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Have we learned lesson from Lehman’s fall?

Ken Rogoff fears not:

The Confidence Game

CAMBRIDGE – This month marks the one year anniversary of the collapse of the venerable American investment bank, Lehman Brothers.  The fall of Lehman marked the onset of a global recession and financial crisis the likes of which the world has not seen since the Great Depression of the 1930’s. After one year, trillions of dollars in public monies, and much soul searching in the world’s policy community, have we learned the right lessons?  I fear not.

The overwhelming consensus in the policy community is that if only the government had bailed out Lehman, the whole thing would have been a hiccup and not a heart attack.  Famous investors and leading policymakers alike have opined that in our ultra-interconnected global economy, a big financial institution like Lehman can never be allowed to fail. No matter how badly it mismanages its business – Lehman essentially transformed itself into a real estate holding company totally dependent on a continuing US housing bubble – the creditors of a big financial institution should always get repaid.  Otherwise, confidence in the system will be undermined, and chaos will break loose.

Having reached the epiphany that financial restructuring must be avoided at all costs, the governments of the world have in turn cast a huge safety net over banks (and whole countries in Eastern Europe), woven from taxpayer dollars.

Unfortunately, the conventional post-mortem on Lehman is wishful thinking.  It basically says that no matter how huge the housing bubble, how deep a credit hole the United States (and many other countries) had dug, and how convoluted the global financial system, we could have just grown our way out of trouble.  Patch up Lehman, move on, keep drafting off of China’s energy, and nothing bad ever need have happened.

The fact is global imbalances in debt and asset prices had been building up to a crescendo for years, and had reached the point where there was no easy way out.  The United States was showing all the warning signs of a deep financial crisis long in advance of Lehman, as Carmen Reinhart and I document in our forthcoming book This Time is Different:  Eight Centuries of Financial Folly

Housing prices had doubled in a short period, spurring American consumers to drop any thought of saving money.  Policymakers, including the US Federal Reserve, had simply let the 2000s growth party go on for too long.  Drunk with profits, the banking and insurance industry had leveraged itself to the sky. Investment banks had transformed their business in ways their managers and boards clearly did not understand.

It was not just Lehman Brothers.  The entire financial system was totally unprepared to deal with the inevitable collapse of the housing and credit bubbles. The system had reached a point where it had to be bailed out and restructured.  And there is no realistic political or legal scenario where such a bailout could have been executed without some blood on the streets.  Hence, the fall of a large bank or investment bank was inevitable as a catalyst to action.

The problem with letting Lehman go under was not the concept but the execution.  The government should have moved in aggressively to cushion the workout of Lehman’s complex derivative book, even if this meant creative legal interpretations or pushing through new laws governing the financial system.  Admittedly, it is hard to do these things overnight, but there was plenty of warning.  The six months prior to Lehman saw a slow freezing up of global credit and incipient recessions in the US and Europe.  Yet little was done to prepare.

So what is the game plan now?  There is talk of regulating the financial sector, but governments are afraid to shake confidence.  There is recognition that the housing bubble collapse has to be absorbed, but no stomach for acknowledging the years of slow growth in consumption that this will imply. 

There is acknowledgement that the US China trade relationship needs to be rebalanced, but little imagination on how to proceed.  Deep down, our leaders and policymakers have convinced themselves that for all its flaws, the old system was better than anything we are going to think of, and that simply restoring confidence will fix everything, at least for as long as they remain in office.

The right lesson from Lehman should be that the global financial system needs major changes in regulation and governance. The current safety net approach may work in the short term but will ultimately lead to ballooning and unsustainable government debts, particularly in the US and Europe. 

Asia may be willing to sponsor the west for now, but not in perpetuity.  Eventually Asia will find alternatives in part by deepening its own debt markets.  Within a few years, western governments will have to sharply raise taxes, inflate, partially default, or some combination of all three.  As painful as it may seem, it would be far better to start bringing fundamentals in line now.  Restoring confidence has been helpful and important. But ultimately we need a system of global financial regulation and governance that merits our faith.

Markets can be wrong and the price is not always right

Richard Thaler, professor at U. of Chicago, chastises the foundation of the modern finance, the Efficient Market Hypothesis (or EMH) (source: FT),

I recently had the pleasure of reading Justin Fox’s new book The Myth of the Rational Market . It offers an engaging history of the research that has come to be called the “efficient market hypothesis”. It is similar in style to the classic by the late Peter Bernstein, Against the Gods. All the quotes in this column are taken from it. The book was mostly written before the financial crisis . However, it is natural to ask if the experiences over the last year should change our view of the EMH.

It helps to start with a quick review of rational finance. Modern finance began in the 1950s when many of the great economists of the second half of the 20th century began their careers. The previous generation of economists, such as John Maynard Keynes, were less formal in their writing and less tied to rationality as their underlying tool. This is no accident. As economics began to stress mathematical models, economists found that the simplest models to solve were those that assumed everyone in the economy was rational. This is similar to doing physics without bothering with the messy bits caused by friction. Modern finance followed this trend.

