Summary
Roger Lowenstein thought that the current Great Recession could drive a stake through the efficient-market hypothesis (EMH). Analogously, Jeremy Grantham claimed that the incredibly inaccurate efficient market theory cased a lethally dangerous result that led to current plight. However, the EMH is not responsible for the current crisis. Eugene Fama stated that the prices of securities reflect all known information that impacts their value. The hypothesis implies that the prices in the market are mostly wrong, and it is hard to say whether they are too high or too low. Regulators wrongly believed that financial firms were offsetting their credit risks, while the banks and credit rating agencies underestimated the risk in real estate. EMH is not an excuse by the CEOs and regulators of failed financial firms.
After the 1982 recession, the U.S. and world economies entered into a long fluctuations period which called the “Great Moderation”. Risk premiums shrank and individuals and firms took on more leverage. Prof. Robert Shiller collected the data which indicates from 1945 through 2006 the maximum cumulative decline in the average price of homes. This low volatility might lead to the mortgage security composed of a nationally diversified portfolio of loans would have never come close to defaulting. These models led credit agencies to rate these subprime mortgages as “investment grade”. But this assessment was faulty. In fact, never before have home prices jumped that far ahead of prices and incomes.
These are ignored as Wall Street was reaping large profits bundling and selling the securities while American was happy for home ownership. The yields on these mortgages were high despite their investment-grade rating and the market was rightly suspicious of the quality of the securities. However, financial firms ignored these warnings. CEOs failed to exercise their authority to monitor overall risk of the firm and instead put their faith in technicians whose narrow models could not capture the big picture. The misreading of these economic trends did not just reside within the private sector. As home prices continued to climb and subprime mortgages proliferated, there is a permanent blot on the Fed’s record because of the failure to see these problem.
The crisis wasn’t due to blind faith in the EMH. The fact that risk premiums were low does not mean they were nonexistent and that market prices were right. The Great Moderation is real and risks haven’t disappeared, since financial firms drove too fast, the central bank failed to stop them, and the housing deflation crashed the banks and the economy.