(Some of…) What the GFC says (Some of…) What the GFC says about Finance (and vice versa)about Finance (and vice versa)

David JohnstoneDavid JohnstoneNAB Professor of FinanceNAB Professor of Finance

University of SydneyUniversity of Sydney

The Efficient Market HypothesisThe Efficient Market Hypothesis

Markets react (quickly) to new informationMarkets react (quickly) to new information

Corollaries:Corollaries: Market prices impound all available information, or Market prices impound all available information, or

at least all public informationat least all public information

You can’t make money from public informationYou can’t make money from public information

Cynic’s joke – Cynic’s joke – “don’t pick up $10 notes on “don’t pick up $10 notes on footpath, they are not there”footpath, they are not there”

The “beautiful game”:The “beautiful game”: Market price reaction to goals Market price reaction to goals

SwedenSweden vs. Nigeria (Final score 2-1, goals scored at 31 vs. Nigeria (Final score 2-1, goals scored at 31stst (0-1), 39(0-1), 39thth (1-1) and 83 (1-1) and 83rdrd (2-1) minutes. (2-1) minutes.

Contract: Pays $100 if Cubs win game 6 (NLCS)

Price of contract

(Probability that Cubs win)

Cubs are winning 3-0 top of the 8th

1 out.

Time (in Ireland)

Fan reaches over and spoils Alou’s catch. Still 1 out.

The Marlins

proceed to hit 8 runs in the 8th inning

[Source: Wolfers 2004]

Markets cannot see all that is comingMarkets cannot see all that is coming

Why EMH analogy breaks downWhy EMH analogy breaks down

EMH says nothing about the stock price being right in any EMH says nothing about the stock price being right in any sense, just that it reacts to new informationsense, just that it reacts to new information

The direction of the reaction is not predicted (except The direction of the reaction is not predicted (except afterwards)afterwards)

There is never a true stock price, so no way to test the There is never a true stock price, so no way to test the market’s positionmarket’s position

It’s more a Keynesian beauty contest (informed participants It’s more a Keynesian beauty contest (informed participants may invest contrary to their own valuations – thus delaying may invest contrary to their own valuations – thus delaying “price discovery”)“price discovery”)

Hard to bet against a stock (unlike a soccer team) (the Hard to bet against a stock (unlike a soccer team) (the “limits to arbitrage”)“limits to arbitrage”)

Luck and bull markets keep “noise” traders in the gameLuck and bull markets keep “noise” traders in the game(that’s before you allow for all the behavioural drivers)(that’s before you allow for all the behavioural drivers)

Market price = “consensus” view, hence maybe sillyMarket price = “consensus” view, hence maybe silly

Conclusion on EMHConclusion on EMH

Either (1) it says nothing testable, and is thus like Either (1) it says nothing testable, and is thus like a religious teneta religious tenet

or (2) it fails to capture what people expect of or (2) it fails to capture what people expect of rational markets – namely to foresee at least those rational markets – namely to foresee at least those events that are obviously coming events that are obviously coming (e.g. Dot.Com crash, US housing loan bubble/oversupply, (e.g. Dot.Com crash, US housing loan bubble/oversupply, the worthlessness of Ninja and Liar loans etc.)the worthlessness of Ninja and Liar loans etc.)

NB. Markets are not expected to foresee NB. Markets are not expected to foresee “Black Swans” (e.g. Sept 11) - but what about “Black Swans” (e.g. Sept 11) - but what about “Black Monday” Oct 1987“Black Monday” Oct 1987

Quiggin’s View of EMHQuiggin’s View of EMH

“…“…the dotcom bubble of the late 1990s was, to my mind, a the dotcom bubble of the late 1990s was, to my mind, a clear-cut and convincing example of an asset price bubble. clear-cut and convincing example of an asset price bubble. Anyone could see, and Anyone could see, and many saidmany said, that this was a bubble, , that this was a bubble, but those, like George Soros, who tried to profit by but those, like George Soros, who tried to profit by shortselling lost their money when the bubble lasted longer shortselling lost their money when the bubble lasted longer than expected…”than expected…”

““Even the strongest advocates of the EMH would not seek Even the strongest advocates of the EMH would not seek to apply it to, say, the Albanian financial sector in the to apply it to, say, the Albanian financial sector in the 1990s, which was little more than a series of Ponzi 1990s, which was little more than a series of Ponzi schemes.”schemes.”

http://johnquiggin.com/index.php/archives/2009/01/02/refuted-economic-doctrines-1-the-efficient-marhttp://johnquiggin.com/index.php/archives/2009/01/02/refuted-economic-doctrines-1-the-efficient-markets-hypothesis/kets-hypothesis/

So back to earth – what in Finance So back to earth – what in Finance drove the GFC ?drove the GFC ?

