(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
 Corollaries:
 Market prices impound all available information, or
at least all public information
 You can’t make money from public information
 Cynic’s joke – “don’t 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 31st (0-1), 39th (1-1) and 83rd (2-1) minutes.
[Source: Wolfers 2004]
Markets cannot see all that is coming
Contract: Pays $100 if Cubs win game 6 (NLCS)
Price of contract
(Probability that
Cubs win)
Fan reaches over
and spoils Alou’s
catch. Still 1 out.
Cubs are winning
3-0 top of the 8th
1 out.
The
Marlins
proceed to
hit 8 runs
in the 8th
inning
Time (in Ireland)
Why EMH analogy breaks down
 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)
 There is never a true stock price, so no way to test the
market’s position
 It’s 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”)
 Luck and bull markets keep “noise” traders in the game
(that’s before you allow for all the behavioural drivers)
 Market price = “consensus” view, hence maybe silly
Conclusion on EMH
 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.)
 NB. Markets are not expected to foresee
“Black Swans” (e.g. Sept 11) - but what about
“Black Monday” Oct 1987
Quiggin’s 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…”
 “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.”

http://johnquiggin.com/index.php/archives/2009/01/02/refuted-economic-doctrines-1-the-efficientmarkets-hypothesis/
So back to earth – what in Finance
drove the GFC ?
 Most people have never heard of EMH so it
can hardly be blamed
 The villain (and the hero) is leverage
– Einstein loved the maths of money
Simple example
 I own $100 and borrow $900 at 10%
 I invest at 20%
 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
 Say debt costs 5% and assets return 10%
200000
180000
160000
Equity
140000
no debt (D/E = 0)
120000
D/E = 2
100000
D/E = 5
80000
60000
40000
20000
0
0
5
10
15
Years
20
25
30
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
 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 dealmakers (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
(“Liar’s Poker”)
“How Ivy League Narcissist Culture
Killed Wall St” (Kevin Hassett)
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Class warfare in the US:
Narcissist MBAs bought into “their own” models
Customers rated secondary
MBA grandiose sense of entitlement
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)
 http://www.projo.com/opinion/contributors/content/CT_hass
ett22_02-22-09_0NDBQJT_v16.4003053.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 Lewis’s View on
Causes of GFC
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Ability of IBs to dress up subprime mortgages as investment grade securities
Rubber stamping MBS by Moodys under coercion from Wall St
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
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 else’s money
(J. Seigal at Wharton notes that IBs carried large portfolios of MBS)
Unregulated leverage of IBs
IBs as corporations rather than partnerships
IB employees not hooked into long term rewards/engagements
Moodys getting rich by slackening standards, showing others how
US culture inured to financial risks
http://www.fool.com/investing/general/2008/11/26/michael-lewis-on-thefinancial-panic.aspx#
Some psychological factors
(Behavioural Finance)
 Overconfidence (we are all better than average)
 Interpretation of profits as proof of trading ability
(what happened to “day traders”)
 “Regret” when others make profits and you don’t
 Seeing patterns in randomness (Feynman)
 Too little awareness of adverse selection risk
 Hedonic editing, susceptibility to positive feedback
 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)
 Doubling-up to recover losses
 Thinking conveniently of “tulip bulbs” as all the same
(Bookstaber p.175)
 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
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”
 (Remember the story in Liar’s 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
So How does Finance Theory
Come Out of the GFC?
 Economic logic intact. EMH still vacuous
 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)
 More awareness of unreliable statistical assumptions
 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
 Deeper grasp of globalized “systematic” risk and how
liquidity in markets can vanish
Gutfreund’s view from the bank:
 “I asked Gutfreund (ex Salomon Bros) about his biggest
decision. “Yes,” he said. “They—the heads of the other
Wall Street firms—all 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, it’s their
problem,” he said—and obviously not theirs alone. When a
Wall Street investment bank screwed up badly enough, its
risks became the problem of the U.S. government. “It’s
laissez-faire until you get in deep shit,” he said, with a half
chuckle.