Have Recent Crises Blown a Hole Through Modern Financial Theory?

I grew up in a time when markets were considered to be "continuous." Portfolio insurance. Robert Merton's 1987 treatise Continuous-Time Finance. Liquidity was presumed to be available. And while markets could and did gap due to an event, new information, etc., it could and would clear with transactions taking place at the new level.

The financial markets, through price discovery in the presence of liquidity, conveyed valuable information that could be used for both security selection and asset allocation. The field of financial economics, as such, was predicated upon the existence of bids and offers and, therefore, liquidity. And this phenomenon was assumed to persist across time.

But this is not the world I observe today; quite the contrary. Price movements are not only discontinuous, but the notion of liquidity across time as traditionally assumed simply does not exist. Something has happened to rock the prevailing academic paradigm. Have the experiences of the past six months essentially blown a hole through the heart of modern financial theory?

This line of thought was spurred by my friend and mentor Bill Janeway. He is working on a project with colleagues at Cambridge that delve deeply into the issue I am going to tangentially speak of. I personally can't wait for their study to be released. But in the meantime, consider what Merton said back in 1957 as it relates to capital markets:

The conscious motivation for creating a capital market is to provide the means for financial transactions. However, an objective consequence of this action is to produce a flow of information that is essential for all agents' decision-making, including that of those agents who only rarely transact in the market.

You see, the problem is that without transactions it is hard to get information, and without information it is hard for people to transact. We are caught in this Catch-22, the Fed's prescription for which is injecting hundreds of billions of dollars into the financial system. And while this creates money, it does not necessarily create liquidity in the instruments for which no bids are available. Why? Because potential investors are sorely lacking information, either intrinsic to the securities or extrinsic in the form of observable market prices. This is partly due to the complexity of the instruments in question, the structured asset-backed market and related derivatives. And while this problem is not intractable, it is easy to imagine that getting sufficient information to make educated bids will take quite some time.

Another problem is that an element of liquidity was predicated upon the faith and belief in the ratings system. A AAA-rated security was available for purchase by trillions of investment dollars, AA-rated fewer trillions, A-rated hundreds of billions, and so on. But now that we've seen tens of billions of AAA-rated securities marked like junk, the very foundations of the institutional investment model have been shaken. Trust has been shattered. No trust, no liquidity. This partly explains the strength of the rally in U.S. Treasuries, even in the face of a sharply declining dollar. Most investors aren't looking to a rating agency for comfort that the U.S. Treasury will make good (no chuckles, please), ergo, the trust issue is moot and liquidity in Treasuries is plentiful. But we can't and don't live in a riskless world. The problem is that too many investors and market intermediaries thought we did. This was telegraphed by the historically low levels of volatility during the latter part of 2006 and into early 2007.

Today we live in a world fraught with risks that we barely understand, risks that modern financial theory doesn't have great answers for. A new model is needed that incorporates the effects of discontinuity as an outgrowth of, among other things:

• Complexity - structured securities, derivative instruments;

• Interdependency - widely disseminated holdings that can pollute portfolios globally, hundreds of trillions in counterparty exposures;

• Intermediary errors - ratings that don't reflect the risks, financial institutions with weak control environments and poor risk management practices; and

• Bad actors - originators, underwriters, traders and managers with mis-aligned motives.

We have seen examples of each of these in the past six months, seeming "black swans" that don't appear so unusual any more. It's not that these risks didn't exist before. It is that their confluence when experienced over a short period of time yielded results that were unforeseen to many. Our models and academic frameworks needs to be robust enough to handle these occurrences and to provide a model for maintaining liquidity, price discovery and information dissemination. Based upon today's market action we've got a long way to go.

Comments

[tuj]

The word "WHOLE" should be corrected in your title.

[rdial54]

I wish all that was not true. But we have had a great run. Time to take some profits when we can and look to place cash back in over time. Can't time the market but sure don't want to be all in when we are all down.

[BespokeNonSense]

While I agree with the general idea of this article, I have to disagree with a couple of points that I find superficial.

1. The "discontionuesnes... (word of the year) in market prices and lack of liquidity are not unique characteristics of today's markets. Actually market practitioners and academia have touched on these subjects before (Mandelbrot for one, Schiller another). The only thing that changes are the intricate details of what causes lack of liquidity and jumps in market prices.

2. Black-Scholes formula of pricing options is still, unfortunately, the basis for most derivative pricing. Unless this changes, we'll keep seeing these types of blow ups from time to time, from LTMC to Bear Stearns. The markets are fractals and do not feet the "Bell Curve" (the basic assumption of Black Scholes) the sooner we learn this the better for us.

[InformationArbitrage]

Fractals, I didn't say that they were unique to this market. Read the last paragraph. What I said is that changes in market structure and security design, among other things, have exacerbated the trend towards discontinuity over the past 30 years. I agree with you comment.

[Eaise]

It is very refreshing to finally see the right question being asked and addressed. Was going to congratulate you for being on the right track Roger but later saw that Bill Janeway and his gang deserve the credit. Never-the-less, thanks for the preview. I too look forward to the release of their analysis. I currently have no faith in the accuracy of any of the available financial information. If it is valid at all, it is so only as a "snapshot" as of the moment the data was mined and analyzed. Tomorrow may deliver a vastly different picture for us to digest or regurgitate.

[customer man]

The notion that there is a big difference between the real world and the academic neo classical hypothesis of how it is are does not seem very new...why all the surprises ?

[WAKEUP]

Simply put, the stock market is in serious danger of becoming passe; that is, there's much more money to be made in other areas, IF a person is willing to inject some actual WORK into their efforts. One quick example: Last year, I used $5,000 that I ordinarily would have invested in the market, and instead started a small information-processing business, AT HOME. I made no other financial investment in the business, only my "labor." After seven months, I sold the business for over $90,000. I had no special expertise in the type of business; I simply did the necessary work. Entrepreneurial efforts are an excellent alternative to the stock market. There is that pesky, four-letter word involved, though: WORK.

[wisdomseeker]

Phrasing the no-pricing/bad-ratings... issue in terms of information and continuity is very insightful; thanks for the article!

But I think the prescription at the end is incorrect. Less important than building a more sophisticated academic-intellectual model is getting back to basics in the real world. The less information is needed to understand something, the more continuity of liquidity will be improved. What we need are simpler and more transparent real-world securities, so that (a) less information is required for buyers to establish pricing points, (b) it's harder to commit fraud because everyone can see what they're getting, and (c) it will be harder to lose investor confidence in the next panic. The current bubble was built on the antithesis of all three of these points, and the global investing community, having been burned badly in so many ways, is now holding Wall Street's feet to the fire until it gets what it wants. I suspect the first major financial company that "gets" this will have a huge competitive advantage for the next decade.