The Origin of Financial Crises

It is not quite clear what is the real focus of George Cooper's book The Origin of Financial Crises. The subtitle - "Central banks, credit bubbles and the efficient market fallacy” - gives away this lack of concentration. Cooper, an investment fund manager and fund strategist, gives considerable space in this short book (172 pages…large print and widely spaced lines) to all three topics and really does not tie everything together well to move us forward.

The book’s cover, however, presents the urgency of the work. The Economist magazine is quoted on the cover… “A must read,” we are told. So we delve in:

Let’s start with the Efficient Market Hypothesis, a theory that Cooper is specifically attacking. Cooper contends that this theory is totally lacking in reality and that empirical tests have not supported its predictions. Yet the academic community has been particularly successful in selling this hypothesis to both the financial community and the makers of monetary policy so that it is used in portfolio management to control risk and by central banks for the conduct of economic policy.

Cooper goes so far as to conclude that “If blame (for the current financial crisis) must be laid anywhere it must be placed at the collective feet of the academic community for having chosen to continue promoting their flawed theories of efficient, self-regulating markets, in the face of overwhelming contradictory evidence.” QED.

Moving on to “credit bubbles," Cooper discusses the “Financial Instability Model” (which is derived from the work of Irving Fisher, John Maynard Keynes, and Hyman Minsky … all from the academic community). The crucial element behind this hypothesis is that financial markets, as opposed to “goods” markets, exhibit “self-reinforcing cycles.” All the characteristics consistent with self-reinforcing markets, like wealth effects and mark-to-market accounting practices, contribute to the actual behavior of markets and produce results that contradict the Efficient Markets Hypothesis. Cooper even uses the Financial Instability Hypothesis to explain the falling savings rate in the United States.

The bottom line is that this hypothesis is the only one, Cooper believes, that can account for the creation of financial bubbles, and hence explain the performance of the United States economy since 1971. (Cooper picks August 1971 as the date when the dollar became a pure “fiat” money because President Nixon took the United States dollar off the gold standard at that time.) And it is argued that financial bubbles can occur “rationally” within the Financial Instability Model whereas credit bubbles cannot really be explained as rational in the Efficient Markets Model, even though all market participants in this model are assumed to act rationally.

In terms of “central banks," Cooper contends that all central banks have inconsistent goals and are also deliverers of “moral hazard” to the banking system and financial markets. He argues that central bank goals of high economic growth and price stability are inconsistent and give policy makers an inflationary bias unless they are extremely disciplined (more disciplined like the European Central Bank than the Federal Reserve System). This inconsistency can create moral hazard since the markets know that fighting inflation will not go too far because of the focus on economic growth. Furthermore, the role of lender of last resort also contributes to the presence of moral hazard in the banking system… and with the new authority claimed by the Federal Reserve this fall, even more moral hazard has been added to the system.

Cooper does conclude two things: Government needs to spend more effort identifying credit bubbles and stopping them; and financial dislocations ultimately must work themselves out and cannot be short-circuited by policy makers. He argues that policy makers need to include two pieces of information in their decision making process: asset prices and debt levels. If both asset prices and debt levels are increasing faster than the economy is growing, then policy makers need to identify the situation as a bubble and do something in order to stop the “bubble” from getting out-of-hand.

And Cooper contends that if the financial and economic systems do not get to work out their dislocations completely during a down-cycle, then the policy makers are doing nothing but adding more moral hazard to the system. In essence, once the damage to the economy and the debt-deflation is underway, the consequences must ultimately be lived with. Otherwise the economy becomes riskier and riskier, which means any future adjustment will just be longer and deeper.

I have mixed emotions about this book. Cooper really doesn’t say anything new in it. However, I don’t disagree with the thrust of many of his arguments. The book is short, is a relatively easy read, and it summarizes a lot of material (even though the author provides very little backup of his claims). There is no bibliography, and references to research sources do not include information about where articles, etc., may be found. Readers may find the book helpful, but those who want more substance and more support for the arguments presented in the book will have to go elsewhere.

Comments

[Moon Kil Woong:]

One problem with the free market theory of the economy is that the economy has never been truly free. Basically government mucks around all the time and prevents it from ever being efficient.

The only good thing government can provide, making sure markets are honest and free from fraud and abuse is somehow magically lacking these days making it an utter failure.

So yes, there is moral hazard and unnecessary stimulation during the whole cycle. Why should we be amazed that things are so bad after letting our government behave so badly for the last 10 years. I add a couple years of Clinton to be fair because the end of the Clinton era abolished the Glass Stegal act which began a great undermining of financial stability. Otherwise Clinton did quite a good job.

