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.