Can There Be Market Solutions With No Real Markets?

from Barry Ritholtz

“I don’t know of any economist who doesn’t believe that better functioning capital markets in which assets can be traded are a good idea.”
- Lawrence Summers

There are Markets, and then there are markets. I am less sure that Larry Summers understands the differences between the two. ...

Summers is part of a group whose ideology is that Markets are a solution to many of our economic woes. I don’t necessarily disagree with this, except on the definition of what a market is. Indeed, what many economists and free market zealots call “Markets” are somewhat misleading. A place where people come together to buy and sell goods is a small “m” market — a bazaar or flea market — and may not be ideal for what some people expect from capital “M” Markets. Consider purposes of price discovery, information transmission, transaction efficiencies that are less than ideal in markets where the goods are non-uniform, information is expensive or time consuming to obtain, where transactions are infrequent, and where expertise is rare. (I’ve made many of the same point regarding prediction markets, also).

And that pretty much describes the RMBS and CDO markets. Its is one of the primary reasons why there was no exit when toxic securitized paper needed to be dumped.

The major Markets — Equities, Fixed Income, Commodities, Futures, Options and Currencies — have on a daily basis billions of transactions worth trillions of dollars. They are broad, deep, liquid. You can sell any of these assets, in size, instantaneously.

And this points out why the decision to buy any size in RMBS, CDOs and even CDS was so problematic. The commercial and investment banks and funds that chose to invest in these “financial products” – difficult to value, thinly traded, non-uniform — was the root of the problem...

The banks made a poor decision: “Let’s bypass the broad, deeply traded traditional markets and instead create new markets for new products.” Not only that, but they dove headfirst into these markets in huge size. No one should be surprised that the net result was a flawed system of garbage paper, with too little room at the exits in case of emergency...

Buying billions of dollars of securities when there is no easy exit, no liquidity, and no transparency is near the top of the list of really dumb things the banks did.