by David Dreman
After 2002, leverage began to soar to as high as 35 to 1 to 40 to 1 for some of the mortgage lenders, investment bankers, and hedge funds and up to 30 percent for some of the most aggressive banks. Margin was plentiful and, with cheap rates almost effortless to obtain, it encouraged leverage, much as it had for LTCM or in the 1987 crash. Mortgage originators*35and mortgage companies almost had the banks throwing money at them.
Finally, banks and investment bankers also financed a large number of innovative, often complex investment companies that owned large holdings of such bonds as well as often extremely obtuse derivatives. Forget that the security for many of the loans was subprime mortgages or that the investment bankers leveraged their capital enormously. The banks’ risk-control departments thought all this was fine. After all, near the top of the bubble the volatility of the RMBS portfolios continued to be very low, and they had also learned from Professors Merton, Scholes, and Fama that volatility never changes for long. Risk was in an iron cage, so they could relax and make big money for their firms and themselves.
But despite the assurances of Fed chairmen Alan Greenspan and Ben Bernanke after him, as well as many other experts, that everything was just peachy, the nation’s frenetic housing bubble was coming to an end. By late summer 2006, home prices began to drop, and they fell steadily through 2007. By early 2007, the home mortgage market began to disintegrate. Housing prices continued to drop in 2008 to April 2009, accompanied by a flood of homeowners who went into arrears on their mortgages, along with a rising tide of foreclosures. Not surprisingly, the market for mortgage bonds collapsed. Beginning in 2007, liquidity began to freeze, and by 2008 it had dried up almost completely. Residential mortgage-backed securities, which had started turning down in August 2006, collapsed in the following two years. The damage was worse than that caused by any stock market crash in the nation’s history. Interesting that Standard & Poor’s, which gave AAA ratings to thousands of issues of subprime trash, gave U.S. Treasuries a lower rating in 2011. But that’s another story.
Figure 5-1 shows that the supposedly low-volatility ABX-HE-BBB investment mortgage index, rated as investment quality (one of the higher bond ratings), sank into a black hole, dropping almost 98 percent from its July 19, 2006, price to its April 2009 low. To take another example, even AAA mortgage-backed subprime securities, the highest credit rating, fell 70 percent or more during this period.
How could this happen? There are numerous reasons, but most of the damage was once again caused by leverage and lack of liquidity. As we saw, banks, investment banks, hedge funds, and other mortgage buyers were all very highly leveraged.
Table 5-1 illustrates the destruction caused to highly leveraged owners of mortgage-backed securities or any other type of investment, for that matter. The table assumes that the speculator borrows thirty times his capital, in the range of mortgage security borrowing noted a few pages back. If the prices of his RMBS securities dropped only 3.3 percent, his capital would be wiped out entirely. If the bonds dropped 5 percent, he would lose his capital plus an additional 50 percent.
But as we know, housing prices didn’t go down 5 percent; they went down 33 percent to their lows in April 2009, and the drop in RMBS securities was significantly higher. If the buyer had owned ABX AAA RMBS subprime securities (the highest rating the agencies gave), on margin, he would have lost 70 percent of his principal to the low. If he had leveraged them thirty times, he would have lost twenty-one times his original investment in margin calls. If he owned the ABX issue we looked at in Figure 5-1, he would have lost thirty times his initial investment. To put this into numbers, if an institution had invested $10 million in this bond, leveraging it thirty times, the loss would have been $294 million.
That’s why Bear Stearns, Lehman Brothers, and Washington Mutual, all heavily leveraged in toxic bonds, no longer exist. That’s also why the Treasury, under Hank Paulson, needed $700 billion of Troubled Assets Relief Program (TARP) funds to bail out the banks and investment bankers. Without that fund, many more would not exist today.
But why couldn’t investors just sell the toxic securities? Again, the answer was a complete lack of liquidity. The portfolios normally held a wide variety of mortgage-backed securities with dozens of different pools. Nobody knew what they were really worth. In a bottomless market, why take the risk? Leverage and liquidity targeted mortgage bonds with the devastating power of a nuclear bomb. Thank you again, EMH and CAPM.
Granted, not all mortgage bonds fared quite this badly, but these figures make clear why the massive bailout of financial institutions was undertaken. Whether it was right or wrong to rescue the banks and investment bankers, given the shocking incompetence of many of their senior executives, is a question the reader should answer. But after three severe wipeouts caused by excessive leverage and lack of liquidity, shouldn’t they, too, at least have been aware of the enormous danger to the financial system of too much leverage and too little liquidity?
