links for 2008-04-28
Methinks Fareed Zakaria Will Vote for Barack Obama

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.