Liquidity in the Age

Christopher Joye and I have a long opinion piece in The Age today [reproduced over the fold]. It discusses the notion that a minimal level of liquidity in some financial markets (such as home lending) has public good qualities rationalising government attention. This is the basis upon which we argue for institutions like AussieMac.

Facilitating the blooming of liquidity

The Age, 10th April, 2008

Christopher Joye and Joshua Gans

A FEW weeks ago, we recommended that a new government agency, which we called “AussieMac”, be set up to deal with the credit crisis and to provide a minimum level of liquidity to Australia’s housing finance industry.

The idea behind AussieMac is to leverage off the Commonwealth’s credit rating to raise inexpensive AAA-rated debt and use these funds to acquire high-quality, low-risk “prime” home loans off the balance sheets of Australian lenders, thus providing an immediate,

low-cost solution to the current, and any future, credit crisis. AussieMac would be a permanent government institution that would irregularly provide lenders with injections of liquidity when markets fail for reasons unrelated to the health of the Australian economy or the performance of borrowers.

The notion underlying such institutions is that the provision of a basic level of liquidity in key economic markets is a public good. The assurance of liquidity is important in the economy because many transactions and investments cannot take place unless funds are pre-committed and available in an ongoing manner. While this is certainly true in housing finance, it also extends to other areas such as small-business lending, where alternative forms of finance (such as equity) cannot be readily utilised.

The private supply of liquidity is likely to be adequate when risks are fully diversified. However, as we have observed in recent times, the Australian economy can face systematic shocks. These are becoming increasingly common and more quickly transmitted in today’s highly networked world. Such risks are not easily diversifiable by private investors alone and, in times of crisis, the supply of liquidity can dry up.

Away from the theoretical ideal of financial markets, investors in the real world are finding that they are being faced with periods of profound illiquidity, extremely poor price discovery and, in certain cases, complete market failure. The past two decades supply many examples of such illiquidity and governments acting to remedy it. In 1998, for instance, huge hedge fund LTCM confronted severe illiquidity for its securities when the Russian government defaulted on its debt obligations. The US Federal Reserve facilitated a bail-out of LTCM by a consortium of investment banks.

To many, these incidents highlight the increasingly accepted notion that markets are not always efficient. It is also being more recognised that market traders and investors have systematic behavioural biases. Pioneering academics such as 2002 Nobel prize winner Daniel Kahneman and the late Amos Tversky have applied principles from psychology, sociology and anthropology to show that in practice people’s behaviour can deviate strikingly from the equilibrium predictions of the “efficient markets hypothesis” (and the idea of “rational expectations” in particular).

The action of behavioural biases can be seen in the speculative booms and busts that have occurred throughout history, from Dutch tulip mania to junk bonds in the early 1980s and the related 1987 sharemarket crash, to the late 1990s tech craze and the tech wreck of 2001.

People are subject to a wide range of biases, including irrational loss-aversion, “framing”, use of “heuristic” rules of thumb, hindsight biases, and cognitive dissonance (i.e., discounting information that conflicts with our assumptions).

Academics have shown that there can be major mispricings and return anomalies in financial markets due to these behavioural biases. In particular, the tendency to identify non-existent patterns in random return sequences, and to place too much confidence in our own judgement, can result in big overreaction and underreaction in market prices. There is also compelling evidence of the anecdotal market phenomenon of herding and “groupthink”, in which strongly anomalous market-wide effects can materialise when there is collective fear or greed among investors.

Whether we recognise these issues affects how we conceive of regulation and its effect on financial markets. For example, recent regulatory changes that require institutions to “mark to market” securities that they would previously hold to term may further exacerbate liquidity crises caused by information asymmetries and/or irrational investor behaviour.

In the presence of mark-to-market prices that do not accord with reasonable assumptions of fair value, institutions are reluctant to lend to one another. This can create big problems for the financial system at large as transactions that were previously considered to be nearly risk-free are subject to perceptions of “counterparty risk”. Bear Stearns discovered this in March this year when Goldman Sachs refused to deal with it. The result was a rare non-bank bail-out in which the US Fed took Bear Stearns’ otherwise illiquid assets as security and lent JPMorgan the $US30 billion that it needed to buy the company.

When markets fail and price discovery collapses, the provision of a minimum level of liquidity is a public good. Critically, the knowledge that liquidity will be available even in situations where the economy faces an aggregate shock makes investments contingent on that liquidity (such as building and small-to-medium enterprise investing) cheaper at all times.

It is, therefore, not so much a stimulus in bad times, but more a form of insurance to mitigate costs during those times.

We are at present witnessing the adverse effects of a liquidity shock in Australia’s home lending market. Since the advent of the US subprime crisis we have seen the closure of the “primary” AAA-rated Australian mortgage securitisation market for reasons unrelated to the quality of our financial institutions or the borrowers they service. This is a market that has funded up to 20% of Australian home loans and accounted for $284 billion worth of transactions since 2002.

The ability to securitise very low-risk Australian home loans was critical to the emergence of competition in the home loan industry during the mid-1990s. This competition resulted in the margin on home loan rates charged by lenders falling from about 4% in 1992 to about 1.4% today. Since the closure of the primary securitisation markets, the “new” home loan market share of the big five major banks has increased from 75% to more than 85%. Lenders such as Macquarie Bank, RAMS and ANZ’s Origin business have withdrawn from the market entirely, while other smaller lenders have had to ration credit. This is the consequence of not having a public policy that guarantees a minimum level of liquidity.

The Federal Government needs to investigate the institutions that can provide a threshold level of liquidity in the economy. At present, this task is left to the RBA, but in a limited and non-transparent manner that only benefits the banks.

An organisation such as AussieMac could institutionalise liquidity as a public good on a more transparent and widely available basis.

Joshua Gans is an economics professor at Melbourne Business School. Christopher Joye is chief executive of Rismark International.

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