Page 1 of 4 Health warning for a computer age
By Paul Davidson
The last line of the original manuscript of my book John Maynard Keynes was
written in July 2006. It noted that when, not if, the next Great Depression
hits the global economy, Keynes' General Theory analysis will be rediscovered
by economists [1]. As this is being written in October 2008, it appears that
this time has come.
The winter of 2007-2008 will prove to be one of discontent and the beginning of
the end in the classical theory of the efficiency of global financial markets.
For more than three decades, mainstream economists had preached, and
politicians had swallowed, the myth of the efficiency of such free markets.
Those who do not study the lessons of history are bound to repeat its errors.
Economists forgot the events of the Great Depression and the collapse of
unfettered financial markets that followed the "Roaring Twenties" prosperity.
For history has repeated itself with
the growth of deregulated markets and the prosperity of the 1990s ending up in
2008 with the greatest recession since the Great Depression
Starting with the subprime mortgage crisis in the United States at the end of
2007, events have demonstrated that the Efficient Market Emperor theorists have
no clothes - only Nobel Prize medals to cover their naked errors. Within a few
months, the so-called US subprime mortgage problem developed from a small blip
on the economic radar screen to a situation that has caused the collapse of
financial markets and threatened the viability of financial institutions world
wide.
Nevertheless as late as December 20, 2007, The Wall Street Journal ("Don't
Count On A Stimulus Plan") indicated that former Federal Reserve chairman Alan
Greenspan, a strong proponent of the Efficient Market Theory (EMT), recommended
that politicians do nothing to prevent a possible recession that may be coming
as result of the subprime mortgage lending mess. Greenspan recommended letting
the market solve the problem by "letting housing prices (and securities pegged
to mortgages) fall until investors see them as bargains and start buying,
stabilizing the economy".
Similarly, in a December 14, 2007, New York Times article ("After The Money's
Gone"), the 2008 economics Nobel Prize winner, Paul Krugman, defined the
housing problem as a case where the price of housing exceeded a "normal ratio"
relative to rents or incomes. Like Greenspan, Krugman did not suggest anything
that politicians could do to relieve the distress caused by the deflating
housing bubble. Instead Krugman apparently believed that an efficient housing
market would solve the problem by deflating house prices. Krugman estimated
that housing prices would have to fall by 30% to restore a "normal ratio" and
then normality would be restored.
History tells us that the decade of the 1920s saw a stock market bubble of
unprecedented proportions develop as most economists thought rising stock
prices merely reflected the market's knowledge of the unbridled prosperity that
would continue in the US economy. Just a few days before the stock market crash
of October 24, 1929, eminent American economist Irving Fisher told an audience
that the stock market had reached a high plateau from which it could only go
up. Then suddenly the bottom fell out and stocks lost 90% of their value.
Professor Fisher, who put his money in what he believed, lost almost US$10
million in the stock market crash.
After the 1929 market crash, one out of every five banks in the US failed.
Several years after the Crash and the beginning of The Great Depression of the
1930s, a US Senate committee held hearings on the possible causes of the Crash.
These hearings indicated that in the early part of the century individual
investors were seriously hurt by banks whose self-interest lay in promoting
sales of securities that benefited only the banks. The hearings concluded that
the fact that banks, in the 1920s, significantly increased their underwriting
activities of securities to be sold to the public was a major cause of the
crash and subsequent depression.
Consequently, in 1933, Congress passed the Glass-Steagall Act, which banned
banks from underwriting securities. Financial institutions had to choose either
to be a simple bank lender or an underwriter (investment banker, brokerage
firm). The Act also gave the Federal Reserve more control over banking
activities.
As a result, for several decades bank-originated mortgage loans were not
resalable - they were illiquid assets. The originating bank lender knew that
he/she would have to carry the mortgage loan debt security on his/her balance
sheet over its life. The value of this asset on the balance sheet was equal to
the outstanding principal of the loan. If the borrower defaulted, the lender
would bear the costs of foreclosure and any loss on the outstanding mortgage.
Thus, the originating bank lender thoroughly investigated the three C's of each
borrower - collateral, credit history, and character - before making the a
mortgage loan.
