海角大神

Hedge funds have mostly been exonerated in the typical narrative of the financial crisis, which concentrates blame on some combination of mortgage lenders, investment banks and government agencies.

础听new paper聽by Yale professors Gary Gorton and Guillermo Ordonez, however, may indicate that hedge funds and other well-informed, aggressive traders played a much more important role in triggering the crises than is widely understood.

聽The paper, titled 鈥淐ollateral Crises,鈥� examines the important role short-term collateralized debt plays in the financial system. In other papers Gorton has argued that short-term collateralized lending between banks and money market funds is a form of private money within the banking system. It is the medium of exchange within this 'private' system.

聽In order for collateralized debt to perform this function, the debt needs to be 鈥渋nformation insensitive.鈥� Which is to say, the institutions lending the money need to be able to implicitly trust quality of the collateral without investigating to make sure it is sound鈥攍argely because a money market fund doesn't have the resources to investigate the quality of every triple-A rated mortgage-backed security that backs up its short-term loan to a bank.

聽But how can a money market fund avoid being given the worst quality collateral? Here the complexity of the collateral comes in to play. In order to prevent borrowers from engaging in adverse selection鈥攊.e. giving the money market fund junk collateral鈥攖he collateral must be complex enough that it isn't profitable for anyone to produce enough information about the debt to carry out any kind of predatory behavior.

In short, predatory trading must be too expensive to work.

聽鈥淚n other words, optimal collateral would resemble a complicated, structured, claim on housing or land, e.g., a mortgage-backed security,鈥� the authors argue.

聽Mortgage-backed securities were complex and opaque enough that they made ideal collateral. A party on one side of a collateralized loan could count on the fact that the other side was just as ignorant about the collateral as he was.

聽Although Gorton and Ordonez do not go into the collateralized debt obligation market, it is easy to extend the argument to CDOs. The higher the level of complexity, the more expensive it would be to engage in predatory collateralization. A CDO would be even more 鈥渋nformation insensitive鈥� than a MBS. And a CDO-squared would be even more so.

The trouble is that the lack of information means that borrowing occurs against good and bad collateral. This leads to a credit boom, with 鈥渂lissful ignorance鈥� leading to increased consumption and more lending. Over time, ignorance about the quality of collateral and the financial health of the lenders and borrowers becomes more and more pronounced.

It would stand to reason that a type of Gresham鈥檚 law would develop in this kind of situation. Bad collateral would drive out good collateral. Once someone starts to figure out how to affordably detect collateral quality, he would begin to hoard high quality collateral and trade with only low quality collateral. Or, even more aggressively, he might begin to explore ways to short the low quality collateral.

Gorton and Ordonez talk about 鈥渁ggregate shocks鈥� inducing the production of information about credit quality. But I鈥檓 not sure we need any shock at all. All we need is a few guys to see an opportunity to decide to trade on the decay of information about the collateral.

In other words, you just need a few guys at hedge funds or on trading desks at investment banks to find a way to acquire or produce information about credit quality. They might not even need accurate information鈥攋ust a hunch will do.

In the initial stages of this process, a few well-informed traders enter the market with predatory trades based on credit quality. Recall how much research guys like John Paulson and Michael Bury did about the securities they shorted. These guys had decided that it wasn鈥檛 too expensive to produce information. They were arbitraging ignorance.

Once other market participants realize that some people on the other sides of their trades are well-informed predatory traders, the MBS collateral flips from 鈥渋nformation insensitive鈥� to 鈥渋nformation sensitive.鈥� Lenders can no longer assume that they aren鈥檛 receiving low-quality collateral.

But not everyone can develop into a well-informed trader. For many it makes more economic sense to withdraw altogether鈥攖o stop lending against the collateral pool corrupted by predatory behavior. The result is that liquidity dries up and credit contracts. Margin calls can make the problem even worse, as lenders demand higher margins or additional collateral to make up for declining market value.

Doesn鈥檛 this sound like a pretty good description of our financial crisis?