In their defense, I would say only that they were completely wedded to the idea that volatility was the only measure of risk to worry about and therefore did not factor in liquidity, leverage, or other risk factors. This held even though some of the largest of them, including Citigroup, owned a dozen or more mortgage originators (companies that underwrote the mortgages) and clearly knew how bad the product really was. As for Professor Fama and his colleagues, did this experience shake their belief that volatility is the only measure of risk or that the market is efficient? Apparently not. In 2007, with mortgage-backed security prices already dropping rapidly, Fama said in an interview, “The word ‘bubble’ drives me nuts,” and went on to explain why people could trust housing market values. “Housing markets are less liquid, but people are very careful when they buy houses. . . . The bidding process is very detailed.”12 Amen.
Rational Markets Don’t Have Bubbles or Crashes
In spite of what we’ve just seen on bubbles in this chapter and in earlier ones, most EMH believers still deny that bubbles and crashes exist. “I don’t even know what a bubble means. These words have become popular. I don’t think they have any meaning.”13 That’s Professor Fama, trying to defend the central core of the efficient-market hypothesis, that prices are always where they should be. He denies the existence of manias and crashes. Still, bubbles and IPOs present a particularly vexing point to EMH because they seem to defy consistently rational behavior. Fama and other EMH adherents are backed into a corner. EMH has to deny the existence of manias and panics, or it will be pierced by a fatal arrow—not a particularly pleasant way for a popular hypothesis to die. There was only one escape, and Professor Fama, never accused of not being highly intelligent, found it.
He states emphatically that bubbles don’t exist. Why? Because rational investors always keep prices where they should be. In the New Yorker article, Fama dodges, ducks, or sidesteps the volley of arrows the well-versed financial reporter John Cassidy fires at him. But in doing so he steps into a position even more challenging that to my knowledge has never been examined.
Continuing with EMH logic, if, as Fama says, there are no bubbles or panics, we have to look more closely at the rational investors who perform this extraordinary feat. We already examined this question in some detail in chapter 2*36 and again briefly in this chapter and found there are no widely followed fundamental analytical methods used by security analysts, money managers, and other rational investors that condone buying stocks at prices anywhere from 10 to 100 times or more normal valuation levels in a bubble. What is apparent from chapter 2 is that analysts and money managers do move away en masse from their analytical methods and pay bizarre prices. By doing so they are not acting with the automaton-like rationality EMH assumes. If they did follow their fundamental training, prices could not reach bubble levels.
EMH believers seem to have put themselves into an untenable position. They state that it is professionals and other sophisticated investors who keep prices where they should be. But as we see, obviously the log
ic doesn’t work. Could it be that once again EMH theory has made a bold assumption about the behavior of sophisticated investors without a shred of evidence that it is correct? A statement that seriously threatens the central premise of EMH theory is that it is highly knowledgeable investors that keep prices where they should be. Perhaps a little more research on how highly sophisticated investors act, rather than how they should act in theory, might prove very helpful.
Have We Learned Anything Yet?
You can now judge how accurate EMH has been in its core assumptions:
About liquidity
About leverage
About the correlation between volatility and returns
About whether volatility is stable over time
About rational investment “automatons” always keeping prices right
All the theoretical pillars of EMH and CAPM appear to have been knocked down. We have also seen the enormous damage done to the markets and economy during the long and celebrated reign of EMH.
What now? Should we just walk away from the markets, and forget about investing except under the mattress? EMH has led many millions of people to disastrous investment decisions. But there is a better way. It lies not far ahead of us, now that we are past the Black Knight and rode beyond the worst of the efficient-market forest. There are still major opportunities in the markets, I assure you, if we know how to identify them.
First, though, we need to equip ourselves with stronger armor and new broadswords forged by psychology and the new contrarian strategies. This done, we will learn how to dispose of the EMH dragon for good.
Chapter 6
Efficient Markets and Ptolemaic Epicycles
MY EXPERIENCE AS a Forbes columnist for more than thirty years—writing columns that EMH partisans did not take kindly to—gives me the tiniest inkling of what Galileo went through with his scientific work in the early seventeenth century. The great Italian scientist supported the new heliocentric idea of the solar system when a huge majority of philosophers and astronomers still subscribed to the geocentric view, namely, that the earth is the center of the universe. Galileo was forced to recant his views. When he published again, in 1632, he was arrested by the Inquisition, was found “vehemently suspect of heresy,”1 was forced to recant yet again, and spent the rest of his life under house arrest.
The geocentric view, by the way, had an impeccable pedigree going all the way back to the work of Ptolemy, a revered scholar who lived in the second century A.D. in Alexandria, the University of Chicago of its day. He was part of a cosmopolitan elite who had made the Egyptian city a jewel of scholarly activity, and his own outstanding contribution was the Ptolemaic system.