From the starting point of rational investors came the idea of the efficient market hypothesis, a theory first elucidated by my colleague and golfing buddy Gene Fama. The EMH has two components that I call “The Price is Right” and “No Free Lunch”. The price is right principle says asset prices will, to use Mr Fama’s words “fully reflect” available information, and thus “provide accurate signals for resource allocation”. The no free lunch principle is that market prices are impossible to predict and so it is hard for any investor to beat the market after taking risk into account.

For many years the EMH was “taken as a fact of life” by economists, as Michael Jensen, a Harvard professor, put it, but the evidence for the price is right component was always hard to assess. Some economists took the fact that prices were unpredictable to infer that prices were in fact “right”. However, as early as 1984 Robert Shiller, the economist, correctly and boldly called this “one of the most remarkable errors in the history of economic thought”. The reason this is an error is that prices can be unpredictable and still wrong; the difference between the random walk fluctuations of correct asset prices and the unpredictable wanderings of a drunk are not discernable.

Tests of this component of EMH are made difficult by what Mr Fama calls the “joint hypothesis problem”. Simply put, it is hard to reject the claim that prices are right unless you have a theory of how prices are supposed to behave. However, the joint hypothesis problem can be avoided in a few special cases. For example, stock market observers – as early as Benjamin Graham in the 1930s – noted the odd fact that the prices of closed-end mutual funds (whose funds are traded on stock exchanges rather than redeemed for cash) are often different from the value of the shares they own. This violates the basic building block of finance – the law of one price – and does not depend on any pricing model. During the technology bubble other violations of this law were observed. When 3Com, the technology company, spun off its Palm unit, only 5 per cent of the Palm shares were sold; the rest went to 3Com shareholders. Each shareholder got 1.5 shares of Palm. It does not take an economist to see that in a rational world the price of 3Com would have to be greater than 1.5 times the share of Palm, but for months this simple bit of arithmetic was violated. The stock market put a negative value on the shares of 3Com, less its interest in Palm. Really.

Compared to the price is right component, the no free lunch aspect of the EMH has fared better. Mr Jensen’s doctoral thesis published in 1968 set the right tone when he found that, as a group, mutual fund managers could not outperform the market. There have been dozens of studies since then, but the basic conclusion is the same. Although there are some anomalies, the market seems hard to beat. That does not prevent people from trying. For years people predicted fees paid to money managers would fall as investors switched to index funds or cheaper passive strategies, but instead assets were directed to hedge funds that charge very high fees.

Now, a year into the crisis, where has it left the advocates of the EMH? First, some good news. If anything, our respect for the no free lunch component should have risen. The reason is related to the joint hypothesis problem. Many investment strategies that seemed to be beating the market were not doing so once the true measure of risk was considered. Even Alan Greenspan, the former Federal Reserve chairman, has admitted that investors were fooled about the risks of mortgage-backed securities.

The bad news for EMH lovers is that the price is right component is in more trouble than ever. Fischer Black (of Black-Scholes fame) once defined a market as efficient if its prices were “within a factor of two of value” and he opined that by this (rather loose) definition “almost all markets are efficient almost all the time”. Sadly Black died in 1996 but had he lived to see the technology bubble and the bubbles in housing and mortgages he might have amended his standard to a factor of three. Of course, no one can prove that any of these markets were bubbles. But the price of real estate in places such as Phoenix and Las Vegas seemed like bubbles at the time. This does not mean it was possible to make money from this insight. Lunches are still not free. Shorting internet stocks or Las Vegas real estate two years before the peak was a good recipe for bankruptcy, and no one has yet found a way to predict the end of a bubble.

What lessons should we draw from this? On the free lunch component there are two. The first is that many investments have risks that are more correlated than they appear. The second is that high returns based on high leverage may be a mirage. One would think rational investors would have learnt this from the fall of Long Term Capital Management, when both problems were evident, but the lure of seemingly high returns is hard to resist. On the price is right, if we include the earlier bubble in Japanese real estate, we have now had three enormous price distortions in recent memory. They led to misallocations of resources measured in the trillions and, in the latest bubble, a global credit meltdown. If asset prices could be relied upon to always be “right”, then these bubbles would not occur. But they have, so what are we to do?

While imperfect, financial markets are still the best way to allocate capital. Even so, knowing that prices can be wrong suggests that governments could usefully adopt automatic stabilising activity, such as linking the down-payment for mortgages to a measure of real estate frothiness or ensuring that bank reserve requirements are set dynamically according to market conditions. After all, the market price is not always right.

