Reaction Wheel

This morning I was rereading Merton and Bodie’s “A Conceptual Framework for Analyzing the Financial Environment” in The Global Financial System: a Functional Perspective, published in 1995 but still immensely interesting*. This passage, though, ended the paper:

In the traditional bank arrangement, there is a mismatch between the liquidity of the deposits issued by the bank and the loans backing those deposits. Indeed, it is this mismatch in liquidity that is often cited as the root cause for banking panics…

The current environment of low and secularly declining transactions costs for securitization supports a hierarchical and incremental chaining approach as an efficient means for providing liquidity. Liquidity is enhanced whenever a collection of assets is “repackaged,” and the resulting collection of assets created have a smaller bid-ask spread than the original assets. Thus highly illiquid and opaque assets can be financed with short-term debt instruments. Portfolios of the more liquid of those securities, in turn, can be used as assets to back other securities that will have even greater liquidity, and so on.

Thus, at each link in the chain, the differential in liquidity is relatively small. Cumulatively, it is possible to create virtually perfectly liquid securities while minimizing the danger to the system of ever experiencing a “crisis” because of a mismatch between the liquidity of an intermediary’s assets and liabilities.

The idea is appealing on the face of it, but we can’t, obviously, still believe it. If I was going to criticize, I think I would start with how the authors seem to be confusing instrument-level liquidity with institutional-level and how these could be quite different markets. But this is pretty unsatisfying, if only because these institutions are just collections of individual assets anyway.

I think the better answer may be that it wasn’t securitization at all at fault in the recent difficulties. Of course, at the rate we’re ruling out causes, we may eventually have to accept the sole remaining explanation for the near-seizing up of our vaunted financial system–no matter how improbable it may be: collectively we’re no smarter than a troop of chimpanzees.

OK, maybe it’s not that improbable.

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* We’re having a contest to see who can have the most boring Saturday. I’m winning.