Efficient Markets

http://online.wsj.com/article_email/SB10001424052748703573604574491261905165886-lMyQjAxMDA5MDIwODEyNDgyWj.html

Wherever the Wharton School at UPENN is currently ranked in the various business school surveys (and that's usually somewhere in the Top 3), their Finance Department continues to be number 1 by consensus. And the number 1 professor in their Finance Department is Jeremy Siegel who has authored the article attached.

Siegel nicely summarizes the positions of those who feel that Efficient Market Theory (or EMH: Efficient Market Hypothesis) is the basic cause of the financial crisis. Siegel's definition of EMH is that the prices of securities reflect all known information that impacts their value. The hypothesis, again according to Siegel, does not claim that the market price is always right. He goes on to allow that EMH is not an "excuse" for the failures of CEOs and regulators who did not see the risks that sub-prime mortgage backed securities posed to the financial stability of the economy.

With the housing boom in this decade boosted by historically low nominal and real interest rates, the development of the securitized subprime lending market was inevitable. According to data accumulated by Professor Robert Shiller of Yale, in the 61 years from 1945 through 2006, the maximum cumulative decline in the average price of homes was 2.84% in 1991. In this environment, 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 since national home prices rose 88.7% from 2000 to 2006 (versus a 1% rise in median household income) totally out of sync with incomes and GDP growth.

This should have sent up red flags and cast doubts on using models that were based only on historical declines to judge future risk. With few exceptions (Goldman Sachs being one), financial firms ignored these warnings. CEOs failed to exercise their authority to monitor overall risk to the firm. And, the Fed never saw the signs.

A theory doesn't cause a crisis. Actions taken or not taken cause a crisis. Siegel rightly points out that blind faith in EMH did not "cause" the crisis. And, again, Siegel rightly points out that the "risks" have not disappeared. His analogy that, just because automobiles are safer today than they were years ago, does not mean that you can drive 120 mph, works perfectly. Ergo, our financial firms drove too fast, our central bank failed to stop them, and housing deflation crashed the banks and the economy.

Regardless, Siegel goes on to point out that neither the rating agencies' mistakes nor the overleveraging of the financial firms in the subprime securities is the fault of the Efficient Markets Hypothesis. The fact that 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 to prospective buyers.