Uneven "recovery" in housing

Distressed sales now make up around two-thirds of transactions in Las Vegas and Miami; even in midwest area, where housing had relatively less drop, 39% of mortgage owners have negative equity (or underwater).  At last, the market for the more expensive houses (500K and above) is simply not moving.  It looks like still too early for housing recovery.  (source: WSJ)

The U.S. housing market was unified by the bust. After peaking in 2006, home prices across the country joined the march downward. Are investors prepared for a return to more normal times?

[u.s. housing recovery]

It wasn't long ago that a nationwide price decline was considered almost impossible by many, not having been observed since the Great Depression. Supply and demand have usually dictated prices on a local level.

And yet, now that there are signs of stabilization, some investors appear to be hoping for prices to recover across the board. Better housing data, such as a rise in the S&P/Case-Shiller index have helped stocks extend a heady rally. A one-time government tax deduction for first time buyers and seasonal demand for homes have added a timely boost.

But a look on a regional level shows a different story. The likes of overbuilt Las Vegas and Miami have yet to see prices turn. There, distressed sales now make up around two-thirds of transactions, according to the National Association of Realtors.

Such distressed sales, mainly foreclosures, are discounted on average 15% to 20%, dragging overall prices lower. Granted, that may set the stage for higher prices when foreclosures slow, but there still is little sign that inventory is near equilibrium.

On the face of it, other parts of the country appear to have better traction. Take the Midwest. Cleveland saw prices rise 10% in the three months through June, the fastest of any location in S&P/Case Shiller's 20-city index.

Midwestern states will likely face some hiccups in any recovery. The NAR reckons the Midwest still has 8.0 months' supply of single-family homes on the market between $100,000 and $250,000, compared with 8.9 months a year ago. During the 1990s, the average nationwide was 6.6 months.

That supply could be tough to clear. The many buyers underwater on existing homes will struggle to move, even to a cheaper home. In Ohio, for instance, some 39% of mortgages have negative equity, or are attached to properties worth less than outstanding debt, according to research firm First American CoreLogic. The national average is 32%.

Demand may stay especially weak for homes in high price categories. The NAR says just 2.5% of the 460,000 homes sold in July cost $500,000 or more. In the fourth quarter of 2004, such homes accounted for 11.2% of the total.

That presents potential for higher average sales prices if more high-end sales are completed. But, with "jumbo" mortgages harder to come by, demand is likely to remain concentrated at lower price levels.

Of course, stability in some housing markets is refreshing. But after the summer house-hunting season ends, the sum of a fragmented market is unlikely to be a unified rise.

Treasuries or gold?

Which is a better investment, under different scenarios?  WSJ analyzes:

Is the outlook for the world economy dark enough for gold to continue to glitter?

Remarkably, the gold price has appreciated 12% since April, a period during which financial-meltdown fears appear to have receded and investors have rushed back into riskier assets. Gold's resilience suggests continuing demand for an asset that could outperform in worst-case scenarios.

But not every difficult economic outcome is the same. That is something investors need to remember as they decide whether gold — rather than Treasurys — really is the best disaster hedge.

Treasurys start with several advantages. They produce an income stream, whereas gold doesn't. And, although Treasurys would be hit if there is a strong economic rebound with low inflation, gold would likely be hammered.

[gold prices] 

Next, Treasurys actually did better than gold in the fear-drenched period at the end of last year. The Merrill Lynch price index for the 10-year Treasury jumped 11.6% from September through the end of 2008. The Comex gold price was up 6.6% over the same period, and it sold off sharply in the middle of the meltdown. That last fact suggests gold benefits when markets are functioning — like now — but the metal, like other assets, can fall when markets close down.

In other words, Treasurys could trump gold in a Japan-like environment, where deflation pushes up real yields but isn't high enough to cause serious stress on the financial system and the wider economy.

But gold has a big friend in Western central banks, especially the Federal Reserve, which is still printing enormous amounts of dollars to support key markets. This makes the inflation outlook uncertain, helping gold and hurting currencies like the dollar.

The printing looks set to continue. Ominously, this weekend, the G-20 said central-bank liquidity support "will need to remain in place for some time."

One area where that support could stay in place for a long time is for the U.S. housing market. Right now, there is almost no private-sector demand for nonconforming residential mortgages, reflected in the fact that the U.S. government has effectively or explicitly guaranteed as much as 85% of all mortgages originated this year, according to Inside Mortgage Finance. In turn, the Fed is buying nearly 80% of government-backed mortgages packaged in securities. If it pulls back, house prices could resume their slide, triggering more foreclosures and losses for banks.

Finally, soaring fiscal deficits favor gold. The IMF expects G-7 countries to show a combined fiscal deficit equivalent to 10.36% of GDP this year, more than double the level following the 1990-91 recession. True, it is impossible to time a fiscal Armageddon bet. The yen has stayed strong even as Japanese government borrowing has exploded over the past 20 years.

But government finances are now deteriorating in most developed countries.

For pessimists, if we're in for a Japanese-style deflationary bust, buy Treasurys. For other disaster scenarios, go for gold.