The Importance of Price Signals in the MBS Market

Brad DeLong replies to my post on whether hedge funds helped to stabilize the MBS market with a subtle but powerful argument. If I may attempt a paraphrase: hedge funds are marginal price-setters, and in financial markets a very large number of people look at marginal prices as part of a constant process of re-evaluating their own idea of what securities are worth. If a few hedge funds started pushing down the price of the ABX index, a lot of investors might immediately have had second thoughts about the mortgage market more generally, without the long chain of arbitrage which would otherwise have been necessary.

It's a good point, but also a limited one. This kind of effect, I think, can only really happen in markets which already are at an inflection point. If the MBS market is in full overdrive, weird price action over at the ABX isn't going to make much of a difference. If the market is nervous, however, and just needs an excuse to turn, then it will pick on anything - it might be the ABX index, but on the other hand it might be something much more fundamental like subprime default rates.