Most people have never heard of EMH so it Most people have never heard of EMH so it can hardly be blamedcan hardly be blamed

The villain (and the hero) is leverageThe villain (and the hero) is leverage– Einstein loved the maths of moneyEinstein loved the maths of money

Simple exampleSimple example

I own $100 and borrow $900 at 10%I own $100 and borrow $900 at 10% I invest at 20%I invest at 20%

My equity after one year is: My equity after one year is:

1000(1.20) - 900(1.10) = $210 (110% profit)1000(1.20) - 900(1.10) = $210 (110% profit)

But if my investment produces -20%, my equity is:But if my investment produces -20%, my equity is:1000(0.8) - 900(1.1) = -190 (290% loss) 1000(0.8) - 900(1.1) = -190 (290% loss)

The ideal – exponential growthThe ideal – exponential growth Start with $100 and run a constantly Start with $100 and run a constantly

rebalanced portfolio with fixed D/Erebalanced portfolio with fixed D/E Say debt costs 5% and assets return 10%Say debt costs 5% and assets return 10%

0

20000

40000

60000

80000

100000

120000

140000

160000

180000

200000

0 5 10 15 20 25 30

Years

Eq

uit

y

no debt (D/E = 0)

D/E = 2

D/E = 5

Now add the human factors Now add the human factors to the maths of leverageto the maths of leverage

Behind the GFC is a complicated array Behind the GFC is a complicated array of sociological and psychological of sociological and psychological factors, all influential and all interacting factors, all influential and all interacting with each other with each other

Finance is becoming now more conscious of Finance is becoming now more conscious of its roots in psychology and sociology and its roots in psychology and sociology and less in physics and engineeringless in physics and engineering

Some sociological factors (at the Some sociological factors (at the corporate/investment banking level)corporate/investment banking level)

A quick and unordered list onlyA quick and unordered list only– Agency problem endemicAgency problem endemic– Huge debt-to-equity models (Priv Equity-nearly Qantas)Huge debt-to-equity models (Priv Equity-nearly Qantas)– Rich short-term rewards for “deals” (fund managers vote Rich short-term rewards for “deals” (fund managers vote

for big corporate salaries and bonuses – rewards then for big corporate salaries and bonuses – rewards then trickle down)trickle down)

– Disrewards for loss of market share (race to bottom)Disrewards for loss of market share (race to bottom)– No dis-reward for failure (moral hazard)No dis-reward for failure (moral hazard)– Use of clever mathematical finance tricks as deal-Use of clever mathematical finance tricks as deal-

makers (e.g. securitization of almost any cash flow makers (e.g. securitization of almost any cash flow stream, mortgage backed securities, derivatives such as stream, mortgage backed securities, derivatives such as credit default swaps, low start loans etc.)credit default swaps, low start loans etc.)

ContinuedContinued

– Reverence for quant finance models (internally and Reverence for quant finance models (internally and externally)externally)

– Financial models dominate “actual business” modelsFinancial models dominate “actual business” models– Belief in statistical arbitrage (collecting pennies in front Belief in statistical arbitrage (collecting pennies in front

of steamrollers) of steamrollers) – Ratings agencies mix the good with the badRatings agencies mix the good with the bad– Faith in all mergers/acquisitions as ways to create valueFaith in all mergers/acquisitions as ways to create value– Sophisticated sales pitches backed by quant and IT Sophisticated sales pitches backed by quant and IT

sophistry sophistry – ““White Shoes” hand over to Masters of the Universe White Shoes” hand over to Masters of the Universe

(“Liar’s Poker”)(“Liar’s Poker”)

““How Ivy League Narcissist Culture How Ivy League Narcissist Culture Killed Wall St” (Kevin Hassett)Killed Wall St” (Kevin Hassett)

