In a New York Times piece of March 23, “It’s Hard to Thaw Frozen Markets,” Tyler Cowen concludes that “regulators should apply capital requirements consistently to the off-balance-sheet activities of financial institutions.” That conclusion follows from a surprisingly innocent confidence in regulation in general and capital requirements in particular. But it also follows from a faulty analysis of the situation.
Cowen writes, “What is distinctive today is the drying up of market liquidity — the inability to buy and sell financial assets — caused by a lack of good information about asset values.…The results have been a form of financial gridlock.”
To explain this alleged “drying up” process he says, “Starting in August, many asset markets lost their liquidity, as trading in many kinds of junk bonds, mortgage-backed securities and auction-rate securities has virtually vanished.” Cowen thinks “market prices have been drained of their informational value” in “many asset markets.”
With the possible exception of mortgage-backed securities, that seems fanciful if not absurd. The spread between junk bonds and Treasury widened mainly because Treasury yields fell, but there is massive trading in such bonds. Sales of nonfinancial commercial paper have grown briskly this year, and so have sales of financial paper aside from the “asset-backed” variety. There may be little trading of mortgage-backed securities, but that just suggest many owners (unlike, say, e‑Trade) are in no hurry to sell at prices low enough to attract borrowers.