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When markets lose their mind
by Martin Hutchinson
September 10, 2007
Freemarket economics is famously predicated on “market rationality,” theidea that each participant in the economy acts as a coolly reasoning“homo economicus” in purchase and investment decisions. Yet as thedisintegration of the 1995-2007 credit bubble continues it is becomingmore and more obvious that in several areas economic decision-makingduring this period has been highly irrational. There are no completesolutions to this problem, but there are palliatives.
Subprimemortgages themselves exemplify irrational markets, yet theparticipants’ activities at each stage were economically in their ownrational interest:
- Lowincome consumers took on mortgages they had no prospect of affordingbecause they believed from the experience of others that house priceswould rise sufficiently to bail them out. In any case being often nearbankruptcy the potential profit from successful speculation appeared tothem greater than the potential loss from default.
- Mortgagebrokers sold subprime mortgages because they got a commission forselling them and were not responsible for the credit risk.
- Investmentbanks packaged the subprime mortgages into multiple-tranche mortgagebacked securities because they received fat fees for doing so and againhad no real responsibility for the credit risk.
- Ratingagencies gave the upper tranches of mortgage debt favorable ratings,because they made a great deal of money from providing ratings forasset backed securities, needed to keep in the favor of the investmentbanks who brought them this attractive business, and had mathematicalmodels (either their own or the investment banks’) “proving” that thedefault rate of the securitized mortgages would be low.
- Investmentbank and rating agency mathematicians produced models “proving “ thatdefault rates would be low, ignoring the real-world correlationsbetween defaults on low quality consumer debt, because they were wellpaid to do so – the alternative was to return to a miserablecheese-paring existence in academia.
- Finallythe investors bought asset backed securities because they could achievea higher return on them in the short term than their borrowing costs,and could tell their funding sources (in the case of hedge funds) orbosses (in the case of foreign banks) that they were taking very littlerisk because of the securities’ high rating.
Eachstep of the process was rational (albeit operating on imperfectinformation), yet because incentives were hopelessly misaligned, thefinal result was an irrational market, in which loans that would not berepaid were securitized and sold to investors seeking an above-marketreturn at below market risk, a combination that in the long run oughtnot to exist without the application of extraordinary intelligence.
Inthe credit card business, currently equally likely to subside into aslough of defaults, the rationale was a little different. Here thesubprime credit card consumer had no rational basis for believing thatanything he bought with the card would become sufficiently valuable topay off the card debt. Instead, the credit card business became atribute to the power of advertising; by sending out credit cardsolicitations weekly to every deadbeat in the United States, the cardcompanies were able to persuade consumers that taking on too much debtwas a perfectly natural means of acquiring the consumer goods orvacations they craved. “Homo economicus” would have rejected excessivecard offers; in the real world unsophisticated consumers are deludedinto thinking that credit card debt is manageable, and that theirincome will increase sufficiently to service it. As with subprimemortgages, credit card lenders would not have been so aggressive if theassets had resided on their balance sheet, but through securitizationthey too could delude themselves that they were sloughing off thecredit risks onto anonymous third parties.
Thederivatives market was also an area in which irrationality held fullsway. Here the fault was excessive belief in mathematical models. Itwas attractive to traders and to operating management to pretend thatmarkets were fully stochastic random walks – after all, Nobel prizeshad been given for this assertion – and to assess Value at Risk on thatbasis, ignoring the reality that markets often behave in a highlynon-random manner. By doing this, management could claim to investorsthat risk positions were in reality modest, while traders could bet thefuture of the institution on gambles that may go spectacularly wrongevery few years, but in the meantime keep the investor capital and thebonuses flowing in.
Whenin mid-August Goldman Sachs announced that a “25 standard deviationevent” had caused the value of its quantitative fund to drop 30%, theimplication was that the subprime mortgage crisis had caused the marketto behave in some wholly unexpected pathological manner, normally to beanticipated only two or three times in the history of the universe. Inreality such “25 standard deviation events” happen two or three times adecade and are perfectly normal. The abnormality, in which the marketlost its mind, was in Goldman basing its reputation and its investors’wealth on such obviously inadequate mathematical techniques.
