When fin markets expect govt intervention in a firm, it leads to higher stock prices of the firm. This makes it difficult for policymakers to price the share appropriately. To put it differently, how do policymakers estimate the correct share price in such times? They call this the “hall of mirrors” problem.
The paper is too mathematical. So, here is a discussion on the paper:
Before “regulators intervene in Citibank they want to see that the price is very low. The fact that the price is very low … gives them reason to intervene,” Goldstein said. “If the market expects intervention, the price might go up.” But if that happens, the government might not intervene, and a bank that desperately needs help will not get it. “There is a feedback loop that makes it very difficult to pin down what is going to happen.”
The past year has seen many examples of such turmoil. In one week last July, the price of shares in Fannie Mae nearly doubled to $14.13 from $7.07 on hopes of a government rescue for the mortgage finance company. Similarly, banking giant Citigroup has seen its shares bounce wildly as investors tried to get a handle on whether the government would take some type of corrective action to stabilize the banking behemoth.
The hall-of-mirrors problem occurs when government action is expected to increase the value of a security, as was the case last fall when Congress was debating the $700 billion Troubled Asset Relief Program. It is not an issue when government action, such as nationalization, threatens to wipe out equity holders. In that case, there is no feedback loop because the stock becomes virtually worthless.
What are the solutions?
The guessing game could be ended by improved communication between the market and the government, with the responsibility lying largely with government, Goldstein and Bond suggest. “You have to cut one side of the loop,” they write. One way to accomplish this would be for government to state clearly what it will do under particular circumstances, instead of acting in an apparently ad hoc manner as it has done during the financial crisis. Troubles at Bear Stearns, Lehman Brothers and American International Group each elicited different responses from regulators. That added to the tremendous uncertainty and turmoil in the market.
With a similar goal in mind, Goldstein and Bond propose the establishment of a prediction market on government interventions, similar to those that allow traders to bet on the outcome of presidential elections. Such a market would exist alongside the securities market, and it would allow investors to buy and sell options that are essentially bets on whether or not the government will rescue a company.