domingo, outubro 05, 2008

Efficient Market Fallacy condemns us to repeated Manias, Panics and Crashes

Now that the international financial market is in turmoil, with institutions collapsing from coast to coast and country to country, financial experts are questioning the efficient market theory.

If the "market is always right", how can things turn out so wrong.

Clearly, information does not flow freely but is often assymetric. Participants are not all alike and some may actually exercise considerable market power and attempt to move the market in their favor.

A recent article (11-Sept-2008) in the Economist magazine cited the book on “The Origin of Financial Crises: Central Banks, Credit Bubbles and the Efficient Market Fallacy” published by Harriman House.
But the Charles Kindleberger 1989 classic MANIAS, PANICS and CRASHES, should be required reading for financial regulators and bank and insurance executives, at least once a year.

MANIAS... shows us once again the truism that those who forget the lessons of history are condemmed to repeat them.

The current crisis reminds us once again that a Bank is like a Bicycle.
When it fails, it just topples over.
And bank failures are ALWAYS caused by liquidity problems, even when there are underlying asset value and solvency problems as well. Banking is also basic social infrastructure, providing a "public service". More than just "greasing" the economy, it plays the key role of aggregating and allocating assets between savers and borrowers, AND taking risk as intermediary.
Economic history is full of successive banking crises and liquidity bubbles bursting in one sector after another. That's why commercial banking became a closely regulated industry, with low but steady returns on capital, and separated from investment banking with its high but highly variable returns on capital. When the distinction between retail commercial banking and wholesale investment banking fell with the end of Glass Steagall, the domino effect had that much more room to play itself out. Having forgotten the lessons of (economic) history, we seem to be condemned to repeat them, with a big assist from negative real interest rates, poor monetary policy and disoriented bank regulation.

It is strange that the problems started in housing finance. Home mortgage loans are NOT difficult to understand nor to model, nor should they need Government guarantees. Home loans are one of the "plain vanilla" products of traditional commercial bank intermediation.

The difficulties have come mostly with execessively structured MBS - Mortgage Backed Securities, with tranching, swaps and strips accross a dozen counterparties. These new products raised as many risk problems as they appeared to solve.

Whereas banks traditional had to cope with credit risk, interest rate risk and liquidity mismatch risk, with these new financial products, they have been adding large quantitities of counterparty risk and opacity.

As the crisis spreads before bottoming out, the image of falling dominos may rather misleading. With falling dominos, you could at least see the contagion, and you could jump ahead to remove half a dozen pieces and contain it. But the MBS and and other structured financial products, now consideres "toxic", have proved to be like a "house of cards under a thick blanket". You can see it shake, you know it's going to come down. But you can't predict how or when the collapse will come. And worst of all, you can't figure out how to intervene to prevent the crash.
VER: Darien Scheme the XVII century bubble to corner Panama that ruined Scotland