Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

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.

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