Jan 10 05:58 AM

[Sigmund:]

I consider the efficient market hypothesis to be bunkum! I am older than dirt and my experience is that financial markets tend to appear to be mean reverting around rates of return. I do note a minor caution, the mean rate of return appears to be increasing at a moderate rate. As to Cooper's book, I may, or may not read it. If your review is on point, I wont read it. What I do see before us all is the fact of our fiat currency and the fact that it has been a 'reserve' currency for so long. How will we extricate ourselves from this mess that we have created?

Jan 10 08:33 AM

[Dr.Jackpot:]

No-------it's not a mystery at all. Alan Greenspan's low interest rate policy was to boost banks at the expense of savers (who else had money ? ?) and it finally caught up with him. But at .00005% return our retirement has been confiscated. That double talking #%//>** !!!

Jan 10 08:45 AM

[CautiousInv...:]

Cooper goes so far as to conclude that “If blame (for the current financial crisis) must be laid anywhere it must be placed at the collective feet of the academic community for having chosen to continue promoting their flawed theories of efficient, self-regulating markets, in the face of overwhelming contradictory evidence.” QED.

Academics develop and provide frameworks for understanding market behavior, but are not the dominant participants. Efficient market theory is based upon transparency and reliable information........whi... then leads to price discovery.

Taking Congress and HUD out of the mix, had the ratings agencies properly graded the toxic, sub-prime products being packaged as CDO's, they would have been priced much differently and the market would demanded a higher yield to compensate for the higher risk. In turn, this would have made sub-prime loans more expensive.....and fewer would have been issued.

Jan 10 09:30 AM

[ferguson:]

Cautious investor makes a critical point that is too often overlooked. If the rating agencies had performed their fiduciary duties in evaluating these new investment vehicles (MBS, CDO, CDS et al) they would have rated them much lower which would have stopped the spread of the fraud in its tracks. In fact, since the rating agencies had no historical experience with such vehicles, they should have declined to give them any rating which would have had the same effect.

It may be assumed that the business world will have a certain fraction of employees and policy makers who will "push the envelope" in order to create profit. Occasionally that expands into the kind of fraud of which we have seen more than a little in the last decade.

The average investor relies on the rating agencies to use experience to evaluate risk. In this case they had no experience, but proceeded to provide the highest ratings. They failed very badly in their essential responsibility and may be both civilly and criminally responsible.

The regulatory agencies (including both the SEC and the Federal Reserve) are only slightly less culpapable. The performance of the SEC under Christoper Cox parrallels the performance of FEMA under whatsisname Brown (of you're doing a great job, Brownie, fame). Bottom line, we all lined up for the free lunch and, when the credit fueled cornucopia was revealed to be a fraud, we wonder how it could have happened. Same old story. There is no free lunch. Never has been. Never will be.

Jan 10 10:20 AM

[CoinMiner:]

Count me in – a great article! My initial thoughts also centered around the increasing demand by immigrants. The author states he finds no reasons why an immigrant would want to move here in the next few years. However, that is the perception form the glass half empty – the realization from a boomer that America is on the decline and thus why would anyone move here. However, look at the situation from the perspective of a possible immigrant and things look much different.

Demographics trump. Just in the Americas the population density alone, generally higher in all other American countries except Belize and Canada, make the US look very attractive. Expanding the view worldwide, the aging white US boomers are outnumbered by the young Asians still too reach their earnings potential.

At least in my geographic area, northern San Francisco Bay, these demographic trends are evident in day to day dealings. The days on market have decreased in the counties I follow b.c. prices have fallen (up to 60% in some zip codes) to the point shown on the third graphic in the article. Namely, house process have decreased from 7x annual salary (the top of the market in October 2005) to about 2-2.5 times annual salary, near the 100 year mean of around 2x salary. The buyers to date seem evenly divided between smart money investors (yes, these homes will now cashflow above the 4-5% stated above) and young asian couples.

This is the view from my neighborhood…

Jan 10 10:56 AM

[morph366:]

Just want to comment on the view from Cautious Investor that it is not the academic community that should be held accountable for a lot of the mess but credit ratings agencies.
Apart from the obvious issue regarding the conflict of interest where S&P, Moody's etc were paid by the issuers of the instruments rather than the purchasers - (where does the fiduciary responsibility reside in this situation?), there is the larger problem which is what models should the credit ratings agencies have used to properly estimate the risks of complex derivatives?
If the intellectual/academic framework for modelling financial asset prices and in turn the likelihood of crises and contagion arising is deeply flawed - which it is and which ultimately must be attributed to sloppy thinking by orthodox academics and teachers of finance - where should we be looking for prudent advice about how to price these instruments?
The comment by Ferguson that "The average investor relies on the rating agencies to use experience to evaluate risk." highlights the troublesome nature of the role of credit ratings agencies. There should be a government warning - similar to that seen on tobacco products - that relying on assessments of risk by such agencies can be hazardous to your wealth.

