Merton on the Crisis

Nobelist Robert Merton gave a talk on the crisis, and he had a few novel points.

First, everyone castigates the markets for creating really complex instruments like derivatives, such as credit default swaps and mortgage backed securities. But, compare these assets to the assets and liabilities within a company: goodwill, deferred tax expense, intangibles, patents. Who can value these from first principles? Further, the company has the ability to change its business mix at any time, creating new products. We happily trade equities of these companies, and these are residual claims on this pyramid of assets and liabilities. Thus, the complexity of a mortgage-backed security of any sort is actually quite modest in that context. The complexity is not the key problem, in his view.

Secondly, he notes that when people extend debt, they aren't used to a portfolio that is in this kind of distress. So, take a bond trader used to managing his risk via hedging with Treasuries. The interest rate risk is paramount, and exposure to the stock market infinitesimal. After this major credit event, the sensitivities of his portfolio with equities is greater than his sensitivity to interest rate risk. This change is new to him, and he is confused. Looking at this like a put option that goes from out of the money to in the money, highlights how this regime change can happen, how a sensitivity to equity and volatility change goes from zero to material.

He argues we don't need a new paradigm to explain this, even mentioning 'Black Swan' by name. I agree that the concept of Black Swans is unhelpful, but I think the existing paradigm needs something new to explain this, in terms of the transmission mechanism.