(Some of…) What the GFC says about Finance (and vice versa) David Johnstone NAB Professor of Finance University of Sydney

The Efficient Market Hypothesis Markets react (quickly) to new information Markets react (quickly) to new information Corollaries: Corollaries: Market prices impound all available information, or at least all public information Market prices impound all available information, or at least all public information You cant make money from public information You cant make money from public information Cynics joke – dont pick up $10 notes on footpath, they are not there Cynics joke – dont pick up $10 notes on footpath, they are not there

The beautiful game: Market price reaction to goals Sweden vs. Nigeria (Final score 2-1, goals scored at 31 st (0-1), 39 th (1-1) and 83 rd (2-1) minutes. Sweden vs. Nigeria (Final score 2-1, goals scored at 31 st (0-1), 39 th (1-1) and 83 rd (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 8 th 1 out. Time (in Ireland) Fan reaches over and spoils Alous catch. Still 1 out. The Marlins proceed to hit 8 runs in the 8 th inning [Source: Wolfers 2004] Markets cannot see all that is coming

Why EMH analogy breaks down EMH says nothing about the stock price being right in any sense, just that it reacts to new information EMH says nothing about the stock price being right in any sense, just that it reacts to new information The direction of the reaction is not predicted (except afterwards) The direction of the reaction is not predicted (except afterwards) There is never a true stock price, so no way to test the markets position There is never a true stock price, so no way to test the markets position Its more a Keynesian beauty contest (informed participants may invest contrary to their own valuations – thus delaying price discovery) Its more a Keynesian beauty contest (informed participants may invest contrary to their own valuations – thus delaying price discovery) Hard to bet against a stock (unlike a soccer team) (the limits to arbitrage) Hard to bet against a stock (unlike a soccer team) (the limits to arbitrage) Luck and bull markets keep noise traders in the game (thats before you allow for all the behavioural drivers) Luck and bull markets keep noise traders in the game (thats before you allow for all the behavioural drivers) Market price = consensus view, hence maybe silly Market price = consensus view, hence maybe silly

Conclusion on EMH Either (1) it says nothing testable, and is thus like a religious tenet Either (1) it says nothing testable, and is thus like a religious tenet or (2) it fails to capture what people expect of rational markets – namely to foresee at least those events that are obviously coming (e.g. Dot.Com crash, US housing loan bubble/oversupply, the worthlessness of Ninja and Liar loans etc.) or (2) it fails to capture what people expect of rational markets – namely to foresee at least those events that are obviously coming (e.g. Dot.Com crash, US housing loan bubble/oversupply, the worthlessness of Ninja and Liar loans etc.) NB. Markets are not expected to foresee Black Swans (e.g. Sept 11) - but what about Black Monday Oct 1987 NB. Markets are not expected to foresee Black Swans (e.g. Sept 11) - but what about Black Monday Oct 1987

Quiggins View of EMH …the dotcom bubble of the late 1990s was, to my mind, a clear-cut and convincing example of an asset price bubble. Anyone could see, and many said, that this was a bubble, but those, like George Soros, who tried to profit by shortselling lost their money when the bubble lasted longer than expected… …the dotcom bubble of the late 1990s was, to my mind, a clear-cut and convincing example of an asset price bubble. Anyone could see, and many said, that this was a bubble, but those, like George Soros, who tried to profit by shortselling lost their money when the bubble lasted longer than expected…many saidmany said Even the strongest advocates of the EMH would not seek to apply it to, say, the Albanian financial sector in the 1990s, which was little more than a series of Ponzi schemes. Even the strongest advocates of the EMH would not seek to apply it to, say, the Albanian financial sector in the 1990s, which was little more than a series of Ponzi schemes. markets-hypothesis/ markets-hypothesis/ markets-hypothesis/ markets-hypothesis/

So back to earth – what in Finance drove the GFC ? Most people have never heard of EMH so it can hardly be blamed Most people have never heard of EMH so it can hardly be blamed The villain (and the hero) is leverage The villain (and the hero) is leverage –Einstein loved the maths of money

Simple 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: 1000(1.20) - 900(1.10) = $210 (110% profit) My equity after one year is: 1000(1.20) - 900(1.10) = $210 (110% profit) But if my investment produces -20%, my equity is: 1000(0.8) - 900(1.1) = -190 (290% loss)

The ideal – exponential growth Start with $100 and run a constantly rebalanced portfolio with fixed D/E Start with $100 and run a constantly rebalanced portfolio with fixed D/E Say debt costs 5% and assets return 10% Say debt costs 5% and assets return 10%

Now add the human factors to the maths of leverage Behind the GFC is a complicated array of sociological and psychological factors, all influential and all interacting with each other Behind the GFC is a complicated array of sociological and psychological factors, all influential and all interacting with each other Finance is becoming now more conscious of its roots in psychology and sociology and less in physics and engineering Finance is becoming now more conscious of its roots in psychology and sociology and less in physics and engineering

Some sociological factors (at the corporate/investment banking level) A quick and unordered list only –Agency problem endemic –Huge debt-to-equity models (Priv Equity-nearly Qantas) –Rich short-term rewards for deals (fund managers vote for big corporate salaries and bonuses – rewards then trickle down) –Disrewards for loss of market share (race to bottom) –No dis-reward for failure (moral hazard) –Use of clever mathematical finance tricks as deal- makers (e.g. securitization of almost any cash flow stream, mortgage backed securities, derivatives such as credit default swaps, low start loans etc.)