Jan 10 10:57 AM

[wg:]

All of this seems to miss that point that NONE of this would have happened if the FEDERAL GOVERNMENT, in particular the Clinton Administration, later abetted by Barney Frank, etc. had not only PERMITTED, let alone ENCOURAGED, not to mention PRESSURED, but in many cases for heaven's sake ORDERED lending institutions to ABANDON SOUND LENDING PRACTICES and write mortages for people whom they KNEW would probably not pay them back. Had these mortages never been written (and they should not have been), there would have been no toxic paper in the first place, no sub-prime derivitatives etc., and no housing bubble either.

Jan 10 11:05 AM

[prudentinve...:]

For the theory of efficient markets to have a chance, a stable unit of money needs to exist. After-tax interest rates have to be higher than inflation, to make accumulation of capital meaningful. After all, the basic premise of a capitalist system is to allow people who produce more than they consume to save their surplus as accumulated capital, which can then fund new capital-intensive industries.

The failure of efficient markets theory can be the result of the lack of a necessary foundation of sound money

Jan 10 11:07 AM

[reveigel@ms...:]

In my opinion no one will focus on the real problem. And that problem is the GOVERNMENT, with Congress the main culprit. If they would do their job in an intelligent and competent manner we would never have reached this point. Balance the budget, get out of the way and let the private sector do the job it can and would do if left alone. By doing year and years of deficit spending and thus years and years of inflation, in a sense they are providing us with counterfeit money. It is worth 100 cents today and tomorrow it might be worth only 50 cents. It is a very subtle program but if people would ever wake-up and realize what is happening to pay checks and savings some good things might happen. If not, we will just go through this mess over and over.

Jan 10 11:35 AM

[Bill Herbert:]

>> All of this seems to miss that point that NONE of this would have happened if the FEDERAL GOVERNMENT, in particular the Clinton Administration, later abetted by Barney Frank, etc. had not only PERMITTED, let alone ENCOURAGED, not to mention PRESSURED, but in many cases for heaven's sake *** ORDERED lending institutions to ABANDON SOUND LENDING PRACTICES and write mortages for people whom they KNEW would probably not pay them back***<<

Let's set the record straight here. This is an urban myth - the*** lie *** that banks were "ordered" to make loans to deadbeats or people with grossly inadequate incomes. That is just a bunch of banker BS which tries, and fails, to divert attention from the hard, cold fact that the banks took inordinate risks, and made many thousands of very bad loans, because they were making a lot of money by doing so. In addition, the BANKS, not the Feds or any Govt agency, were the ones who corrupted the entire rating process. And they created the toxic mortgage derivatives that enabled them to dump the trash loans onto duped investors, which later blew up in their faces. That FACT has been thoroughly proven and documented.

There was NEVER any order or law passed which said that banks had to make bad loans. What the Community Reinvestment act said was that the banks had to make loans in poor economic areas in proportion to their deposits received from those areas. In other words, you can't take savings deposits from the poor, and lend to the rich, without also making a proportional amount of loans or credit available to the poor areas. This would include loans made to businesses such as restaurants, construction firms, janitorial services and so on.

In fact, I'm not aware of any amounts being specifically earmarked for residential loans, although it certainly WAS encouraged, as a way to boost home ownership levels among the "lower middle class" and thereby promote more stable communities by virtue of increased home ownership. This is not a flawed goal in my opinion. But the greedy, sloppy bankers found a way to make a quick buck, while ultimately endangering the health of the financial system, which now affects rich and poor alike.

So let's put the blame squarely where it belongs - on Wall Street banks like Lehman, Bear, MS, GS, Merrill etc. plus the crooked ratings agencies.

And stop distorting the truth by claiming that Congress somehow "ordered" this mess to occur.

I assure you - you cannot cite ONE concrete example of that being the case.

Jan 10 11:37 AM

[1234987:]

Toxic CDO's & Subprime only came unravelled when the price of homes dropped in value due 2 the banking industry DUMPING huge numbers of REO homes taken from these borrowers.

The policy makers saw a bubble in housing and tried 2 control it by raising interest rates too quickly. Not a very good way of controling the markets but you would have 2 say mission accomplished Bush & his advisors. But they didn't calculate an ideal Exit strategy & housing which moves our economy has tanked taking everything with it.

