The Efficient Markets Hypothesis: What Have We Learned?

Thanks to Fernando Martin for passing this along: The Global Financial Market Crisis and the Efficient Markets Hypothesis: What Have We Learned? (by Ray Ball, U. Chicago).

Abstract: The sharp economic downturn and turmoil in the financial markets, commonly referred to as the “global financial crisis,” has spawned an impressive outpouring of blame. The efficient market hypothesis - the idea that competitive financial markets ruthlessly exploit all available information when setting security prices - has been singled out for particular attention. Like all good theories, market efficiency has major limitations, even though it continues to be the source of important and enduring insights. Despite the theory’s undoubted limitations, the claim that it is responsible for the current worldwide crisis seems wildly exaggerated. This essay discusses many of those claims. These include claims that belief in the notion of market efficiency was responsible for an asset bubble, for investment practitioners miscalculating risks, and for regulators worldwide falling asleep at the switch. Other claims are that the collapse of Lehman Bros. and other large financial institutions implies market inefficiency, and that an efficient market would have predicted the crash. These claims are without merit. Despite the evidence of widespread anomalies and the advent of behavioral finance, we continue to follow practices that assume efficient pricing.

Repo 105: Fooled Again?

I'm still trying to figure this Repo 105 thing out. I read an interesting article in the Financial Times: Fooled Again, but it leaves many questions unanswered.

The paper version of this article has an inset called How Repo 105 Worked. Here is what it says.

Banks use repurchase agreements, known as repos, all the time for short-term financing. One borrows cash and gives the other securities, such as government bonds, as collateral. Both agree to unwind the arrangement on a set date. The deals, which run only for days or weeks, are accounted for as financings, and remain on the books with banks recording and asset--the cash--and a matching liability in the promise to buy back the collateral.

Lehman's 105 was different -- insteach of handing over securities equivalent to the cash it received, the bank gave more than was necessary. The point was to exploit a loophole allowing such over-collateralized deals to be accounted for as true sales. Lehman then reported its obligation to repurchase the securities at a fraction of the full cost, and used the cash it had received to pay off its liabilities, thereby "shrinking" its balance sheet.

Now, if you understand this, you are smarter than me!

The first paragraph seems OK, except that perhaps "matching liability" should be replaced with "corresponding liability."

The second paragraph seems just plain wrong to me. Lehman's 105 was not "different" in the sense the cash loan was over-collateralized. Over-collateralization (the "haircut") is normal in repo transactions.

And the point was not to exploit the "loophole" of treating the repo transaction as a "true" sale. After all, repo is short for "sale and repurchase agreement." There is a legitimate sense in which there was a sale.

And if one does treat the transaction as a sale, then I think there is a legitimate reason for why one should not have to record the corresponding liability to repurchase the asset (pay back the cash loan).

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An example. Imagine that I have asset (capital) worth $100 and no debt. I am worth $100. Imagine that I repo my asset for $90 in cash: What does my balance sheet look like?

I am an economist (not an accountant); so I would say that your B/S should now look like this:
Assets: $100 (capital) + $90 (cash)
Liabilities: $90 (cash loan -- promise to repurchase asset)
Wealth: $100 (unchanged)

But as this is a repo, let's take the "sale" part of repo seriously. That is, imagine that I have "sold" my asset. In fact, there is a sense in which I have sold it: I have diverted control of the asset to my creditor, who holds it as collateral. It's not like I (or other shareholders) can access this asset in the event of default. If this is true (and it is), then why should I record the asset on my books? OK, suppose I don't. Then my B/S looks like this:

Assets: $90 (cash)
Liabilities: ...what...you want me to record the $90 loan? Shouldn't I leave this loan off my books? After all, I am not counting the corresponding asset as something I own. And I do not have to pay back my loan -- I have the (legal) option of not doing so; in which case the creditor gets to keep my asset. Moreover, if I do include the $90 liability, then my reported net worth drops to zero! Let's be reasonable here and not include the liability; in this case...
Net worth: $90 ($10 less than prior to the repo, but still higher than zero, which would grossly underestimate my net worth)
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If there was a problem with what actually transpired, it probably resides in the fact that the transaction was not disclosed (off balance sheet items were not reported). While this sounds like funny business (and it no doubt was), I do not think that any law was broken (and keep in mind that everything was disclosed to Ernst & Young, the accountants in this case).

As the Financial Times article explains, there are a lot of grey areas in the theory of accounting. If a firm exploits these grey areas to make their books look (temporarily) better, who is to blame? The firm, the "independent" accountants, or the accounting principles themselves?

If your answer is the firm, then be prepared to condemn most firms (and individuals too) of the practice of keeping some assets and liabilities off balance sheet. Be prepared to blame governments as well, since many important government liabilities are not recorded in "official" government debt measures. In short, this is not a problem that resides with just a few Lehman executives.

What is Repo 105, Man?

And so it appears that Lehman Brothers cooked their books. Another example of capitalism run amok. (It is convenient here to ignore how governments cook their books all the time. Is anyone from the Greek finance ministry going to jail, by the way?).

The accounting trick, apparently, was the use of Repo 105; see here (or Google Lehman and Repo 105). I've never heard of this before, and I'm still not sure I understand it. Let's see...

Imagine that I own a home worth $105,000. That's the full extent of my wealth. I have no debt. My balance sheet records $105K in assets and net worth.

Now, imagine that, for whatever reason, I need $100K in cash for a few days. I could sell my house, but net of the realtor's fee, I am left with less than $100K. I could take out a home equity loan, but this is expensive too. By far the cheapest way to acquire the short-term cash I need is by repo (a sale and repurchase agreement).

