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How bad news can be good news
This is from an old MR post, summarizing Bernanke's contributions to economics:
1. The theory of irreversible investment, circa 1983. Before Bernanke, Dixit, and Pindyck, models often assumed that investments could be reversed or "taken back." Bernanke outlined how the irreversibility of investment might matter. Often individuals will choose to wait and sample more information, rather than make an immediate decision. Small changes in information could lead to big fluctuations in investment. Large changes in interest rates might have little effect. Bad news can hurt you more than good news helps you. This was Bernanke's first major contribution to economics [and I believe part of his doctoral dissertation].
In this model it is also the case that bad news can cause equity prices to rise. If the bad news resolves outstanding uncertainty, people may be willing to go ahead and invest, rather than continue to play wait and see. One way to think about it is that the news could always have been even worse, so bad news can in effect be good news. Another way to think about it is even truly bad news gets the waiting over with and spurs investors to cross a "do something" threshold. Now I'm not saying that is what happened today, I'm just saying that maybe this thought crossed Bernanke's mind...
Addendum: Elsewhere in the wonderful world of finance, here is why Bear Stearns is selling for more than $2 a share...
Posted by Tyler Cowen on March 18, 2008 at 04:41 PM in Economics | Permalink
Comments
I don't understand. Why doesn't bondholder A choose to avoid the $2 loss on the share by letting bondholder B make that little sacrifice?
Posted by: dearieme at Mar 18, 2008 5:34:29 PM
If you're going to pay $7/shr to vote for a deal that will cause you a 70% loss ($5/shr loss) in order to protect your stake in a bond, the bond better have been trading damn near zero.
This is one of those ex post rationalizations - the narrative fallacy - that makes sense until you consider the economics of the transaction
Posted by: at Mar 18, 2008 7:07:01 PM
The marginal gains from holding an amount of equity, in terms of securing an individual bondholder's position, are sufficient enough to eat the share haircut. Normally there would be a commons problem, but here the gains are great enough to spur individual action.
Posted by: Petrarca at Mar 18, 2008 7:07:02 PM
7:07:01 has it wrong. If your own equity purchases increase the chance of a deal going through by 2% and cost you $40mln, then it strictly dominates doing nothing if your bondholdings are trading at 75% of the $10bln they'd be worth if backed by JPM. The size of the bonds held, relative to the cheap option of picking up BSC stock, justifies equity purchases.
Posted by: Petrarca at Mar 18, 2008 7:14:40 PM
Actually the main reason BSC is up is daytraders and speculators.
This happens all the time with "dead stocks" facing bankruptcy. The crazy rally in the other financials, esp. Lehman, simply encouraged traders to chase this puppy up the wire. . .
Posted by: Matthew at Mar 18, 2008 9:34:02 PM
Your contention that "bad news can cause equity prices to rise" is misleading. "Bad" and "Good" are relative terms, therefore if the news is 'good' is is 'good' relative to expectations, and if the news is 'bad', it is 'bad' relative to expectations.
Think about this: Does it make sense to consider the 'goodness' or 'badness' of a piece of information independent of expectations/circumstances? Of course it doesn't. Therefore, the 'goodness' or 'badness' is relative to the circumstances.
"the news could always have been even worse, so bad news can in effect be good news." Inversed reads - "The news could always have been better, so good news can in effect be bad news"
>>> If the news is better that what the investor expected, then it is 'good' news, it if is worse that expected, then it is 'bad' news.
Another way to think about it is even truly bad news gets the waiting over with and spurs investors to cross a "do something" threshold (but SO DOES GOOD NEWS).
>>> What if passing the "do something" threshold is a bad thing for me?
I suggest you rephrase your contention that "bad news can be good news" into something like the following:
"What would be 'bad news' in normal circumstances, may not be 'bad news' in special circumstances"
Posted by: Mao Enn at Mar 19, 2008 5:54:05 AM
mao...I suggest you get your own blog, and try to write topics that fit in news readers well/subject lines well, and are interesting. Good luck with that.
Posted by: shawn at Mar 19, 2008 8:33:55 AM
Irreversibility of time is one of the major foundations of Post-Keynesian economics.It is not a new idea.Many things have already been written on this by the PKs.
Posted by: GVV at Mar 19, 2008 9:45:17 AM
I'm glad somebody brought up the free rider problem (though they called it a commons problem).
The only thing which has to happen to make people willingly eat an equity loss is that sufficient debt is held by individual actors and that these actors feel that the deal is sufficiently close to going through to make their contribution worthwhile.
Now, the real game becomes one of chicken. If I know that my neighbour is in the same position as me then why don't I let him take the equity hit instead of me?
Posted by: A. Nonymous at Mar 19, 2008 11:04:55 AM
Commenting after midnight = I'm just glad I commented on the right post.
Posted by: Petrarca at Mar 19, 2008 12:08:50 PM
I think one of the last commenters on Salmon's site hit it exactly. A *lot* of people were holding short positions on Bear and made some nice profits. But they have to buy the stock at some point to cover. So current stockholders are trying to ring a few extra dollars out of the positions by refusing to sell at 2+epsilon, confident that they will for sure get 2 when the deal goes through, no downside but a lot of upside to demanding more than $2/share. Short sellers OTOH, have the opposite situation, their further profit is limited, but exposure in the event of a black swan that scuppers the deal *and* sends Bear's value back to "normal" is huge.
So most of them will be willing to cover at more than 2+epsilon rather than try to wring an extra few cents out of the deal. Apparently this de-straddle hedge is considered to be worth $5/share right now. Seems high to me, but the idea it is worth something significant isn't far-fetched. I would have expected 1-2/share, but it may be there are more shorts open than people who really need to sell so sellers are playing chicken with the short holders, apparently fairly successfully.
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