Finance and Econ 101 again

Over at Felix Salmon’s blog, the discussion of synthetic CDOs has included comments like “there was unlimited demand for the AAA tranches” and “the supply of underlying bonds was insufficient”.  This inspires the following Econ 101 exam question.

Econ 101 question:  There is a market that is a “black box” — that is, we have very little information about how it operates.  We do, however, have some information about this market:

(i) the supply of the good is universally viewed as insufficient
(ii) demand for the good is excessive, in fact, it’s sometimes described as unlimited

Explain what you think is going on in this market. [Hint: Draw a demand and supply diagram, and then find a situation that we have studied that would have the characteristics of this market.]

Answer:  A price ceiling.  Prices are so low that supply is “insufficient”, but at the same time demand is “excessive”.  These are the characteristics of a market where a price ceiling has been set by government policy.  If demand is actually being met it must come from outside the market — perhaps from abroad.

In a market with a price ceiling — for example, when government wants to keep staple items cheap for consumers — it is very clear that market forces are not operating to bring supply and demand into equilibrium.  On the contrary, the government must act so that consumer demand is actually satisfied — one method is to subsidize production of the good in question.

So when financiers claim that there was “insufficient supply” and “unlimited demand” for bonds, they are describing a classic case of an environment where the market price of these bonds is being held down below the equilibrium price.  This is only possible if some “identical” substitute is being sold to the buyers with “unlimited demand”.  The financiers are pretty clear about how demand was met:  “the synthetic was only useful because the supply of underlying bonds was insufficient”.  In other words, synthetic bonds (or credit default swaps) were used to manufacture a larger supply of mortgage bonds than the market could provide.

Basic Econ 101 analysis indicates that it was these synthetic bonds that made it possible for a disequilibrium environment that looks just like a price ceiling to be sustained in the mortgage market for a prolonged period of time.

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