The recent U.S. financial crisis, the U.S. stock market crash of 1987, and other recent anomalies have seriously challenged Fama's classic efficient capital markets hypothesis. These events have made it likely that future capital markets research will be enriched by the important role that human behavior plays in the success or failure of the financial markets. This paper examines the factors causing the recent crisis within the United States financial senices sector, the degree to which it may be explained by efficient capital markets theory and the degree to which such behavioral finance concepts as noise, excessive volatility, fashion and fads, and irrational behavior compromise that theory.
Keywords: Financial Crisis; Efficient Market Hypothesis; Behavioral Finance
The financial crisis in the U.S. economy in the late summer and early fall of 2008 was so great that it largely overshadowed the presidential election campaign. Each day the media reported new evidence signaling the continuing decline of our financial markets and economy. For example, in a period of a few months beginning in early September 2008, the government-sponsored enterprises known as Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation) were placed in conservatorship; Lehman Brothers filed for bankruptcy; Bank of America acquired Merrill Lynch at a significant discount; the government intervened to help insurance giant American International Group (A.I.G.); The Washington Mutual Investment Fund was closed by the Federal Office of Thrift Supervision; Goldman Sachs and Morgan Stanley became bank holding companies; and Wells Fargo Bank eventually took over Wachovia Bank. These events, in addition to the earlier collapse of the IndyMac Bank and the takeover of the investment firm Bear Sterns by J. P. Morgan Chase, contributed to significant upheavals in the credit markets and directly reduced the availability of credit to banks, businesses, and average Americans. This paper examines the factors causing the recent crisis within the United States financial services sector, the degree to which it may be explained by efficient capital markets theory and the degree to which such behavioral finance concepts as noise, excessive volatility, fashion and fads, and irrational behavior compromise that theory.
WHAT CAUSED THE CRISIS?
Much of the initial deterioration can be attributed to the burst of the housing bubble which caused a domino effect throughout the financial markets. As one "domino" after another fell, the entire financial services segment felt the ripple effect. The media initially characterized the financial crisis during 2007 and 2008 as a "credit crunch" or "credit crisis." This credit crisis began in July 2007 when investors lost confidence in the value of securitized mortgages in the United States. The resulting liquidity crisis prompted a substantial injection of capital into worldwide financial markets by die United States Federal Reserve and European Central Bank. The TED spread, an indicator of perceived credit risk in the general economy, spiked in July 2007, remained volatile for a year, and then spiked even higher in September 2008 (Corporate Executive Board, 2008).
In fact, the financial services sector experienced significant growth since the early 1980's, largely due to the introduction of securitization which permits banks to offload credit risk to capital markets and focus on generating fees rather than interest income" (Corporate Executive Board, 2008). As banks increased the number of home loans made to risky borrowers, the mortgage banks and brokers who originated the mortgages, pooled similar mortgages into groups and sold them for a fee. This practice was made more risky by the mortgage originators hiring investment banks to package diese mortgages in different risk categories (tranches) on the basis of their maturities. The investment banks then sold die desirable tranches but retained significant amounts of the less desirable tranches (typically lowest-return, lowest-risk tranches). The investment banks sold diese securities to a wide variety of investors including insurers, hedge funds, Fannie Mae, and Freddie Mac. In some cases, the banks placed die securities in off-balance sheet funds (Structured Investment Vehicles) that the banks themselves sponsored (Corporate Executive Board, 2008). This increased die concentration of risk in their various investments. Anomer factor mat contributed to me growing crisis was die purchase of credit protection (or insurance) in the form of credit default swaps to enhance me credit rating or to hedge die value of die securities. What this effectively did was transform higher risk assets into lower-risk assets. The role of insurance companies, like A.I.G., in providing credit enhancement or protection, made asset values on balance sheets dependent, in part, on insurance company solvency. For this reason, regulators viewed the potential bankruptcy of A.I.G., which had a very large credit default swap portfolio, as posing a systemic risk (Corporate Executive Board, 2008). See Figure 1.
As mentioned earlier, the housing collapse in the U.S. is often cited as having caused the financial crisis but me financial system was already vulnerable because of intricate and over-leveraged financial contracts and operations, as well as a U.S. monetary policy that made die cost of credit negligible and encouraged such overleverage (Corporate Executive Board, 2008).