But homes R affordable again, just no-one can afford one.

Jan 10 11:54 AM

[auto44:]

To those folks that lay the blame on the gov't you couldn't be more right. You do however miss the point that it actually started with Jimmy Carter. It was his initial focus on banks being bad guys with red lineing communities. The punishment for doing this was to retard a banks growth opportunities elseware.
As for the efficient market therory, which is suppose to be effective only part of the time, it couldn't work anyway with out accurate and truthful numbers which we rarely get, even with the very expensive Sarbanes oxly act which it seems is not being enforced. Who has been punished by this act. The current mess is due to our inability to trust anyone. Regardless of all the theroies that have been expounded we are in a lack of trust bubble. As long as we keep electing people whose only skill is getting money to run a campaign and spout what the main stream press will allow them to say we will be in trouble. Intelligence and ethics and independent thought are not the mark of most elected officials today.

Jan 10 12:49 PM

[John Lounsbury:]

Several commenters have mentioned the chief flaw in the Efficient Market Hypothesis (I don't believe scholars have called it a theory.) - it assumes transparency.

After all, at its core, this hypothesis is nothing more than instantaneous reversion to the mean. When information is hidden, instantaneous reaction is impossible.

Jan 10 01:11 PM

[stockguru32:]

I don't know if a book can list all the origins of this crisis. Great article on it though at crashmarketstocks.com

Jan 10 01:34 PM

[bcncv:]

Although I could make many comments, I'll stick with one for the sake of brevity.

EMH is an interesting framework for understanding the unpredictability of markets. However, one of its (many) oversimplifications is the assumption that all investors are seeking to buy undervalued assets and sell overvalued assets. This fails to take into account the growing percentage of momentum and technical traders that buy assets with no regard to its fundamental valuation.

Jan 10 01:37 PM

[MAUX:]

The bottom line of this financial crisis is "packaged lies". Our economy must be ruled by the concept of "real value". If speculation is left alone crisis can be avoided. When a bank loans me 150K for a house, I pay in monthly installments plus interest until my 150K are paid in full - period. The idea that if my "estimated value" of the house doubled, or even tripled doesn't make my mortgage more or less than the original 150K on the bank's books. How in the world then, can a bank "sell" a packaged bundle to another with speculative inflated values of mortgages? One would argue that when the value of the house goes down, so does the value of the mortgage. Not true: the borrowed sum that has to be paid by the home owner is still the same!
When governments sits idle while bankers speculate their values up, the greed factor takes over, and here we are now in a financial calamity.

Jan 10 01:39 PM

[dw57:]

nobody ordered the mortgage lenders to make bad loans, they did that on their own. they are not subject to CRA. blaming a 30 year old law for a problem that was created in the last few years show how some are trying to distract the rest of us from their responsibility for their mess. we could blame government like in Florida for allowing FELONS to become brokers. we could blame government for not implementing regulations that would have stopped this when it was proposed. we could blame government for allowing 40 to 1 leveraging (from the sec). we could blame fannie and freddie for being collaborators (by buying the contracts the brokers wrote). but if the brokers were never allowed to write the contracts there never would have been problem would there?

Jan 10 01:43 PM

[MAUX:]

I truly believe that what the experts call technical, should actually be called emotional momentum. Herd mentality is pretty predictable. When a technical chart shows signs of moving up (or down), it indicates a momentum which feeds on itself - at times for only a brief period - at other times for several days. Capitalizing on this (the human nature) can make or lose millions of dollars. True, fundamental forces also trigger technical response, except that in this case it is backed by true facts - earnings!


On Jan 10 01:37 PM bcncv wrote:

> Although I could make many comments, I'll stick with one for the
> sake of brevity.
>
> EMH is an interesting framework for understanding the unpredictability
> of markets. However, one of its (many) oversimplifications is the
> assumption that all investors are seeking to buy undervalued assets
> and sell overvalued assets. This fails to take into account the
> growing percentage of momentum and technical traders that buy assets
> with no regard to its fundamental valuation.

Jan 10 01:46 PM

[dw57:]

the other have what caused this problem has been the destruction of wages that has been going on for 30 years. had that happened, consumers (aka employees) would not have had to borrow so much. but considering we now have wages that have less purchasing power than we had 30 years ago we are in much worse shape. we just have more expensive toys that people can buy!

Jan 10 01:46 PM

[bosun.j:]

He did it, they did it, she did it, no, they did it, No HE did it, no......

Jan 10 02:31 PM

[1234987:]

OK now that the blame is openly debated lets get to a fix solution!!

