Abstract
Compared to the worldwide financial carnage that followed the Subprime Crisis of 2007-2008, it may seem of small consequence that it is also said to have demonstrated the bankruptcy of an academic financial institution: the Efficient Capital Market Hypothesis (“ECMH”). Two things make this encounter between theory and seemingly inconvenient facts of consequence. First, the ECMH had moved beyond academia, fueling decades of a deregulatory agenda. Second, when economic theory moves from academics to policy, it also enters the realm of politics, and is inevitably refashioned to serve the goals of political argument. This happened starkly with the ECMH. It was subject to its own bubble – as a result of politics, it expanded from a narrow but important academic theory about the informational underpinnings of market prices to a broad ideological preference for market outcomes over even measured regulation. In this Article we examine the Subprime Crisis as a vehicle to return the ECMH to its information cost roots that support a more modest but sensible regulatory policy. In particular, we argue that the ECMH addresses informational efficiency, which is a relative, not an absolute measure. This focus on informational efficiency leads to a more focused understanding of what went wrong in 2007-2008. Yet informational efficiency is related to fundamental efficiency – if all information relevant to determining a security’s fundamental value is publicly available and the mechanisms by which that information comes to be reflected in the securities market price operate without friction, fundamental and informational efficiency coincide. But where all value relevant information is not publicly available and/or the mechanisms of market efficiency operate with frictions, the coincidence is an empirical question both as to the information efficiency of prices and their relation to fundamental value. Properly framing market efficiency focuses our attention on the frictions that drive a wedge between relative efficiency and efficiency under perfect market conditions. So framed, relative efficiency is a diagnostic tool that identifies the information costs and structural barriers that reduce price efficiency which, in turn, provides part of a realistic regulatory strategy. While it will not prevent future crises, improving the mechanisms of market efficiency will make prices more efficient, frictions more transparent, and the influence of politics on public agencies more observable, which may allow us to catch the next problem earlier. Recall that on September 8, 2008, the Congressional Budget Office publicly stated its uncertainty about whether there would be a recession and predicted 1.5 percent growth in 2009. Eight days later, Lehman Brothers had failed, and AIG was being nationalized.
Highlights
E coincidence is an empirical question both as to the information efficiency of prices and their relation to fundamental value
Compared to the worldwide financial carnage that followed the Subprime Crisis of 2007-2008, it may seem of small consequence that it is said to have demonstrated the bankruptcy of an academic financial institution: the Efficient Capital Market Hypothesis (“ECMH”)
It was subject to its own bubble – as a result of politics, it expanded from a narrow but important academic theory about the informational underpinnings of market prices to a broad ideological preference for market outcomes over even measured regulation
Summary
Assessing the ECMH in light of the Subprime Crisis must begin by noting that at least three markets in securities and their associated derivatives are implicated in the Crisis: the markets in RMBS, in CDOs (bonds tied largely to the returns on RMBS), and in the stocks of financial institutions that were themselves active in the RMBS-CDO market as originators, securitizers, underwriters, insurers, or investors in the markets for. Apart from the fact that the Crisis left the CDO market little time to evolve, the likely reasons were that CDOs were enormously more complex, difficult to value, and illiquid than were pools of RMBS bonds.[71] Bespoke CDS protection on individual CDO tranches of bonds was written either by the CDO managers themselves or by a few large institutions, such as AIG, Lehman Brothers, and monoline insurers It was famously purchased by a small number of investors who wished to short the market, as well as by larger numbers of banks that retained AAA CDO bonds and wished to limit their exposure to asset-backed security risk.[72]. We think the lesson of a relative market efficiency assessment counsels powerfully in favour of continued transparency.[133]
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