August 7, 2009
I continue to be amused and perplexed by ongoing comments from investment practitioners and commentators, lambasting the role of finance theory and its apparent proponents (the mathematical modeling folks) in the current financial crisis. At the very least we are told that finance theory has finally been debunked or disproven, and in more rhetorical pieces it is almost implied that the theories and their proponents may have in some insidious way caused the crisis. Since I think it is absurd to believe that finance theories played a significant role in the crisis, a few basic truths need to be stated!
In addition to a generic “anti mathematics” tone, these critics usually mention one or both of two theories: the Efficient Markets Hypothesis (EMH) and Modern Portfolio Theory (MPT). One way of summarizing the EMH is that investors can’t consistently beat the market over time because all available information is factored into market prices. Markets efficiently process all information. Sometimes people say that this means that “markets are rational,” but to the extent that claim has any meaning, it is just a way of restating that all information is factored into prices at any point in time. It certainly does not mean that the individual players in the market are rational, just that the sum of all their (perhaps irrational) actions leads to efficient pricing.
Modern Portfolio Theory (really a set of economic theories) adds structure to the EMH’s description of markets. In its simplest form, strong assumptions about information efficiency and investor rationality lead to the hypothesis that all investments should be priced relative to their “systematic” risk --- their exposure to the underlying market. To the extent that individual security prices differ from the price implied by their market exposure, this difference is “noise” or random. This means that all investment portfolio outcomes are a combination of (a) exposure to the market plus (b) random noise that is larger or smaller depending on how the portfolio differs from the market.
Now most of Wall Street, Bay Street, and any other streets on which investors and investment product developers live, have to believe that both EMH and MPT are wrong. If you are an investment manager who is trying to “beat the market”, you are buying securities --- equities, bonds, options, currencies, spreads of all kinds --- that you think are “cheap” or undervalued --- hence not efficiently priced. You are also selling securities that you think are “expensive” or overvalued --- again mispriced. You might be wrong, but that’s what you think.
If you are a product developer and innovator at Goldman or Lehman, you in fact know that the product you are creating and selling is mispriced, and that if you get the prices you expect you will make excessive profits. This happens because the buyer you have identified has no idea how to price it correctly, and is willing to accept your story. In other words information is “asymmetric” and not processed efficiently. There is a slight possibility that this buyer believes in EMH and MPT, but chances are buyers of new product lines are active managers and are looking for excess returns as well.
I have seen many citations of Long Term Capital Management (LTCM) as an example of EMH/MPT theorists being given their comeuppance --- I guess because several high-powered academic theorists were involved. But let’s not be silly. LTCM put on thousands of positions that they believed were mispriced or cheap (in violation of EMH and MPT), and they used huge leverage in the process. It turned out that they were under-diversified and essentially unhedged, because most of their positions moved in the same direction. They blew up because of leverage: a small move against them essentially wiped out their capital. Had they been able to “hang on,” and had spreads narrowed as expected (and as they eventually did), they would have made a huge fortune. As it was, their “rescuers” made the money instead! (Note to reader: if you don’t understand this point, please don’t even think about using leverage!)
The perpetrators of mortgage derivatives certainly did not believe in EMH or MPT. From the beginnings on the trading desk at Salomon, to the high-leverage mortgage sales force all over America, we have explicit violation of EMH: sellers always knew much more than the buyers. In fact you might say that it is indeed a lack of efficient market pricing that has caused the current crisis:
So why do people continue to talk about finance theory and its role in the financial crisis? As far as I can tell, almost no one involved in the various aspects of “making money” in the investment business believed in, or acted upon any of the tenets of, finance theory. The “mathematical modelers” are just part of the system, trying to use broader data sets and statistics to find the mispricings that most professional investors believe they can find and exploit.
The best I can come up with is the idea that EMH and MPT might have given some people, especially regulators, a false sense of security. Perhaps the Fed and Mr. Greenspan were less concerned about the asset pricing bubble than they should have been. I find the links a little tenuous, to say the least. The strongest point that I think is reasonable is the possibility that regulators used the EMH to justify their actions (or inactions) that were actually driven by their deeper-held ideologies.
The reality is that the old stand-by's of widespread greed, excessive leverage, and investment mistakes, all accelerated by group think and market momentum, fueled the crisis as they have so many times in the past. As the oft-quoted Chuck Prince of Citi said in July 2007 with respect to the M&A buyout boom still running rampant at the time:
“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing".
Four months later he was no longer in charge because he couldn’t stop dancing in time. Too many others remain on the job even though they didn’t stop dancing either. I hold little hope that “next time will be different” if investors refuse to seriously analyze the true causes of their difficulties and failures