Might I offer, we need 2 stabalize the housing market!!

Remove all the REO homes from the market immediately, All financial institutions are now required 2 sell all REO single family homes 2 a newly formed Resolution Trust II company owned by the GOV. The homes will B purchased from financial institutions at book value or the amount of indebtedness.

The RTC will dispose of these assets in an orderly manner over a period of 5-10 years. The homes will B given 2 Real estate agents in lots of 50 per agent @ 10% commision with the RTC obsorbing operating costs & repairs 20% commision with the agent absorbing the expenses. (IE some formula). The homes would only B sold in stable markets and some with tenants 2 investors or rent 2 own tenants.

This action would immediately cause stabilization of housing prices with an increase in prices as market supply dries up. The average homeowner could now find a buyer with adequate credit 2 purchase their home with the ability of not being upside down on their loans. Thus not further exascerbating the housing mess.

The RTC will sustain some economic losses. These losses will be absorbed or portioned out 2 the banks that sold assets 2 the RTC over a period of 30 years. The banks will be assessed their portion of loss
as a percentage of total homes sold 2 the RTC divided by homes sold by that specific institution. (A percentage). The loss could easily B payed over a long term.

The RTC (Gov) would sell long term bonds 2 finance the homes. (currently 3-4%).

Immediate results:
1-Remove an oversupply of homes on the Sales Market
2-create jobs for 50,000 agents.
3-provide rental homes for a tight rental market.
4-create liquidity 2 the banks freeing up hard 2 sell assets.
5-create a market in which institutions could sell SFH assets in the future.
6-stimulate a market (MLS) in which individuals could sell.
7-Free up liquidity in banks for new loans.
8-Mantain housing prices for local gov tax collections.

I'm sure you could add 2 the list!!!

Jan 10 02:33 PM

[wg:]

*
Re: Copperbaron's remark:
"Let's set the record straight here. This is an urban myth - the*** lie *** that banks were "ordered" to make loans to deadbeats or people with grossly inadequate incomes. That is just a bunch of banker BS which tries, and fails, to divert attention from the hard, cold fact that the banks took inordinate risks, and made many thousands of very bad loans, because they were making a lot of money by doing so. In addition, the BANKS, not the Feds or any Govt agency, were the ones who corrupted the entire rating process. And they created the toxic mortgage derivatives that enabled them to dump the trash loans onto duped investors, which later blew up in their faces. That FACT has been thoroughly proven and documented."

Copperbaron apparently knows not of which he speaks, and proves not of which he writes. The above mentioned "FACT" is "well documented" only by the left wing mouthpieces for Dodds, Frank, Cuomo and Cisnaros at HUD, etc.

Recall that I said that the federal government "permitted, "encouraged," and Pressured" the lenders to make subprime loans before I ever mentioned ordered.

In narrow sense, Copperbaron is correct that the government did not specifically "order" banks to knowingly make "bad" loans. What it did do, however, was "permit, encourage and pressure" banks to consistently debase their lending standards to include more low income customers, or else face sanctions under the CRA (Community Reinvestment ACT). Periodically, the lenders were examined by regulators from HUD and given a CRA "score" or "grade" and if they had not made enough loans to low income applicants, they could find themselves unable to merge, expand, and even be fined.

A close relative of mine was CEO of a commercial bank doing business in Virginia and Maryland but specifically NOT in the District of Columbia. Even though it had no branches there, CRA regulators informed the bank that unless it began offering loans to low income DC applicants, it would face sanctions. With reluctance the banks complied, but soon sold itself.

So, perhaps Copperbaron is technically correct that I was wrong to say the government "Ordered" banks to make bad loans. Lets' just say instead that by permitting, encouraging and pressuring them, the government, like the Godfather, made the banks "an offer they couldn't refuse.

Jan 10 02:43 PM

[1234987:]

WG & Copperbaron:

Copperbaron is correct/so is WG : however to think that CRA which required a small (very small) percentage of asstes 2 be in low income neighborhoods as well as borrower, caused this loosening of credit guidlines is ridiculous.

The competition (insatiable thirst) from Wall street (Lehman, Merrill, Bear) selling 100 million a week of mortgage backed securities, lowered the standards.

Banks saw the loan apps drying up & wondering who was writing the loans. They found mortgage brokers with no regulation sending packages to Wall Street instead of Banks underwritting departments.

Wall street paid more origination fees & had lower lending requiremnets.

Banks only tried 2 compete & thus got caught in the web by purchasing these same packaged loans from wall street that the brokers didn't send 2 the banks underwritting depts in the first place.