Continued –Reverence for quant finance models (internally and externally) –Financial models dominate actual business models –Belief in statistical arbitrage (collecting pennies in front of steamrollers) –Ratings agencies mix the good with the bad –Faith in all mergers/acquisitions as ways to create value –Sophisticated sales pitches backed by quant and IT sophistry –White Shoes hand over to Masters of the Universe (Liars Poker)

How Ivy League Narcissist Culture Killed Wall St (Kevin Hassett) Class warfare in the US: Class warfare in the US: Narcissist MBAs bought into their own models Narcissist MBAs bought into their own models Customers rated secondary Customers rated secondary MBA grandiose sense of entitlement MBA grandiose sense of entitlement Self-confidence rated higher than integrity Self-confidence rated higher than integrity Wall St now like a modern bridge – designed ingeniously for a good time, not a long time (Roman 1000 year old bridges in Italy designed with less science but more generosity towards those who come next) Wall St now like a modern bridge – designed ingeniously for a good time, not a long time (Roman 1000 year old bridges in Italy designed with less science but more generosity towards those who come next) ett22_ _0NDBQJT_v html ett22_ _0NDBQJT_v html ett22_ _0NDBQJT_v html ett22_ _0NDBQJT_v html

Some sociological factors (at the retail client mums and dads level) A quick and unordered list only –Agency problem endemic –Lenders rewarded for lending more, not better –Cult of financial planners (shifty salespeople or empty suit experts?) –Need to self-fund, great appetite for investments –Belief that risk = reward –View that mechanical get rich formulae will work

Continued –Growing appetite for risk - investments pay better than work –Governments subsidise individual investments –Saving/paying back loans no longer seen as wise (lazy money) –Lifestyle must be maintained/enhanced (have it now…) –Consumerism funded by loans funded by China and other countries making the products (loans then securitized

Michael Lewiss View on Causes of GFC Ability of IBs to dress up subprime mortgages as investment grade securities Ability of IBs to dress up subprime mortgages as investment grade securities Rubber stamping MBS by Moodys under coercion from Wall St Rubber 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 standing ultimately on cash from mortgage loans New round of commissions for every new repackaging of existing securities, all standing ultimately on cash from mortgage loans Use of models that understate (perhaps knowingly) the high correlations between default risks in a bad market Use of models that understate (perhaps knowingly) the high correlations between default risks in a bad market Knowledge that if it blows up its someone elses money (J. Seigal at Wharton notes that IBs carried large portfolios of MBS) Knowledge that if it blows up its someone elses money (J. Seigal at Wharton notes that IBs carried large portfolios of MBS) Unregulated leverage of IBs Unregulated leverage of IBs IBs as corporations rather than partnerships IBs as corporations rather than partnerships IB employees not hooked into long term rewards/engagements IB employees not hooked into long term rewards/engagements Moodys getting rich by slackening standards, showing others how Moodys getting rich by slackening standards, showing others how US culture inured to financial risks US culture inured to financial risks financial-panic.aspx# financial-panic.aspx# financial-panic.aspx# financial-panic.aspx#

Some psychological factors (Behavioural Finance) Overconfidence (we are all better than average) Overconfidence (we are all better than average) Interpretation of profits as proof of trading ability (what happened to day traders) Interpretation of profits as proof of trading ability (what happened to day traders) Regret when others make profits and you dont Regret when others make profits and you dont Seeing patterns in randomness (Feynman) Seeing patterns in randomness (Feynman) Too little awareness of adverse selection risk Too little awareness of adverse selection risk Hedonic editing, susceptibility to positive feedback Hedonic 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 might be a recovery) Inertia and psychological inability to get out at a loss (or to miss what might be a recovery) Doubling-up to recover losses Doubling-up to recover losses Thinking conveniently of tulip bulbs as all the same (Bookstaber p.175) Thinking conveniently of tulip bulbs as all the same (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 (Bookstaber, 2007) The Best Insider View According to Markowitz Large positions in CDOs and CMOs were patently visible…how can Citigroup see inventory grow from a few billion to 30 or 40 billion dollars and not react? …this might occur because the incentive structure encourages risk taking more than protection of shareholders… p.xiv Large positions in CDOs and CMOs were patently visible…how can Citigroup see inventory grow from a few billion to 30 or 40 billion dollars and not react? …this might occur because the incentive structure encourages risk taking more than protection of shareholders… p.xiv

Continued…. …even a risk manager who got it right might not have been able to carry the day against the traders. Traders have a self interest in high risk…in a traders-versus-managers debate, traders win handily …even a risk manager who got it right might not have been able to carry the day against the traders. Traders have a self interest in high risk…in a traders-versus-managers debate, traders win handily (Remember the story in Liars Poker about legendary bond trader John Merewether lording over his boss and Salomon Bros icon John Gutfreund) (Remember the story in Liars Poker about legendary bond trader John Merewether lording over his boss and Salomon Bros icon John Gutfreund)

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

So How does Finance Theory Come Out of the GFC? Economic logic intact. EMH still vacuous Economic logic intact. EMH still vacuous Behavioural Finance effects rampant Behavioural Finance effects rampant Quant models are still mathematically correct and often brilliant, just exposed more for how their assumptions can be grossly wrong (some of the time) Quant models are still mathematically correct and often brilliant, just exposed more for how their assumptions can be grossly wrong (some of the time) More awareness of unreliable statistical assumptions More awareness of unreliable statistical assumptions Unhedged believers in models losing their own money look foolish (e.g. Scholes and LTCM, failed IBs) Unhedged believers in models losing their own money look foolish (e.g. Scholes and LTCM, failed IBs) Possible acceptance of the need for governance constraints on individual/institutional behaviour Possible acceptance of the need for governance constraints on individual/institutional behaviour Deeper grasp of globalized systematic risk and how liquidity in markets can vanish Deeper grasp of globalized systematic risk and how liquidity in markets can vanish

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