I highly recommend Knowledge@Wharton’s new subprime crisis website,” entitled “Inside the Subprime Crisis: How Wall Street Alchemists, Ambitious Lenders, Overreaching Consumers and Enabling Lawmakers Pushed the Economy to the Brink of Recession, and How to Avoid a Repeat.”
I highly recommend Knowledge@Wharton’s new subprime crisis website,” entitled “Inside the Subprime Crisis: How Wall Street Alchemists, Ambitious Lenders, Overreaching Consumers and Enabling Lawmakers Pushed the Economy to the Brink of Recession, and How to Avoid a Repeat.”
Harvard finance professor Josh Lerner is quoted today in the Austin American Statesman: “It’s sort of like, heads you win, tails the Fed picks up the pieces”. Professor Lerner made these comments in reference to the historically unprecedented and controversial Fed-engineered rescue of Bear Stearns (cf. “Bear Stearns fetches a better price, shoring up deal” to see this quote in its original context).
Clearly the motivation for the Fed to intervene in this fashion was to prevent a severe and pervasive “credit crunch” in the U.S. economy from going from bad to even worse. A couple of weeks ago, Bear Stearns suffered a classic “run-on-the-bank” scenario; its short-term creditors refused to lend the firm any more money via the extension of overnight loans, and simultaneously demanded repayment of outstanding debt. The net effect completely overwhelmed Bear’s cash position, which in turn forced the investment bank to seek help from JPMorgan Chase and the Fed. Since then, the Fed has opened its so-called “discount window” to investment banks as well as commercial banks. The last (and only other) time that this occurred was during the Great Depression.
From a risk management perspective, the decision by the Fed to take this action involves trading off the benefit of preventing a financial contagion in the short run against longer run moral hazard effects such as Professor Lerner has described. At this point in time, it is impossible to determine whether our economy will be better off as a result of this policy action. The most important asset that any organization, including the government, can have is the trust of its constituents. The problem with ad hoc regulatory interventions like this is that it raises the bar in terms of people’s expectations regarding future public policy; specifically, it encourages the notion that the government will bail you out if you are big enough and manage to mess up badly enough. Economists refer to this as “time-inconsistent” behavior on the part of government. The concern that many have about this action by the Fed is that it may make matters worse by effectively increasing systemic risk going forward. The issue here is whether the long run moral hazard consequences can be reigned in prospectively, or whether the action will effectively “up the ante” and encourage even more risk prone behavior on the part of investors, as suggested by Professor Lerner’s quote.
Yesterday, the S&P 500 traded at a low of 1,270.05 and closed near its high for the day, at 1,338.60. Relative to the opening index value of 1310.41, a 67.95 point intraday move sure feels volatile. Since I have been a fairly serious student of financial markets for the past 20 years or so, I thought that it would be interesting to put this into a larger historical perspective.
To do this, I downloaded daily data on the S&P 500 from Yahoo! Finance for the period January 3, 1950 – January 23, 2008. During this period, there are a total of 14,607 observations. My measure is the ratio of the difference between high and low index values for a given day divided by the value of the index at the open; let’s call this variable PCT_CH_SP500. For example, for January 23, 2008, PCT_CH_SP500 = (1,338.60 – 1,270.05)/1,310.41 = 5.27%. Not surprisingly, I found that in a statistical sense, yesterday’s market action was clearly an “outlier”; only .18%, or 27 of the 14,607 trading days during this more than 57 year time period were more volatile. Here are the descriptive statistics for this data series:
|
Percentile |
PCT_CH_SP500 |
|
10% |
0.00% |
|
25% |
0.49% |
|
50% |
1.15% |
|
75% |
1.67% |
|
90% |
2.16% |
|
95% |
2.55% |
|
99% |
3.55% |
The average value for PCT_CH_SP500 during this period was 1.14%, and the standard deviation was 0.90%. Furthermore, the distribution for PCT_CH_SP500 is highly positively skewed (1.73), and fat-tailed (kurtosis = 23.04).
