Monday, April 28, 2008

Did Hedge Funds Help Stabilize the Mortgage Market?

(Felix Salmon) Brad DeLong approvingly quotes a correspondent:

The fact that there was an ABX index and thus an easy way for people to bet that the mortage-backed securities market would crash probably cut short the bubble--the true hedge funds were stabilizing speculators; the destabilizing speculators were (i) the funds that were long CDOs and (ii) the banks and other issuers who retained the CDOs because their portfolio managers believed their marketeers. A world without derivatives but with mortgage-backed securities would probably be a world in which we have a bigger problem than we have now.

I've heard this argument made before, by Sebastian Mallaby; I didn't buy it then, and I don't buy it now.

It's easy to be awed by the sums of money made by John Paulson and the Goldman Sachs mortgage desk. But compared to the amount of money tied up in RMBS, the profits made by shorting mortgage-backed securities have been tiny. For Paulson to have played a significant role in stopping the mortgage-backed credit bubble from continuing to exapand, he would have had to have been orders of magnitude larger than he was.

But more to the point, the ABX index is an index of CDS spreads referencing subprime RMBS. The chain of arbitrage which would lead from shorting the ABX to RMBS prices falling is long and convoluted: first any drop in the ABX would have to be arbitraged by buying the ABX whilst selling buying protection on the underlying CDS contracts. Then any widening in those underlying CDS contracts would have to be arbitraged by selling protection on the RMBS while at the same time shorting the underlying bonds. (Good luck trying to do that. And of course this isn't a risk-free arbitrage, since CDS and bonds have been behaving in idiosyncratic and dissimilar manners of late.) Then any drop in the price of the specific RMBS which underlie the CDS which underlie the ABX would have to be arbitraged by buying up those bonds while selling the broad mass of other RMBS, creating generalized downward pressure on the secondary-market prices of subprime RMBS. Then a drop in secondary-market RMBS prices would have to be arbitraged by investors buying up secondary-market securities rather than the primary-market securities being offered to them by the investment banks structuring the RMBS deals, and this would have to be a common enough occurrence that the yields on primary-market RMBS deals would rise as a consequence. Finally - as if all that wasn't improbable enough - the higher yields on these RMBS deals would have to somehow feed through into fewer of those deals being done, and less demand from investment banks for securitizable mortgages.

I'm quite sure that's not what happened in reality. Yes, the people who shorted the ABX made a lot of money, but they made money because the RMBS market imploded for reasons utterly unrelated to - and not even precipitated by - the fact that a few hedge funds and prop desks were shorting the ABX. In other words, a world without derivatives but with mortgage-backed securities would probably be a world in which the RMBS market would still lie in tatters, and the only real difference is that John Paulson would be a great deal less wealthy than he is now.

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