How did me markets react during mis period? The S&P 500 Index during 2008 was the most volatile in history. The two graphs below show mis market instability. Graph 1 provides die daily percentage change in the S&P 500 Index since December 3 1 , 2007. Graph 2 shows how explosive the index was late in the 3rd quarter and 4th quarter of 2008.
The markets have remained volatile since the emergence of the financial crisis.
EFFICIENT CAPITAL MARKET THEORY DEFENDED
An efficient capital market (also efficient market hypothesis) is a "market in which prices always 'fully reflect' all available information" (Fama, 1970, p.383). University of Chicago financial economist Eugene Fama, who is widely recognized as the father of modern finance, is best known for his work developing the efficient market hypothesis. In the decades before the 1980s his theory had substantial support because "markets were efficient, prices were unpredictable, and financial economists did not know how to spell the word anomaly" (Thaler, 1993, p.xvi). Today, however, the theory does have its critics because of research that has highlighted several apparent anomalies which appear to refute the efficient market hypothesis. Several of these anomalies include (Malkiel, 2003):
* Patterns of possible predictability based on behavior of past stock prices
* Short-run momentum due to under-reaction to new information
* Some pattern recognition techniques
* Long-run return reversals
* Seasonal and day-of-the week patterns
* Predictable patterns based on time series analysis
* Predicting future returns from dividend yields
* Predicting market returns from initial price-earnings multiples
* Various other time series patterns
* Cross-sectional prediction patterns based on firm characteristics and valuation parameters
* Size effects
* Value stocks
* Equity risk premium
Burton Malkiel (2003) a notable advocate of the efficient capital markets hypothesis provides arguments against the apparent challenges. Some of his arguments include:
* The importance of distinguishing between statistical and economic significance. Once transaction costs are considered, die employed strategy would no longer yield higher returns.
* Predictable patterns tend to disappear once they are published.
* The apparent inefficiencies may really reflect varying risk premiums and investors' required rates of return.
* The question of whether beta is the proper measure of risk; the capital asset pricing model (CAPM) does not capture all of the risk elements.
* Survivorship bias
Malkiel (2003) concludes that our stock markets are more efficient and less predictable than many recent academic papers would lead us to believe. He states that the "true value will win out in the end." Malkiel (2003) further states that markets can be efficient even if they make valuation errors; market participants are irrational; and, stock prices exhibit greater volatility than can be explained by market fundamentals. Malkiel (2003) even supported market efficiency in the stock market crash of 1987 when market prices dropped by one-third. Behaviorists provided psychological considerations to explain that decline since they believed die basic elements of valuation did not change. However, Malkiel (2003) defended die efficient market hypothesis attributing the market crash to the cumulative effect of several unfavorable fundamental events.
Malkiel (2003) again supported the efficient market hypothesis during die internet bubble of the late 1990s when internet and high-tech companies experienced significant declines in what had been incredibly high market values. He argued that the professionals made valuation errors that were outlandish and unsustainable in projecting the growth rates and sustainability of mese companies.
How would Malkiel defend die efficient markets hypothesis as it related to the markets behavior in 2008? Are professionals getting it wrong? Are there unfavorable fundamental events? In fact, the Corporate Executive Board (2008) cited several key mistakes and flawed assumptions including:
* An increase in housing prices beyond rational levels. A speculative bubble, energized by abundant and cheap liquidity, developed as real estate prices rose in property markets in the U.S. and Europe.
* Mortgage banks were able to easily shift the credit risk to other investors. They made their money from fees rather than total returns. Basically, the mortgage originators lacked sufficient incentive to properly police borrower credit because diey knew they were transferring the credit risk to other investors.
* Investment banks and rating agencies did not fully appreciate and understand the risks of both lower quality and higher quality investments. Rating agencies certified the credit- worthiness of die super-senior tranches without fully recognizing the underlying risks.
* Investors and banks used large amounts of short-term debt to purchase long-term securities that exposed diem to declines in asset values or disruptions in short-term markets.
* A flawed assumption that securitization spreads risk. Some banks retained significant concentrations of credit risk through super-senior CDO tranches and off-balance sheet Structured Investment Vehicles.
* A belief that rating agencies possessed the expertise and proper incentives to provide accurate risk evaluations.
* The flawed assumption that investment bank advisory and fee-based businesses required relatively little equity capital. The conventional approach to allocating capital to bank advisory businesses proved to be overly-focused on credit/market value at-risk and failed to protect against revenue volatility caused by losses in confidence (Corporate Executive Board, 2008).