Class warfare in the US:Class warfare in the US: Narcissist MBAs bought into “their own” modelsNarcissist MBAs bought into “their own” models Customers rated secondaryCustomers rated secondary MBA grandiose sense of entitlementMBA grandiose sense of entitlement Self-confidence rated higher than integritySelf-confidence rated higher than integrity Wall St now like a modern bridge – designed ingeniously Wall St now like a modern bridge – designed ingeniously

for a good time, not a long time (Roman 1000 year old for a good time, not a long time (Roman 1000 year old bridges in Italy designed with less science but more bridges in Italy designed with less science but more generosity towards those who come next)generosity towards those who come next)

http://www.projo.com/opinion/contributors/content/CT_hasshttp://www.projo.com/opinion/contributors/content/CT_hassett22_02-22-09_0NDBQJT_v16.4003053.htmlett22_02-22-09_0NDBQJT_v16.4003053.html

Some sociological factors (at the Some sociological factors (at the retail client “mums and dads” level)retail client “mums and dads” level)

A quick and unordered list onlyA quick and unordered list only– Agency problem endemicAgency problem endemic– Lenders rewarded for lending more, not betterLenders rewarded for lending more, not better– Cult of financial planners (shifty salespeople or “empty Cult of financial planners (shifty salespeople or “empty

suit” experts?)suit” experts?)– Need to self-fund, great appetite for “investments”Need to self-fund, great appetite for “investments”– Belief that risk = rewardBelief that risk = reward– View that mechanical “get rich” formulae will workView that mechanical “get rich” formulae will work

ContinuedContinued

– Growing appetite for risk - “investments” pay Growing appetite for risk - “investments” pay better than workbetter than work

– Governments subsidise individual “investments”Governments subsidise individual “investments”– Saving/paying back loans no longer seen as Saving/paying back loans no longer seen as

wise (“lazy” money)wise (“lazy” money)– Lifestyle must be maintained/enhanced (have it Lifestyle must be maintained/enhanced (have it

now…)now…)– Consumerism funded by loans funded by China Consumerism funded by loans funded by China

and other countries making the products (loans and other countries making the products (loans then securitizedthen securitized

Michael Lewis’s View on Michael Lewis’s View on Causes of GFCCauses of GFC

Ability of IBs to dress up subprime mortgages as investment grade securitiesAbility of IBs to dress up subprime mortgages as investment grade securities Rubber stamping MBS by Moodys under coercion from Wall StRubber stamping MBS by Moodys under coercion from Wall St Evolution of an even bigger market for side-bets (Credit Default Swaps)Evolution of an even bigger market for side-bets (Credit Default Swaps) New round of commissions for every new repackaging of existing securities, all New round of commissions for every new repackaging of existing securities, all

standing ultimately on cash from mortgage loansstanding ultimately on cash from mortgage loans Use of models that understate (perhaps knowingly) the high correlations Use of models that understate (perhaps knowingly) the high correlations

between default risks in a bad marketbetween default risks in a bad market Knowledge that if it blows up its someone else’s moneyKnowledge that if it blows up its someone else’s money

(J. Seigal at Wharton notes that IBs carried large portfolios of MBS)(J. Seigal at Wharton notes that IBs carried large portfolios of MBS) Unregulated leverage of IBsUnregulated leverage of IBs IBs as corporations rather than partnershipsIBs as corporations rather than partnerships IB employees not hooked into long term rewards/engagementsIB employees not hooked into long term rewards/engagements Moodys getting rich by slackening standards, showing others howMoodys getting rich by slackening standards, showing others how US culture inured to financial risksUS culture inured to financial risks http://www.fool.com/investing/general/2008/11/26/michael-lewis-on-the-financiahttp://www.fool.com/investing/general/2008/11/26/michael-lewis-on-the-financia

l-panic.aspx#l-panic.aspx#

Some psychological factors Some psychological factors (Behavioural Finance)(Behavioural Finance)

Overconfidence (we are all better than average)Overconfidence (we are all better than average) Interpretation of profits as proof of trading abilityInterpretation of profits as proof of trading ability

(what happened to “day traders”)(what happened to “day traders”) ““Regret” when others make profits and you don’tRegret” when others make profits and you don’t Seeing patterns in randomness (Feynman)Seeing patterns in randomness (Feynman) Too little awareness of adverse selection riskToo little awareness of adverse selection risk Hedonic editing, susceptibility to positive feedbackHedonic editing, susceptibility to positive feedback Increasing paper wealth inducing lower risk aversion Increasing paper wealth inducing lower risk aversion Inertia and psychological inability to get out at a loss (or to miss what Inertia and psychological inability to get out at a loss (or to miss what

might be a recovery)might be a recovery) Doubling-up to recover lossesDoubling-up to recover losses Thinking conveniently of “tulip bulbs” as all the same Thinking conveniently of “tulip bulbs” as all the same

