money markets are killed by it.
After this Bergstrom says problem with sub-prime securities was not lack of transparency. The markets thrived before the crisis with no problems at all. The markets knew the risk and had priced it. The main problem was that these securities were much more sensitive to fall in housing prices than people thought. But isn’t that lack of transparency? Anyways…
Hence, it is not right to say increasing transparency is the solution. Infact, we can never reach the level if full information and half-information is deadly, as seen in the case of liquid money markets. He also illustrates how non-transparency helps facilitate trade in diamonds. This is actually quite brilliant . I never thought of these two markets in this way.
As far as second question is concerned, he says it grew so large mainly because of the global imbalances with loads of monies flowing from emerging to US mainly as former fo not have good financial markets and enough fin assets. And this is actually a concern as US faces the same problem as emerging markets do – managing these huge capital inflows. This is similar to what Rogoff and Reinhart said:
During the 1970s, the U.S. banking system stood as an intermediary between oil-exporter surpluses and emerging market borrowers in Latin America and elsewhere. While much praised at the time, 1970s petro-dollar recycling ultimately led to the 1980s debt crisis, which in turn placed enormous strain on money center banks. It is true that this time, a large volume of petro-dollars are again flowing into the United States, but many emerging markets have been running current account surpluses, lending rather than borrowing. Instead, a large chunk of money has effectively been recycled to a developing economy that exists within the United States’ own borders. Over a trillion dollars was channeled into the sub-prime mortgage market, which is comprised of the poorest and least credit worth borrowers within the United States. The final claimant is different, but in many ways, the mechanism is the same.
However, unlike emerging markets US hasn’t faced the problem of huge outflows. And unlike emerging markets, major debt is in USD which is the home currency. So, though US is better off, the problems of capital flows continue. The capital flows problem was raised by Eichengreen too, but in a different fashion.
The main thought of the paper is we need to look away from the usual solutions like increasing transparency. We still need to understand the market functioning deeper before arriving at regulatory changes.