September 16, 2008-a critical FOMC meeting day
“How did we get into this big of a mess?” asked the journalist. “Asymmetric information” we quickly answered.
Huh? What’s that?
My friend, John Silvia, is not only my fishing partner. He also is one smart economist and an encyclopedia of research references. “Look at George Akerlof’s “Lemons” for guidance” he said.
Noble Laureate Akerlof wrote about how the imbalance in information between the buyer and the seller (asymmetry) can result in lesser quality paper crowding out higher quality. His theory explains some of the financial market dysfunction we see today.
The theory says that a security seller may know the quality, credit risk, payment stream, collateral support, etc. better than the buyer. Hence the seller will sell if the buyer is over paying in the seller’s eyes. The seller can unload lesser quality stuff on the buyer at a price that reflects a higher quality level. Over time, the lower quality stuff crowds out the higher quality stuff and, eventually, the market fails to clear in a normal way. The information asymmetry is that the seller knows more information than the buyer (nothing new there). The financial market impact hits when the buyer realizes his information is incomplete and his guarantee is uncertain. Then, risk premia sky rocket. That describes today.
John Silvia’s summation: “This may be what we have witnessed in the credit markets over the past year and may be seeing again this week. The seller of an asset that may be impaired cannot find a buyer. The seller knows the quality of the portfolio but the buyer does not. Quality information is asymmetric and therefore the buyer is unwilling to take risk in the trade.”
Uncertainty is heightened when the central bank constantly changes the rules and when it fails to explain itself clearly. The result is that market agents read into the actions and the uncertainty premium rises. The market agents presume that the Fed knows more than they do. Right or wrong that is how markets operate.
Fed inconsistency and insufficient explanation therefore fail to calm markets and may exacerbate their volatility and enlarge the turmoil. We see that today in the extremely wide credit spreads.
The Fed has done that this year by saving Bears Stearns (BSC) in March and allowing Lehman (LEH) to fail in September. In both cases the share price suffered immensely. No market uncertainty there. But in the BSC case the toxic portfolio portion was placed in a Delaware LLC called Maiden Lane and the Federal Reserve funded it with $29 billion. It appears on the Fed’s balance sheet as the Fed slowly works off the position.
This transaction allowed the rest of BSC to be merged into JP Morgan Chase and that meant the debt of BSC and the derivative contracts in which they were counter parties did not fail. The Fed action with BSC calmed markets temporarily and narrowed risk premia.
The Fed then put in place new tools that were directed at the primary dealers. These have been discussed many times (see www.cumber.com) but it is important to realize that the primary dealers are those who handle some of the transmission of the Fed’s policy into the credit markets and they are viewed by the rest of the world as a very private club. LEH was among them.
Previously the Fed and the federal authorities had assisted Countrywide to be merged with Bank of America. Countrywide was a primary dealer. Markets saw this policy of saving primary dealers repeated with BSC, another primary dealer. Markets expected this to be repeated with LEH.
LEH’s failure was and is a global shock. One of two things can be surmised. Either option we surmise is bad and raises uncertainty.
Option one is that LEH may have been a larger mess than BSC or it may have been worse or both. If that is so, it failed 6 months after the Fed’s new tools were in force and had been applied. One would have expected the patient to be healing if the new medicine were effective. So if the LEH was a bigger mess than expected, by allowing failure the Fed is sending a message to the markets that its new tools are insufficient or impotent.
The other option is that the Fed has changed policy and that it will not act in the lender of last resort capacity. That implies that the primary dealers are not safe and that the markets are on their own without a life support central bank function.
AIG is not a primary dealer. But it is a huge global financial enterprise and it faces credit rating issues that impact its ability to clear the counter-party risk. AIG knows the quality of its portfolio but the market does not. Hence Akerlof’s principle is at work. That is why the Fed must act.
The AIG problem comes on the heals of the LEH failure and immediately following the Fannie Freddie shock. This has the appearance of a cascade or a contagion. Failure of LEH has created contagion because of counter-party risk that was not contained by the Fed. Failure of AIG will make this much worse.
Stemming a contagion is the job of the central bank. To do so, it must diminish uncertainty and restore confidence with transparency and clarity. And it must apply its lender of last resort function which Dennis Gartman explained so well in his recent market letter. Gartman accurately summarized that “a central banks obligation is to be there at times of monetary duress, discounting reasonably liquid "paper" for the purpose of making certain that liquidity exists in the banking and trading system in order to avoid the periodic paroxysms that markets are prone to find themselves devolving into. Walter Bagehot, in his seminal "textbook" on the issue of central banking, Lombard Street, said that a central bank’s raison d’être is to supply liquidity when liquidity is needed…”
I add to Dennis’ quote that it is the primary dealers who do this for the central bank and with the support of the central bank. That is why LEH failure is so important and why it is causing contagion.
Within the Fed, there are those who understand this link between quality perception by the seller and imperfect quality knowledge of the buyer. Janet Yellen, president of the San Francisco Fed, wife of George Akerlof and a co-author with him is fully cognizant of this principle. She may raise a voice of reason here. This writer hopes so.