Markus Brunnermeier's presentation and the Negative Feedback Loop

Much has been written lately about the unintended consequences of investing through financial intermediaries.  Of course the intent is for the intermediaries to coordinate the transfer of capital from less productive to more productive uses. This gives the owner of less productive capital an opportunity for a higher return when their capital is used for more productive purposes. Capital is provided to those who can employ more than have, giving them an opportunity for a greater return.  The intermediaries charge a fee for the service of coordinating the parties involved and their transactions.  Everyone is happy because everyone makes money.  Sometimes.

For the last couple of years, the media has been highlighting a laundry list of things that can cause an investment to go bad. From price shocks to fraud and lack of due diligence to intention misrepresentation, the list goes on and on.  Markus Brunnermeier gave a lecture based on his paper, “A Macro-Model with a Financial Sector” that he is writing with Yuliy Sannikov. In the lecture he mentioned several reasons why investments may not work out as planned and he showed how he was modeling them.   He illustrated the benefits of “inside money”.  Examples would be an intermediary putting its own money at risk give incentive for monitoring the investment which helps lower the investors’ risk, or an entrepreneur having money at risk in the investment as an incentive to increased effort.

It was difficult for Dr. Brunnermeier to cover all his material in 90 minutes so I surely could not do all of his work justice here. Instead I’ll just mention the part that stuck out for me the most, the negative feedback loop.  Normally negative shocks are modeled as causing a lower payout for the investment and this behavior is described as linear.  Dr. Brunnermeier noted that these model work near the steady state but they do not hold below the steady state so a new model is required.  The reason is that when shocks are large enough leveraged intermediaries not only reduce payouts but they must also sell assets at fire sale prices.  These fire sales cause asset prices to fall leading to a feedback loop where lower asset prices reduce intermediaries’ net worth causing them to sell assets to raise funds to meet leverage requirements.  So much for buy low and sell high.