Gov is required 2 encourage lending in all markets especially low income & CRA areas. This lending did not bring any crisis to any market.

Jan 10 03:40 PM

[wg:]

On Jan 10 03:40 PM 1234987 wrote:

> WG &amp; Copperbaron:
>
> Copperbaron is correct/so is WG : however to think that CRA which
required
> a small (very small) percentage of asstes 2 be in low income
neighborhoods
> as well as borrower, caused this loosening of credit
guidlines
> is ridiculous.
>
> The competition (insatiable thirst) from Wall street (Lehman,
Merrill,
> Bear) selling 100 million a week of mortgage backed
securities,
> lowered the standards.


Well, so you say. But prior to ramping up the CRA by the Clinton administration, there were virtually no such things a "subprime loans," "Alter. A's " etc. Bankers would have been horrified at making such loans. But when banks \were informed that FAnnie Mae, Freddie Mac etc. have been told to take such loans off the banks' hands, sure, the banks were glad to write them, exacting all sorts of riduculous "point" fees. Were the banks greedy? Sure. Was Wall Street greedy? What else is new? Asking Wall Street not to be greedy is like asking a labrador retriever not to jump in that pond. Greedy and STUPID, too, but none of it would have happened. NONE OF IT without OUR OWN GOVERNMENT permitting, encouraging and pressuring banks to ABANDON SOUND LENDING PRACTICES and write mortgages to people who were not qualified to pay them back--ALL IN THE NAME OF SOME KIND OF SOCIAL ENGINEERING.

Jan 10 05:28 PM

[Crocodilian:]

Thank you for a very good book review. You've done a lot of things which reviewers often don't do -- noted some of why a book has some buzz (which this one does) and that it seems to be an unfocused "rush job" by a fund manager who's not quite up to professional writing.

Of what use is even a very good summary with no bibliography and poor sourcing? The whole point of books which serve as "reviews of the literature" is to arm the reader with the best references. . . if this one doesn't, then its far less useful.

I dare say your review has saved me the price of this book . . .

Jan 10 06:45 PM

[dw57:]

but banks weren't the lenders. they just bought the contracts, and while you could make a case (minor at best) that the Clinton administration 'ramped' up pressure in support of the CRA,. But you cant make that claim for the Bush administration. they have yet to find a regulation in the business world that they will actually enforce. its not part of their DNA.
and all of wall street seemed to be really happy until the band stopped playing. and now there is no trust in the business world. and the public certainly will not trust them for a few years (maybe 10 or more). and why should they, they create a big mess....and get their friends to bail them out. and trash the real economy with it. but fixing their own self crested seems to be asking to much!


On Jan 10 05:28 PM wg wrote:

>

Jan 10 09:21 PM

[SW Richmond:]

Amen, brother. The effect of interest rates on capital is not something central bankers like to talk about. In fact, monetarists think capital can be printed.


On Jan 10 11:07 AM prudentinvestor wrote:

> For the theory of efficient markets to have a chance, a stable unit
> of money needs to exist. After-tax interest rates have to be higher
> than inflation, to make accumulation of capital meaningful. After
> all, the basic premise of a capitalist system is to allow people
> who produce more than they consume to save their surplus as accumulated
> capital, which can then fund new capital-intensive industries.

>
>
> The failure of efficient markets theory can be the result of the
> lack of a necessary foundation of sound money

Jan 10 09:27 PM

[SW Richmond:]

Free markets make decisions based on information. If the information is missing, hidden or misleading, bad decisions get made.

Economic decisions based on politics are never about economic realities but about elections, kickbacks, bribes, etc. These decisions ALWAYS lead to misallocations and distortions. The best we can achieve is to minimize the government's decision making power in the economy. The exact opposite is happening right now.


On Jan 10 01:11 PM John Lounsbury wrote:

> Several commenters have mentioned the chief flaw in the Efficient
> Market Hypothesis (I don't believe scholars have called it a theory.)
> - it assumes transparency.
>
> After all, at its core, this hypothesis is nothing more than instantaneous
> reversion to the mean. When information is hidden, instantaneous
> reaction is impossible.

Jan 10 09:33 PM

[Smarty_Pants:]

Lots of good comments and points made.

For what it's worth, it seems to me that the EMH is an oversimplification. People don't always act rationally. If they did, then there wouldn't have been billions in 'liar loans' made, regardless of the legalities or political pressures.

Is it rational for a 23 year old college student to borrow $170,000 to buy a house, renovate, and flip it in order to pay for schooling? No. Yet you can see it happen on TV and discover that the 23 year old has absolutely no clue what they have gotten themselves into. As we always see, it usually works out because there always seems to be some greater fool standing ready to bail them out ... until there isn't.

