How much is that subprime-linked CDO in the window?

The magic of "price discovery" broke this summer, says a central banker. But don't ask government to fix it.

Published October 22, 2007 7:53PM (EDT)

"Over the past several months," Federal Reserve governor Randall S. Kroszner said in a speech Monday morning, "in some financial markets ... the price discovery process appears to have actually broken down."

Did an earthquake just shake the Chicago School? The role of free markets in determining the price for, well, just about anything, is at the heart of that particular branch of economics most often associated with Milton Friedman. For this crew, "price discovery" is the magic mantra that solves everything.

Kroszner, speaking at a breakfast sponsored by the Institute for International Bankers, provided a handy definition:

When markets are functioning properly, one of the key roles that they perform is what economists refer to as "price discovery." Essentially, price discovery is the process by which buyers and sellers' preferences, as well as any other available market information, results in the "discovery" of a price that will balance supply and demand and provide signals to market participants about how most efficiently to allocate resources. This market-determined price will, of course, be subject to change as new information becomes available, as preferences evolve, as expectations are revised, and as costs of production change.

Judging by his résumé, Kroszner, who did a stint as a professor at the University of Chicago, served as one of Bush's Council of Economic Advisors from 2001-03, and was editor of the Journal of Law & Economics before joining the Fed, sounds like a Chicago Schooler himself. So we should perhaps regard his comments on price discovery breakdown carefully.

The locus of the confusion comes as little surprise: those highly complex and opaque financial instruments known variously as collateralized debt obligations and collateralized loan obligations. Despite having access to literally the best financial minds money can buy, the institutions and investors busily trading such derivatives did not know what they were truly worth.

Why, in this instance, did price discovery go awry? Kroszner pinpoints two reasons. First, investors failed to conduct the necessary due diligence required to properly evaluate the risk involved in these financial instruments. Second: The complexity of the newfangled concoctions made them inherently harder to figure out.

Kroszner's prescription for solving the problem: Do more due diligence! Hire better, smarter people, and devote more resources to risk analysis! In other words, do a better job.

Notably, Krozner makes no reference to any potential governmental role in this process, such as, for example, statutory requirements for the kind of increased disclosure or transparency that would make it easier to make sense of these derivatives. Instead, we should just rely on the good old invisible hand, and after a little turbulence the markets will reassess all the toxic waste screwing up the balance sheets of Citigroup et al. with the appropriate price tags.

Is such faith in price discovery justifiable? I wonder if any of the international banking lobbyists listening to Kroszner were pondering the implications of a Wall Street Journal article published Monday morning: "Options Bets on Crude Could Pull Prices Higher."

Energy traders, reports Matt Chambers, are beginning to bet on the likelihood of $100 a barrel oil in December.

As of Thursday, there were nearly three times as many options held to buy the December crude-oil-futures contract at $100 a barrel as there were to sell the contract at $80, according to Nymex data ...

Concentrations of bets on options at certain levels can act as a magnet for crude-oil prices as the options-expiration date approaches, as big traders try to push futures prices to levels where their options positions become profitable.

The italics are mine. Unless I am missing something, that sentence basically states that big energy traders manipulate the market so as to increase their profits. How exactly does that jibe with the notion that a price discovery process efficiently allocates resources? If my heating bill goes up because an energy trader pushed the price of natural gas up beyond where the laws of supply and demand would indicate, I am being harmed while someone else cashes in.

As noted previously in How the World Works, the emergence of new, unregulated electronic commodity exchanges allowed energy traders to manipulate markets under cover of darkness. Higher energy bills for everyone ensued because a few big players gamed the market.

Kroszner seems to be saying that after a bumpy ride, the market will be better equipped to handle the new complexity of modern financial innovation. But in the meantime, the fallout from the proliferation of complex derivatives tied to the housing sector is all around us: mounting foreclosures, bankruptcies, a general slowing of the economy. Because remember -- the housing bust did not necessarily cause the credit crunch all by itself. It was at least a two-way street; Wall Street's greed for high-yielding risk created a clear incentive for the subprime mortgage boom. Isn't it possible that if government had stepped in and required a little less opacity, we might all be better off?

By Andrew Leonard

Andrew Leonard is a staff writer at Salon. On Twitter, @koxinga21.

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