Fire sale prices versus stagnation prices

The concept of “fire sale prices” is a useful one in many contexts – some examples are the October 19th 1987 US stock market crash, the LTCM crisis of 1998, and the 2007-8 US credit-liquidity crisis. In all three of these cases, security prices crashed in a particular sub-market, policymakers stepped in providing extraordinary credit-liquidity support, and eventually (quickly in the first two cases, slowly in the last) the capital market situation normalized. Unfortunately, “fire sale prices” is a useless or even harmful analytical tool for understanding the current Irish financial predicament. A better term for current conditions in Irish asset markets is stagnation prices rather than fire sale prices. Policymakers should look to Japan circa 1991 and the following two decades, rather than the USA, for a useful historical precedent. The fire sale concept gives the wrong policy guidance in the Irish situation; it is metaphorically like trying to use a fire hose to drain a swamp.

Andrei Shleifer and Robert Vishny have a series of papers exploring the use of the fire sale concept in modelling financial markets. There has been a large outpouring of papers by other authors with similar or related models, but the Shleifer and Vishny model is clear and simple and their survey is particularly good. They provide a definition:

“A fire sale is essentially a forced sale of an asset at a dislocated price…. Assets sold in fire sales can trade at prices far below value in best use, causing severe losses to sellers.”

They discuss how fire sales can cause financial and macroeconomic instability via credit and liquidity channels. In a related paper they laud US policymakers for their prompt and correct response in 2007-9 in injecting massive credit and liquidity into the markets for mortgage-related and credit-related securities caught up in the fire sale environment of 2007-9.

Fire sale mitigation policies are unusual as economic policies in that, as a rule, they should result in a net profit for the policymaker. This follows from the theory of the limits to arbitrage. This certainly seems to apply in the US case – the Federal Reserve made a trading profit of $79.3 billion in 2010 and $76.9 billion in 2011. The Fed vastly outperformed the best-performing hedge fund both years, at U.S. civil service pay rates, and without actually trying to make a profit. TARP was also profitable or near profitable, after an adjustment for the expensive but necessary bail-out of the US automobile industry. This is the nature of fire sale mitigation policies – they are about buying securities slightly below fair value and holding them temporarily on government account while injecting liquidity and credit.

The bad news is that this has near-zero relevance for Ireland. Irish asset markets are not suffering from a fire sale problem but rather from a long-horizon stagnation problem. The appropriate comparison case is not from the USA but rather Japan circa 1990. Japanese policymakers and financial institutions worked endlessly to slow the pace of adjustment, leading to an almost twenty year period of stagnation, suppressing growth and business innovation, and leaving a massive overhang of government debt. Irish asset markets need to be forced to adjust quickly and reach their new (much lower) equilibrium values with un-frozen free trading and clear, public pricing. This applies to banks, collateralized pools of debt, commercial leases, and commercial and residential property. Preventing this from happening is not preventing a “fire sale” rather it is guaranteeing a long stagnation. It could even last twenty years, as in Japan.

Another question – what is it about the US environment that gives rise to fire-sale-induced financial crises of typically short duration? Part of the answer lies in the USA lead in financial innovation. New financial innovations were key to all three fire-sale market crashes mentioned in the first paragraph of this post (portfolio insurance, statistical arbitrage, and numerous CDO innovations, respectively). High-frequency trading (the most recent big innovation) will be the likely cause of the next fire-sale-related crash, if one comes in the USA.* Ireland seems to avoid these fire-sale crashes, but is plagued instead by long-lasting periods of stagnation. Let us hope the current one is not dragged out for a decade.


*A post-script on HFT and the Tobin tax. After my last blogpost, Frank Barry asked me to give more details about Tobin’s use of the term “sand in the wheels” and its application in old-fashioned engineering. I do not know that much about the engineering use of sand in the wheels – I only heard Tobin discussing it in an interview. I now know that historically the sand in the wheels technique was used in the case of a metal (steel or iron) wheel aligned on a track and needing better grip, such as an old-fashioned railway wheel on a wet track. It is used for wheel-type mechanisms and not for gears with teeth. See Wikipedia for some details for those with an interest. I remember Tobin saying he was annoyed that many commentators mistook him as suggesting sabotage, and I remembered that key idea correctly. Sand in the wheels is a technique to improve, not hinder, performance.

Nama’s Property Price Insurance Scheme

A little bit more detail has emerged (via press interviews rather than detailed technical documents) about the Nama property price insurance scheme as it is currently proposed. The basic design was leaked to the press in early July, and was discussed in my earlier thread. The emerging details of the scheme as announced so far are not reassuring. The scheme has considerable potential to manipulate recorded property sales prices, to damage confidence in Irish property market openness, and to build up a hidden future cash flow liability for Irish taxpayers. The motivation given by Nama for implementing the scheme is not entirely convincing.

Forbearance and Frontrunning in Irish Property Markets

The most recent Financial Stability Report from the Bank of England warns about the danger to U.K. economic stability from excessive debt forbearance by U.K. domestic banks. The governor of the Bank of England, Mervyn King, put stress on this risk in his speech introducing the report (although he also noted that this does not mean that forbearance is always a bad thing). In the report, only the potential UK fallout from the Euro crisis ranks more highly than excessive debt forbearance on the list of risks to the UK banking system. This should ring alarm bells in Ireland, since the level of debt forbearance in Ireland at present is much higher than in the U.K.  Encouraging debt forbearance is a deliberate Irish government policy, and the extreme level of forbearance by domestic Irish institutions is storing up potential problems for the future.

There is a considerable overhang of unwanted or distressed (in some cases unfinished) property assets in Ireland (see Ronan Lyons and Namawinelake for discussion). The smart-money players (foreign-owned banks with Irish property assets) might front-run the slower-footed players (domestic, taxpayer-owned banks and Nama) by selling relatively quickly, leaving the Irish taxpayer to fund any eventual shortfall. (I am including the IBRC, the vestiges of Anglo Irish and Irish Nationwide, in my definition of domestic banks.) So loan forbearance and front-running in Irish property markets could interact to the detriment of taxpayers.   


Nama’s Mortgage Enhancement Scheme

In today’s Irish Times, Fiona Reddan has an interesting short article about Nama’s planned mortgage-enhancement scheme. The scheme is intended to unload some of Nama’s large inventory of houses and flats without unduly lowering property prices.  The scheme, at least as it has been described so far, will work as follows.  Suppose that Nama wants to sell a particular flat for 100,000.  It will offer a buyer the following deal. The purchaser must put down 10,000 in cash, and take out a mortgage from a bank for 72,000.  Nama will pay (itself) the remaining 18,000 and record the flat as sold at 10,000+72,000+18,000 = 100,000.  If after an initial period, say five years, the fair market value of  the house is more than 82,000 (the amount already paid by the homeowner) than the homeowner must “top up” the difference to a maximum of 18,000.  If the fair-market value of the house is 82,000 or less at this date, the homeowner has no need to pay the remainder.

NCC report on costs of doing business in Ireland

The National Competitiveness Council has just published the Costs of Doing Business in Ireland Report 2011.

You can download it from here.