His treatise, using hundreds of years of celestial observations, explained the motion of the sun and planets and provided convenient tables allowing the computation of future or past positions of the planets. The basic premise was that the earth was the center of the universe and the planets, the sun, and the stars orbited around it. The Ptolemaic system was universally accepted by the civilized world for almost 1,600 years, filling a major role in land and sea navigation.
None other than Galileo introduced the telescope to astronomy in 1609. He became the first man to observe the craters of the moon, sunspots, the four large moons of Jupiter, and the rings of Saturn. Far from abandoning the Ptolemaic system, the model became increasingly complex in order to incorporate the new observations. Now the planets and stars moved around one another and around the earth in a combination of circles, epicycles, and eccentrics (large deferent circles—don’t ask—around whose centers the epicycles revolved). The result of this hodgepodge was a mind-boggling whirl.
Nonetheless, the Ptolemaic system met two major criteria of a useful scientific hypothesis: it was “predictive” in correctly forecasting where various celestial bodies would be at future points in time, and it was “explanatory” because it codified a system of planetary motion.
It was also entirely wrong.
Which brings us back to EMH. As discussed earlier, EMH and its companions, MPT and CAPM, are based on extensive mathematical analysis. Other critics and I would not dispute this. Apart from the strong evidence of the theory’s inaccuracy that we saw in the record of events covered in the preceding chapter, the controversy now moves further to the reason why: the underlying assumptions of EMH, as we’ll see, are highly questionable, or have never been tested, or are outright fallacious. Much of the ultrasophisticated mathematical analysis is constructed on these seriously flawed assumptions, which appear to be built on sand. Just as a space launch requires a sophisticated launch pad for a highly complex shuttle to be able to blast off, so highly advanced mathematics requires a solid base to predict market action correctly.
The second important area we’ll look at is the mathematical testing itself. Here I think you’ll find some surprises. Much of the original EMH testing was flawed, as we saw with volatility theory in the previous chapter, and didn’t prove that volatility was the sole or even an important risk factor. Once we’ve examined these assumptions and their flaws, you’ll understand why I liken the continued belief in EMH to the unyielding acceptance of the Ptolemaic system after Galileo had shown that the sun does not revolve around the earth.
Volatility’s Last Stand
The preceding chapter showed that EMH assumptions had gone down in flames in the cases of the 1987 market crash, the Long-Term Capital Management debade (1998), and then the 2007–2008 crash and the steep recession following it. One of the chief culprits was inadequate risk theory, with its focus on volatility to the almost complete exclusion of leverage, liquidity, and other important risk factors. Unlike the Ptolemaic system, EMH hasn’t even had reliable predictive power, and it offers no more accurate explanations of market movements than Ptolemy did of planetary motion.
Two questions we should now ask:
1. Why was there an almost obsessive focus on volatility as the sole measure of risk by the academics?
2. Was this focus justified?
Let’s look at these questions next.
Much of the previous chapter swirled around volatility. Does greater volatility reward investors with higher returns, and lower volatility with lower returns? From what we’ve seen in that chapter, the answer is a definite no. In reality, academic research found answers to this question more than three decades ago. Let’s look at these answers now.
How did leading EMH academics know that investors measured risk strictly by the volatility of the stock? They didn’t, nor did they do any research to find out, other than the original studies of the correlation between volatility and return, whose results were mixed at best. The academics simply declared it as fact. Importantly, this definition of risk was easy to use to build complex computer finance models, and that’s what the professors wanted to do. They could then build a simple but elegant theory.
Economists find this view of risk compelling, if not almost obsessional, because it is the way rational man should behave according to economic theory. If investors are risk-averse and economists can show this to be so, they have proof of a central concept of economic theory: that man is a rational decision maker. If investors will take greater risks only if they receive higher returns—eureka!—an eight-lane highway opens between investment markets and microeconomic theory. And via this highway, investment markets deliver to economic theory the ultimate payload—proof positive of rational behavior in markets they’ve searched for more than two centuries. Right or wrong, the idea is too seductive for economists to give up.
As we know, the professors also devised measures to adjust mutual funds’ and money managers’ performance for the riskiness of their portfolios—measures that, if volatility is not the sole measure of risk, are fallacious. Still, four decades or more later, these are still the key measurement of risk and return used. I might return 15 percent a year and my competitor 30 percent, but if her portfolio was much more volatile than mine, I would have the better risk-adjusted returns.
But the critical question is still there: why is volatility the measure of risk, rather than an analysis of a company’s financial strength, earnings power, leverage, liquidity, outstanding debt, and dozens of other measures that investment experts in corporate management use? Sure, volatility is alluring to economic types, but what else has it got going for it? Possibly you accept the measures without question. Most people do. But in truth it is faulty.