I am always careful to note the production date whenever I watch "Flip this House" to see what part of the bubble was recorded. The above 23 year old student made a $60,000 profit from that house in 2005. One has to wonder if the 'greater fool' has yet to walk away from the house they bought at bubble prices from this student.

I keep waiting for the new and revised version of the show, appropriately titled "This Flippin' House", to air and show the unlucky or biggest fools pay top prices and discover that their entire life is ruined when they discover that the house is now only worth 60% of what they borrowed and spent on renovations.

The 'simplified' explanation for the economic crisis is, as many have noted in various posts, an easy access to excessive credit regardless of political, legal, or theoretical causation. This easy access to money results in somebody pushing the risk envelope for a perceived opportunity to profit (think 40+:1 bank leverage, hedge fund errors ala LTCM, etc.) by the use of ever growing sums of borrowed money.

Once the non - rational nature of the enterprise is realized the undertaking collapses, but the debt remains and a loss must be taken by *somebody*.

Today's 'crisis' is simply a frenzied exercise in attempting to avoid assigning that loss to anybody, or alternatively by the taxpayer.

Jan 10 09:38 PM

[icandoitdon:]

this is simplistic.

there is no "sole blame" for this mess. congress may have legislated foolishness but they did not legislate a suspension of sane lending practices. adjustable rate mortgages, option arms, interest only mortgages, negative amortization mortgages, alt-a mortgages, etc. came to be horribly abused tools used by mortgage brokers everywhere to peddle loans to naieve buyers that were financial time bombs.

you might just as easily blame the securitization process, which permitted lending institutions to offload these loans and remove themselves from accountability in the disaster that followed. but moving up the chain, as pointed out, it was the rating agencies that certified the paper that made it saleable and provided liquidity to the market. and lest we forget, the federal reserve under alan greenspan who never met a bubble or a bailout he didn't like, starting with the crash of '87 when he was new to the job, had a one-dimensional view of the role of federal reserve system....to keep the economy growing by providing cheap credit and lots of it. all this man ever did during his tenure was feed liquidity into the system at the slightest sign of a hiccup in the economy. even when he suspected "irrational exuberance" he did nothing. he didn't know the meaning of the word "regulation." he admitted as much to the congress during his testimony on the subprime crisis, stating that he was mistaken in his believe that the free market system was self correcting. christ, i knew that as a graduate student...where the hell was he educated?

rarely in the history of this great country have so many guardians of the public interest failed so miserably in their regulatory duties.


On Jan 10 11:05 AM wg wrote:

> All of this seems to miss that point that NONE of this would have
> happened if the FEDERAL GOVERNMENT, in particular the Clinton Administration,
> later abetted by Barney Frank, etc. had not only PERMITTED, let alone
> ENCOURAGED, not to mention PRESSURED, but in many cases for heaven's
> sake ORDERED lending institutions to ABANDON SOUND LENDING PRACTICES
> and write mortages for people whom they KNEW would probably not pay
> them back. Had these mortages never been written (and they should
> not have been), there would have been no toxic paper in the first
> place, no sub-prime derivitatives etc., and no housing bubble either.

Jan 10 09:50 PM

[robert.b.fe...:]

Social engineering has been demonstrated as a loosing proposition every time it has been tried. While it is true that by it's self the turbo charged CRA would not have produced this magnitude of a collapse it set the stage for bad players. In an attempt to mittigate risk bankers bundled bad paper and sold it to investors as a mortgage backed security and an entire new industry of derivatives including Credit default options (CDOs) and Swaps (CDSs) was born. Then some unscrupulous folks like Mozillo the magician, Frank Reins and his counter part at Freddie Mack figured they could make a pile of money and began actively pushing bad paper sometimes by deceptive practices. Thus creating this huge bubble and our current crises. President Bush and some others including Senator McCaine tried to get a handle on Fannie and Freddie in 2004 which Dodd Killed by threatening to filibuster and again in 2006 which Barny Frank blocked in the Democrat controlled congress.

Jan 10 10:06 PM

[Maxe Paul:]

The efficient market theory works quite well until the inefficient government theory takes over when the former appears stressed. I guess it's only a matter of time now until we start seeing the "Hollywood film" version of events.

Jan 11 03:20 AM

[JasonC:]

Actually, the true reason for the "failure of efficient markets theory" is that not one of its premises has the slightest bearing on reality. It is an ideology meant to justify non-intervention and not a coherent body of thought. It was first created simply to try to reduce the complexity of real economies to simple calculus of marginals already known to Ricardo, but its actual informational assumptions have been worked out since and proven to be utterly false from top to bottom. Any calculative device with imperfect information that could arb away all marginals to efficient intertemporal equilibrium could solve the halting problem; it is formally non-computable and nothing in the world can accomplish it.