(Bookstaber p.175)(Bookstaber p.175) Pyramid schemes still excite (see Bookstaber on Virtual Ponzi)Pyramid schemes still excite (see Bookstaber on Virtual Ponzi)

A Demon of Our Own Design A Demon of Our Own Design (Bookstaber, 2007) The Best Insider View (Bookstaber, 2007) The Best Insider View

According to MarkowitzAccording to Markowitz

““Large positions in CDOs and CMOs were Large positions in CDOs and CMOs were patently visible…how can Citigroup see patently visible…how can Citigroup see inventory grow from a few billion to 30 or 40 inventory grow from a few billion to 30 or 40 billion dollars and not react? …this might billion dollars and not react? …this might occur because the incentive structure occur because the incentive structure encourages risk taking more than protection encourages risk taking more than protection of shareholders…” p.xivof shareholders…” p.xiv

Continued….Continued….

“…“…even a risk manager who got it right might not even a risk manager who got it right might not have been able to carry the day against the have been able to carry the day against the traders. Traders have a self interest in high risk…traders. Traders have a self interest in high risk…in a traders-versus-managers debate, traders win in a traders-versus-managers debate, traders win handily”handily”

(Remember the story in Liar’s Poker about (Remember the story in Liar’s Poker about legendary bond trader John Merewether lording legendary bond trader John Merewether lording over his boss and over his boss and Salomon BrosSalomon Bros icon John icon John Gutfreund) Gutfreund)

Another view of the culture in the IBAnother view of the culture in the IB

“…“…all the firms would have to sell at once to all the firms would have to sell at once to increase their hedges. Palmedo figured it increase their hedges. Palmedo figured it out … selling would drive the market down out … selling would drive the market down even further, which would lead to a even further, which would lead to a downward spiral. But everyone seemed to downward spiral. But everyone seemed to be having too much fun marketing the latest be having too much fun marketing the latest innovation and making money to think innovation and making money to think seriously about this…” p.17 seriously about this…” p.17

So How does Finance Theory So How does Finance Theory Come Out of the GFC?Come Out of the GFC?

Economic logic intact. EMH still vacuousEconomic logic intact. EMH still vacuous Behavioural Finance effects rampantBehavioural Finance effects rampant Quant models are still mathematically correct and often Quant models are still mathematically correct and often

brilliant, just exposed more for how their assumptions can brilliant, just exposed more for how their assumptions can be grossly wrong (some of the time)be grossly wrong (some of the time)

More awareness of unreliable statistical assumptionsMore awareness of unreliable statistical assumptions Unhedged “believers” in models losing their own money Unhedged “believers” in models losing their own money

look foolish (e.g. Scholes and LTCM, failed IBs)look foolish (e.g. Scholes and LTCM, failed IBs) Possible acceptance of the need for governance Possible acceptance of the need for governance

constraints on individual/institutional behaviourconstraints on individual/institutional behaviour Deeper grasp of globalized “systematic” risk and how Deeper grasp of globalized “systematic” risk and how

liquidity in markets can vanish liquidity in markets can vanish

Gutfreund’s view from the bank: Gutfreund’s view from the bank:

““I asked I asked GutfreundGutfreund (ex Salomon Bros) about his biggest (ex Salomon Bros) about his biggest decision. “Yes,” he said. “They—the heads of the other decision. “Yes,” he said. “They—the heads of the other Wall Street firms—all said what an awful thing it was to go Wall Street firms—all said what an awful thing it was to go public public (beg for a government bailout) (beg for a government bailout) and how could you and how could you do such a thing. But when the temptation arose, they all do such a thing. But when the temptation arose, they all gave in to it.” He agreed that the main effect of turning a gave in to it.” He agreed that the main effect of turning a partnership into a corporation was to transfer the financial partnership into a corporation was to transfer the financial risk to the shareholders. “When things go wrong, it’s their risk to the shareholders. “When things go wrong, it’s their problem,” he said—and obviously not theirs alone. When a problem,” he said—and obviously not theirs alone. When a Wall Street investment bank screwed up badly enough, its Wall Street investment bank screwed up badly enough, its risks became the problem of the U.S. government. “It’s risks became the problem of the U.S. government. “It’s laissez-faire until you get in deep shit,” he said, with a half laissez-faire until you get in deep shit,” he said, with a half chuckle. chuckle.