Wrong investors and market dislocation

I have been reading the transcripts of the US House of Representatives Oversight Committee hearing on hedge funds and the financial crisis.

Having enjoyed Andrew Lo’s excellent book on hedge funds, I read his testimony with particular care. I was particularly fascinated by the following statement that he made:

Dislocation comes not from losing money, but from the wrong investors losing money. (lines 725-726, p 34)

I mentioned earlier that dislocation happens not when losses occur, but when losses by individuals that are not prepared for those losses occur. The hedge funds that invest in the worst risk tranches, they are prepared for losses; but when money market funds, pension funds, mutual funds invest in AAA securities that then lose substantial value, that is really the cause for dislocation. (lines 1067-1073, p 49)

That diagnosis ties in well with a report at FT Alphaville about why Lehman’s demise was so devastating to the markets. During the run up to the Bear Stearns collapse, investors stopped rolling over its commercial paper and the amount of this paper outstanding fell by over 80% as far as I can make out from Figure 1 in the report. After the Bear bailout, investors assumed that a large investment bank would not be allowed to fail. As Lehman lurched towards bankruptcy, its commercial paper issuance not only did not fall but actually increased nearly five times.

This means that at the point of its failure, Lehman was being increasingly funded by what Lo called “wrong investors”. The tipping point in the post Lehman crisis was the closure of a prominent money market mutual fund due to losses on its investments in Lehman commercial paper. This in turn led to the collapse of the entire prime commercial paper market necessitating a bailout of that market and an ever widening range of other bailouts.

This is a very potent example of the moral hazard caused by government bailouts. Absent implicit government support, a weakening institution sees a withdrawal by risk averse investors and its funding comes increasingly from those who in Lo’s words are “prepared for losses”. The moral hazard caused by previous bailouts breaks this adjustment and makes subsequent failures a lot more painful than they would otherwise be.

This analysis also suggests that a “silent run” on a financial institution could actually be a good thing under certain circumstances if it is Lo’s “wrong investors” who are doing the running.

Posted at 2:04 pm IST on Fri, 28 Nov 2008         permanent link

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