That is, I "sell" my asset to the bank for $100K and promise to "repurchase" my house a few days later (with a little bit of interest, that I set to zero here) at $100K. If I default on my promise to repurchase "my" house, the bank gets to keep it. If the house is really worth $105K, the bank nets $5K. This is nothing more than a form of collateralized lending. Note that the loan has been "overcollateralized" in the sense that I only get $100K in cash for my $105K house (there is a 5% "haircut" on the collateral). The 105/100 ratio is what is meant by "repo 105."

So what is wrong with this? Nothing, so far: it is a standard repo transaction. The problem, apparently, is in how this transaction is accounted for on my balance sheet.

Suppose that the said transaction occurs near year end, and that I agree to repurchase my home at the beginning of next year. How do my books look at year end?

Well, I'm not sure. I've always been terrible at accounting. I suppose I could say one of two things.

Method 1. I am holding assets of $100K in cash and $105K in capital. I have a liability of $100K. My net worth is $105K.

Method 2. I am holding assets of $100 in cash. But as I have "sold" my home, I have no other assets. And well, it seems appropriate then to "ignore" my promise to repurchase my home in the future (i.e., I treat it as an "off balance sheet item"). My reported net worth is now $100K.

Method 2 is the alleged "repo 105 trick" used by Lehman and signed off on by their accountants, Ernst and Young. Clearly, I must have missed something.

Maybe the existence of leverage changes things? OK, assume that I have a mortgage on my home worth $50K (my equity is $55K). My leverage ratio (debt to equity ratio) is 50/55 = 0.9.

Question: can I still repo my home for $100K? Answer: while you would be put in jail for pledging other people's assets as collateral for your own loan, financial firms are evidently allowed to do so (rehypothecation). Maybe rehypothecation is important for the question at hand (but if so, why is it not mentioned?). Let us assume away rehypothecation for now.

OK, assume that I now need $50K in cash. I repo my home for $55K. There is a 10% haircut on my collateral in this case; a "repo 110" if you will. How do the different reporting methods affect my leverage ratio?

Method 1. I am holding assets of $50K in cash and $105K in capital. My liabilities consist of a $50K mortgage and a $50K obligation to repay my cash loan. My net worth is $55K. My leverage ratio is (50+50)/(50+55) = 0.95. That is, this transaction has increased my leverage ratio (from 0.9).

Method 2. I am holding $50K in cash, but as I have "sold" my home, I have no other assets. Having "sold" my loan, I no longer have a mortgage obligation. And, as before, consistency appears to require that I "ignore" my obligation to repurchase my house. My net worth is now reported as $50K. My leverage ratio is 0. Viola!

So, by using Method 2, I "evaporate" $5K in my net worth (10% of my equity). Call me crazy, but if I was a shareholder, I think I would be rather upset. On the other hand, my firm's reported leverage ratio now looks a whole lot better. Uh...OK...like I said, I never understood accounting.

The key to this whole scandal appears to be that "Method 1" is something of an industry norm for repo contracts, while "Method 2" is not. Nothing necessarily illegal about Method 2 (all sorts of items exist off balance sheet in private and public sector accounts), but perhaps its use should have been disclosed? And if so, by whom? Not Lehman Brothers necessarily; but surely their accountants?

Will Federal Reserve Secrecy Conceal Incompetence and Corruption?

Having your own blog can be lot's of fun. I especially enjoy the spirited debates with some of my readers (from whom I have already learned a lot from).

I had a recent exchange with "Pointbite" where I challenged the sanity of Ron (Conspiracy Theory) Paul. The debate, however, was strangely aborted. I thought that Pointbite had given up. I realize now that there must have been a technical glitch that prevented him/her from posting a response. Happily (for me, at least), I accidently came across Pointbite's rebuttal here.

I think that Pointbite asks some good questions. I'm planning another post on the subject. But for now, let me briefly try to clear a few things up.

First, I am not saying that the Fed should never be audited. And I am not saying that the Fed should keep all things secret forever. What I am suggesting is that there are some types of information that should not be disclosed during a financial crisis. The identity of those banks making use of the discount window or emergency lending facilities is an example of such information that should probably not be disclosed; at least, not until the crisis has passed. Likewise, the terms of the lending arrangements should not be disclosed; again, until well after the crisis is passed.

The rationale for such a policy, whether it ultimately proves correct or not, is at least a plausible one for now. Releasing such information during a crisis is likely to lead to a run on the banks involved; exacerbating the crisis. Moreover, because of the stigma associated with using the window, disclosure of such information would prevent banks from participating. The rationale for encouraging participation, of course, assumes that it is socially desirable. This is debatable, for sure. But it is precisely this that should be debated. Gratuitous attacks on the Fed, like those served by Ron Paul, are absolutely of no help here (although he will find them useful for political reasons).

Some other things of note. The Fed has evidently never released information relating to its discount window lending. On routine lending as the normal term is very short (typically overnight, to healthy institutions, fully secured), I fail to see any purpose from disclosure at any time but if the lag were long enough, no real harm either -- just the burden/cost of publicly disclosing something that no one will much care about.

The Section 13(3) special facilities is a different matter from routine discount window lending. This section has not been used for such a long time that I don't think the Fed has any clear policy concerning the release of information here (except that it shall not be released during a financial crisis). I believe that such information should eventually be released, and Bernanke has evidently suggested as much in his testimony to Congress.

WSJ: Why Financial Reform is Stalled

Came across this excellent article today, by Peter J. Wallison. In case you haven't seen it, click here.

In a nutshell, he criticizes the standard explanation of political gridlock (an hypothesis that does not square well with the fact of resistance on both sides of the aisle in Congress).

Instead, he suggests the following entirely plausible explanation: The current proposals are not grounded in a valid (or persuasive) explanation of what caused the financial crisis. He goes on to give a lucid description of the power of moral hazard.