In the 1970s in the US, deregulation of banking activities began when brokerage
firms began offering money market, high interest, check writing accounts that
competed with traditional banking business. This was he beginning of what is
today called the "shadow banking system". In the 1980s, the Federal Reserve
reinterpreted the Glass-Steagall Act to allow banks to engage in securities
underwriting activities to a small extent.
In 1987, the Fed board allowed banks to handle significant underwriting
activities including those of mortgage backed securities, despite objections of
Fed chairman Paul Volker. When Alan Greenspan became chair of the Fed in 1987,
he favored further bank deregulation to help US banks compete with foreign
banks where the latter are often universal banks that are permitted to act as
investment banks, take equity stakes, and so forth. In 1996, the Federal
Reserve permitted bank holding companies to own investment banking affiliates
that can contribute up to 25% of total revenue of the holding company.
In 1999, after 12 attempts in 25 years, Congress repealed the Glass-Steagall
Act. With repeal there were no longer any legal constraints between loan
origination and underwriting activities. Accordingly, there was a great profit
incentive for a mortgage originator to search out any potential home buyers
(including subprime ones) and provide them with a mortgage. The originator
could then profitably sell, usually within 30 days, these mortgages to an
underwriter, or act as an underwriter to sell to the public exotic
mortgage-backed securities (MBS). The originator therefore had no fear of
default if the borrower could at least make his first monthly mortgage payment.
The underwriter typically packaged these mortgages into "securitized" MBS as
CDOs (collateral debt obligations), or SIVs (structured investment vehicles)
and sold tranches in these assets to unwary pension funds, local and state
revenue funds, individual investors, and other financial institutions including
domestic and foreign banks who, led on by the high ratings of these complex
financial securities by rating agencies, believed these were safe investments
that paid high rates of return.
Of course when the pool of people who had good triple C ratings dried up,
mortgage originators searched out others who would not normally qualify for
mortgages and induced them (often by engaging in fraudulent practices) to take
out mortgages to purchase homes they could not afford. Thus, since the
beginning of the 21st century, this process of packaging and selling MBSs
helped finance the housing bubble that pushed housing prices to historic highs
by 2005.
Ultimately, many of the subprime borrowers could not afford to service their
mortgage debt, and the housing bubble started to collapse. As defaults of
subprime mortgages started to cascade, many potential buyers of MBSs could not
discover the proportion of defaulting loans in any given MBSs, and more
importantly how many more defaults of the mortgages in any MBS might occur in
the future. Consequently, no one knew what these MBSs were worth and no one
would buy these in the market.
Initially this market failure created an insolvency problem for some major
underwriters as the exotic MBS financial instruments that they still held on
their balance sheets lost significant market value, if they could be sold at
all. This problem proved contagious as it spilled over to other markets such as
the auction-rate securities market and the credit default swap markets -
markets that traded in derivatives and the like that no one could trust to
maintain a stable orderly market price movement. What caused this contagion to
spill over and create a tremendous increase in market failures and market
illiquidity?
The answer is simple. This problem developed as economists and market
participants forgot Keynes's liquidity preference theory (LPT) and instead
swallowed hook, line, and sinker the belief that the classical efficient market
theory (EMT) is a useful model for understanding the operation of real world
financial markets. The EMT indicates that all one has to do is to bring
informed buyers and sellers together in an unregulated, free financial market
and the market price will always adjust in an orderly manner to the market
clearing price where the latter is based on market "fundamentals".
In the pre-computer age, financial markets required buyers and sellers to be
represented by dealers who would meet in a physical location (such as the stock
market) to trade. Members of these stock exchanges recognized that at any given
moment of the trading day, there may be a problem of getting a sufficient
number of bone fide buyers and sellers together to maintain a well-organized
and orderly market. It was, therefore, necessary to adopt financial market
rules that required all market participants to deal only with authorized
broker-dealers who were permitted to execute trades in the market. The
broker-dealers acted as fiduciary agents to place orders with other members of
the stock exchange, sometimes called "specialists". Each specialist kept the
books on all buy and sell orders for a specific security at any price.
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