I sorted the dataset from highest to lowest values for PCT_CH_SP500, and it is interesting to see the volatility implications of various major financial events in history. The financial media has drawn comparisons between what is currently happening with other events such as the 1987 stock market crash, the Asian financial crisis in October 1997, the failure of the Long Term Capital Management (LTCM) hedge fund in 1998, and 9/11. The first day that the markets opened after 9/11 was on September 17, 2001, and the value for PCT_CH_SP500 recorded on that day was less than the value for PCT_CH_SP500 recorded yesterday (specifically 5.04% versus yesterday’s 5.27%, although two days later on September 19, 2001, PCT_CH_SP500 came in at 5.26%). In terms of their volatility effects, the Asian financial crisis and the LTCM debacle were both largely two-day events, with dramatic drops on the first day followed by dramatic rallies the second day. Here’s what happened numerically in those cases:
Asian financial crisis
|
date |
open |
high |
low |
close |
PCT_CH_SP500 |
|
27-Oct-97 |
941.64 |
941.64 |
876.73 |
876.99 |
6.89% |
|
28-Oct-97 |
876.99 |
923.09 |
855.27 |
921.85 |
7.73% |
Long-Term Capital Management
|
date |
open |
high |
low |
close |
PCT_CH_SP500 |
|
31-Aug-98 |
1027.14 |
1033.47 |
957.28 |
957.28 |
7.42% |
|
1-Sep-98 |
957.28 |
1000.71 |
939.98 |
994.26 |
6.34% |
The title of “granddaddy of volatility” clearly goes to the 1987 stock market crash. Although October 19, 1987 is famous as “Black Monday” (on this day, PCT_CH_SP500 clocked in at 20.47%, the highest value for all data since January 3, 1950) , the month of October 1987 produced 8 days with higher recorded values for PCT_CH_SP500 than what occurred yesterday:
October 1987
|
date |
open |
high |
low |
close |
PCT_CH_SP500 |
|
16-Oct-87 |
298.08 |
298.92 |
281.52 |
282.7 |
5.84% |
|
19-Oct-87 |
282.7 |
282.7 |
224.83 |
224.84 |
20.47% |
|
20-Oct-87 |
225.06 |
245.62 |
216.46 |
236.83 |
12.96% |
|
21-Oct-87 |
236.83 |
259.27 |
236.83 |
258.38 |
9.48% |
|
22-Oct-87 |
258.24 |
258.38 |
242.99 |
248.25 |
5.96% |
|
26-Oct-87 |
248.2 |
248.22 |
227.26 |
227.67 |
8.44% |
|
28-Oct-87 |
233.19 |
238.58 |
226.26 |
233.28 |
5.28% |
|
29-Oct-87 |
233.31 |
246.69 |
233.28 |
244.77 |
5.75% |
Today, the Wall Street Journal provided a remarkably diverse set of editorials on one specific topic; i.e., the so-called subprime “bailout”. These editorials range from Jesse Jackson’s article entitled “A Marshall Plan for Mortgages” to Treasury Secretary Henry Paulson’s article entitled “Our Plan to Help Homeowners” to Brian Wesbury’s article entitled “Let’s Not Panic and Ruin the World”.
So goes the title of Jon Markman’s essay; Markman basically echoes some of the objections which I raised in my earlier posting entitled “subprime crisis and moral hazard”.
In this morning’s Washington Post, there is an article entitled “Paulson Outlines Mortgage Aid Plan”, which provides some details concerning the Bush administration’s mortgage-relief plan. Today’s Wall Street Journal has an editorial about this plan entitled “No Bailouts for Borrowers”. The WSJ article correctly points out a very important unintended consequence of what is clearly a well meaning but misguided public policy; that is, that sometimes the medicine can be worse than the cure.
The proposed intervention would take us down all kinds of slippery slopes. One must consider that if this plan or some variation of it actually gets implemented, then it may very well prospectively create problems in terms of availability and affordability of mortgage financing in the U.S. economy. Investors who purchase mortgage-backed securities will rationally price in the political risk of future interventions, which will in turn raise the interest rates offered for new mortgages. While Secretary Paulson insists that this will not be a taxpayer-financed bailout, an important aspect of the plan has state and local governments acting as financial intermediaries in that they would use their bonding authority to effectively enable distressed homeowners to sell investment grade tax exempt bonds. There is no free lunch; if state and local governments use up debt capacity in order to provide this funding, it will limit their ability to issue bonds in the future on favorable terms. Finally, as the WSJ article points out, there is also a serious moral hazard with the Bush administration’s mortgage-relief plan, in the sense that “…the federal government would set a troubling precedent and encourage irresponsible behavior in the future by bailing out homeowners (and, indirectly, lenders and investors).”