What should regulators or governments do about it? Much the same thing investors should do about it. Sell bubbles and buy busts. If free private investors did so on enough scale they'd smooth the bubbles away themselves, but they don't. It is profitable to do so. Even modest portions of market value trading on a mean-reverting, rather than trend following, trading rules is sufficient to stabilize bubbly markets. Not completely, but dramatically reduced amplitude of swings etc.

This simply means the government should intervene counter-cyclically in financial markets, if private capital isn't smart enough to do so, itself. Free market ideologues can howl about it all they want, but those they champion as the supposedly infallible all knowing efficient private traders manifestly are not getting it done. Somebody will.

Jan 11 01:51 PM

[Eric L. Pre...:]

Financial risk (VaR) model flaws go much deeper than just the shape of asset price distributions because they rely on the Efficient Market Hypothesis (EMH) to model markets as efficient, always in equilibrium and self correcting where security prices simply react to random news releases. The EMH models day-to-day security price movements as “independent random variables” where purchase or sale is a “zero net present value transaction,” resulting in neither the buyer nor seller having an advantage. Consequently, security trading is modeled like casino gambling where price volatility determines risk assessment. The EMH concludes that because prices always fairly reflect intrinsic value and it is impossible to know what markets are going to do, consequently, fundamental analysis isn’t cost effective. The EMH model is both naïve and specious, i.e., it relies on incorrect premises and, therefore, cannot correctly model market risk. A discussion follows.

Markets are not always in equilibrium nor self correcting but rather are a discounting mechanism, i.e., professional traders look ahead and bid prices either up or down prior to earnings and/or economic news announcements; that is why prices can go up on bad news and down on good news. Security prices from day-to-day seem random, however, portfolio diversification cancels out unsystematic risk, therefore, markets as a whole only have systematic risk. Using a diversified market portfolio, monthly rather than daily data, trend lines and conditional probabilities based on fundamental analysis correctly models systemic market risk; thereby disqualifying the flawed EMH’s reliance on securities’ price frequency and the use of price volatility as a proxy for portfolio risk which is not sufficient information when hedging positions.

(Eric L. Prentis is the author of “The Astute Investor” and “The Astute Speculator,” theastuteinvestor.net )

Jan 11 03:30 PM

[dw57:]

does any body really truly believe that the free market Bush administration ever enforced the CRA? They didn't do much regulating for much of any thing else. why would they do that one?


On Jan 10 10:06 PM robert.b.ferguson wrote:

> Social engineering has been demonstrated as a loosing proposition
> every time it has been tried. While it is true that by it's self
> the turbo charged CRA would not have produced this magnitude of a
> collapse it set the stage for bad players. In an attempt to mittigate
> risk bankers bundled bad paper and sold it to investors as a mortgage
> backed security and an entire new industry of derivatives including
> Credit default options (CDOs) and Swaps (CDSs) was born. Then some
> unscrupulous folks like Mozillo the magician, Frank Reins and his
> counter part at Freddie Mack figured they could make a pile of money
> and began actively pushing bad paper sometimes by deceptive practices.
> Thus creating this huge bubble and our current crises. President
> Bush and some others including Senator McCaine tried to get a handle
> on Fannie and Freddie in 2004 which Dodd Killed by threatening to
> filibuster and again in 2006 which Barny Frank blocked in the Democrat
> controlled congress.

Jan 11 04:31 PM

[dw57:]

actually it doesn't work. since the business community that participates in it, has always gamed it to their benefit. which corrupts it as much if not more than the government does (since they tend to influence the government more than the citizens do) . i think some one mentioned a need and requirement for transparency for a free market. and there never will be that with business wanting to game it. besides there have been studies where isolated Islands demonstrated where the entire free market collapses based on the greed of the people evolved. in a vacuum you could have one. but there never will be one. and economists ignore that people will always over do some thing. and will move in herds.

On Jan 11 03:20 AM maxe wrote:

> The efficient market theory works quite well until the inefficient
> government theory takes over when the former appears stressed. I
> guess it's only a matter of time now until we start seeing the "Hollywood
> film" version of events.

Jan 11 04:36 PM

[Chuch:]

How do you think these new P2P sites this guy talks about at crashmarketstocks.com talk about effects gs and ms? Freak, with these kinds of returns I dont know if I will use a bank again, thoughts?

Jan 11 09:35 PM