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Calamity Markets

Dec 20, 2010 • 224 Views

Some markets are distressed.

For close to 30 cents on the dollar, firms that purchase distressed securities have offered to buy loss claims from victims of the Madoff fraud. Instead of waiting for the settlement process to unfold for undetermined amounts, those who prefer money now can sell their claims. Already though, the market has shifted because of recent news about a $7.2 billion payback from a Madoff investor.

Describing the distressed securities market, The Economist had a good article several years ago. They explained that, “When sentiment turns after a long bull run, the market usually overreacts…Those gutsy enough can enjoy rich pickings.”

Examples?

1. During the 1780s, speculators (also called vultures and bottom fishers) purchased Revolutionary War bonds at a discount from investors who originally purchased them. Then, when the national government fully funded the debt in 1790, the speculators profited.

2. Currently, we could equate doubts about Greek sovereign debt with Revolutionary War securities. Here too, a government borrowed a lot more than some investors expect it to be able to repay. As a result, Greek bonds have been called distressed securities. You might want to look at this map of eurozone debt to see areas of the most distress.

The Economic Lesson

A market is a process through which demand and supply determine price and quantity of a good or a service. When demand and/or supply shift, so too does price.

Called the determinants of demand, the reasons that a demand curve shifts include changes in income, the impact of a substitute or complementary good or service, the number of buyers in a market, and future expectations. On the supply side, the curve primarily shifts because of the cost of production. Cheaper production means higher potential profits and the willingness of suppliers to increase production. Also, changes in the number of suppliers and future expectations of suppliers can move the supply curve.

Looking at the movement of a demand or supply curve can provide insight. For example, why did the price for distressed Madoff securities rise? The $7.2 billion Madoff payback has shifted the supply curve to the left because the future expectations of Madoff victims changed. As a result, equilibrium price approached 50 cents on the dollar.

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