*Here we go again. When do you think Citigroup, JPM, WFC and BofA will come begging eh?
GMAC Asks for Fresh Lifeline
GMAC and the Treasury are in advanced talks to prop up the lender with its third helping of taxpayer money.
E*Trade Loss Widens on Charges
E*Trade Financial's quarterly loss widened on charges related to a vital debt exchange it completed, though the online broker saw improvement in credit trends.
Jeremy J. Siegel: Efficient Market Theory and the Crisis
Neither the rating agencies' mistakes nor the overleveraging by financial firms was the fault of an academic hypothesis.
Financial journalist and best-selling author Roger Lowenstein didn't mince words in a piece for the Washington Post this summer: "The upside of the current Great Recession is that it could drive a stake through the heart of the academic nostrum known as the efficient-market hypothesis." In a similar vein, the highly respected money manager and financial analyst Jeremy Grantham wrote in his quarterly letter last January: "The incredibly inaccurate efficient market theory [caused] a lethally dangerous combination of asset bubbles, lax controls, pernicious incentives and wickedly complicated instruments [that] led to our current plight."
But is the Efficient Market Hypothesis (EMH) really responsible for the current crisis? The answer is no. The EMH, originally put forth by Eugene Fama of the University of Chicago in the 1960s, states that the prices of securities reflect all known information that impacts their value. The hypothesis does not claim that the market price is always right. On the contrary, it implies that the prices in the market are mostly wrong, but at any given moment it is not at all easy to say whether they are too high or too low. The fact that the best and brightest on Wall Street made so many mistakes shows how hard it is to beat the market.
This does not mean the EMH can be used as an excuse by the CEOs of the failed financial firms or by the regulators who did not see the risks that subprime mortgage-backed securities posed to the financial stability of the economy. Regulators wrongly believed that financial firms were offsetting their credit risks, while the banks and credit rating agencies were fooled by faulty models that underestimated the risk in real estate.
After the 1982 recession, the U.S. and world economies entered into a long period where the fluctuations in variables such as gross domestic product, industrial production, and employment were significantly lower than they had been since World War II. Economists called this period the "Great Moderation" and attributed the increased stability to better monetary policy, a larger service sector and better inventory control, among other factors.
The economic response to the Great Moderation was predictable: risk premiums shrank and individuals and firms took on more leverage. Housing prices were boosted by historically low nominal and real interest rates and the development of the securitized subprime lending market.
According to data collected by Prof. Robert Shiller of Yale University, in the 61 years from 1945 through 2006 the maximum cumulative decline in the average price of homes was 2.84% in 1991. If this low volatility of home prices persisted into the future, a mortgage security composed of a nationally diversified portfolio of loans comprising the first 80% of a home's value would have never come close to defaulting. The credit quality of home buyers was secondary because it was thought that underlying collateral—the home—could always cover the principal in the event the homeowner defaulted. These models led credit agencies to rate these subprime mortgages as "investment grade."
But this assessment was faulty. From 2000 through 2006, national home prices rose by 88.7%, far more than the 17.5% gain in the consumer price index or the paltry 1% rise in median household income. Never before have home prices jumped that far ahead of prices and incomes.
This should have sent up red flags and cast doubts on using models that looked only at historical declines to judge future risk. But these flags were ignored as Wall Street was reaping large profits bundling and selling the securities while Congress was happy that more Americans could enjoy the "American Dream" of home ownership. Indeed, through government-sponsored enterprises such as Fannie Mae and Freddie Mac, Washington helped fuel the subprime boom.
Neither the rating agencies' mistakes nor the overleveraging by the financial firms in the subprime securities is the fault of the Efficient Market Hypothesis. The fact that the yields on these mortgages were high despite their investment-grade rating indicated that the market was rightly suspicious of the quality of the securities, and this should have served as a warning to prospective buyers.