Onthe funds management side, fiduciary investment in hedge funds andprivate equity funds is equally an example of market irrationality.Pension funds in particular have an exceptionally long time horizon, soinvesting in short term oriented hedge funds was especiallyinappropriate. It was obvious also that private equity funds dependcrucially on the availability of an active and receptive stock marketfor exit from their investment positions and so in no sense represent a“separate asset class” from conventional US equities. Whileprivate equity fund and hedge fund sponsors have attempted to hide thereality of their funds’ mediocre returns, the truth has been apparentwith a little digging for several years, which is why both types offunds market their returns on a “top quartile” basis, pretending as inGarrison Keillor’s Lake Wobegon that all funds are above average.
Thereality is that only the remuneration of the sponsors is above average,far above that for managers of conventional equity funds, and renderedespecially egregious by the practice of managers extracting their 20%“carry” BEFORE the investments have actually been sold, thus leavingthe fund illiquid and the investors wholly dependent on exits thatmight never be achieved. Again, there was nothing irrational in WallStreet selling these new funds; the irrationality lay in institutionalinvestors buying them. Once it has become obvious what devastation hasbeen wreaked on beneficiary pensions from these investments, it islikely that some of the more enthusiastic fiduciary participants willfind themselves in class action court, if not in jail. The U.S.judicial system is these days particularly unforgiving of marketfailure, as Enron’s Jeffrey Skilling discovered.
Finally,there is the explosion in top management remuneration over the last twodecades. It is folly to imagine that US top management is many timesbetter than in the 1980s, but yet it is paid many times as much in realterms. The initial boost came from stock options, which managementpersuaded the accountants could reasonably be left off the incomestatement. Here both management and the accountants were properlymarket motivated; the irrationality arose from the failure of thepolicing institutions such as the SEC to prevent such looting ofshareholder wealth. More recently, management has been able to increaseits remuneration by threatening the stockholders with defection to aprivate equity buyer. This has resulted in the breakup of a number oflong established companies, almost certainly with highly deleteriousconsequences for the U.S. economy. Again, warped incentives producedbehavior that was from a market point of view mindless.
Fromthe above examples, it is clear that market madness derives from anumber of causes, but primarily from misaligned incentives, excessivesalesmanship and poor regulation. The decade of cheap money hasexacerbated the problem; behavior that would have been punished bybankruptcy before it became widespread has been allowed to spreadthroughout the world’s markets. The behavioral factorsthat sophisticated economists today recognize as important modifiers ofthe pure free market paradigm have become dominant, and have pushed theworld economy a considerable distance from an optimal state.
Themarket will never be completely rational, and nor should we expect itto be. Equally, market irrationality has in the last decade enriched alot of thoroughly unpleasant people at the expense of the economy as awhole. To cure the problem, government action is required only at themargins, tightening regulation on, for example, the marketing of creditcards to end the practice of unsolicited credit offers, so dangerous tothe financially vulnerable and unsophisticated.
Moreimportant, money must be kept tight, in order that periods ofirrational speculation do not extend themselves as they have done since1995. It is likely that this will also involve a substantial shrinkageof the financial services industry, even if not to its 1970s size ofapproximately half its present proportion of the economy. The lastdecade has demonstrated that arcane areas of financial services areparticularly vulnerable to rent seeking sales operations, and thenormal weeding out that occurs in downturns is impossible if bullmarkets are prolonged by a decade or more.
Inmany cases, if core participants had acted responsibly, marketirrationality would not have occurred, but the overly responsible getweeded out of the financial services business in a decade-long bullmarket. It is bull markets not bear markets that produce sharp increases in dishonesty and rent seeking.
Infuture, if after say 5 years the stock market is continuing to soar,the Fed should bring it back sharply to earth by a rise in short terminterest rates. Former Fed Chairman Alan Greenspan should have donethis when he spotted “irrational exuberance” in December 1996; it is tohis everlasting disgrace that he didn’t. Only by such a grounding canthe bubble operators be weeded out and rationality returned.
Ondays when the market drops, financial commentators are filled withgloom as they agonize over the possibility that the US economy isheaded into recession and the markets into freefall. Fear not; marketfreefall and economic recession will sweep away the irrationalities ofthe last decade, and those uninvolved in scams will find their ownwealth and share of the economy increasing comfortably.