Based on the mistakes and flawed assumptions listed above, is the efficient market hypothesis still valid as long as we have evidence of unfavorable fundamental events and professionals making errors? Will there ever be a perfect market in which there are no unfavorable events and human errors? What about the reaction of investors to human error? Are these mistakes and flawed assumptions accountable for all of the volatility in the markets today?
While Malkiel (2003) cited the cumulative effect of several unfavorable fundamental events as a plausible defense of the efficient capital market hypothesis during the stock market decline of October 1987, other authorities cited an obvious lack of fundamental economic news concurrent with the 1987 market crash (Cutler, Poterba, and Summers, 1989). Cutler et al. (1989) found that most of the variation in stock returns could not be explained by readily available measures of new information.
Lawrence Summers questions the theoretical as well as the empirical foundation of the efficient market hypothesis. He concludes:
... the evidence found in many studies that the hypothesis of efficiency cannot be rejected should not lead us to conclude that market prices represent rational assessments of fundamentals valuations. Rather, we must face the fact that most of our tests have relatively little power against certain types of market inefficiency. In particular, the hypothesis that market valuations include large persistent errors is as consistent with the available empirical evidence as is the hypotheses of market efficiency. These are exactly the sort of errors in valuation one would expect to see if market valuations involved inflation illusion or were moved by fads as some have suggested (Thaler, 1993, ppl61-162).
Behavioral finance attempts to explain stock market anomalies that contradict the efficient market hypothesis by applying psychology-based theories (e.g., mental accounting, anchoring, overconfidence, confirmation and hindsight bias, herding, overreaction and availability bias, prospect theory, gamblers' fallacy).
Robert Schiller (1984) proposed that "mass psychology may well be the dominant cause of movements in the price of the aggregate stock market" (p. 458). He argued from a social-psychological standpoint for the importance of fashions and fads in financial markets. Schiller suggested that since investors lack any clear, complete model of the behavior of prices, the process in which their opinions are conceived are social - in other words, individuals are influenced by the views of others. These fashions and fads are unpredictable and investors demand is comparatively unpredictable as well which can cause large swings in the market. Ordinary investors tend to overreact to news and information, whether related to earnings and dividend announcements, macroeconomic data, or consumer confidence. That is, they can be influenced and can move the market (Schiller, 1984).
"Research in experimental psychology has suggested that most people overreact to unexpected and dramatic news events" (DeBondt and Thaler, 1986). Certainly, there were some surprising and extraordinary news events in 2008. Are investors reacting to real information in the market? Black (1986) described noise as "what makes our observations imperfect. It keeps us from knowing the expected return on a stock or portfolio. It keeps us from knowing whether monetary policy affects inflation or unemployment. It keeps us from knowing what, if anything we can do to make things better. . . . noise is information that has not arrived yet. It is simply uncertainty about future demand and supply conditions within and across sectors" (p. 529). Black contrasted noise with information and stated that noise helps keep the markets liquid. Noise traders are not maximizing utility so why do they trade? One reason they trade is they like to do it. Another reason is that because there is so much noise in the market, they think the noise is information and trade on it. Noise may well be one of the major reasons why investors break the utility decision rules and develop rules of thumb. And, before you know it, these rules make their way into mainstream America through the media. So how much of the volatility in the market today is attributable to noise or to real information?
So did the stock market overreact in 2008? The markets have been highly volatile since the beginning of the recent crisis. News events were unforeseen and dramatic. Valuation errors were made. How much of the volatility in the markets is rational versus irrational? How much is attributable to investor uncertainty, overreaction, noise, or fads and fashion? The future of finance and understanding the markets of the 21st century will emerge from the behavioral arena. More focus will be on the behavior of rational and irrational investors and a paradigm shift, albeit small, will emerge to a more open acceptance that the behavior of rational and irrational investors does matter! There will be much research trying to explain the market's behavior during the recent financial crisis and, it is believed that behavioral finance will provide the majority of the answers.
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Mary McCarthy, CPA, CFA, Central Connecticut State University, USA
Paul Solomon, Ph.D., Bay Path College, USA
Paul Mihalek, Ph.D., CPA, Central Connecticut State University, USA
Mary McCarthy, CPA, CFA, has over 18 years experience in the financial services industry serving in various leadership positions. She is currently Associate Professor of Accounting at Central Connecticut State University pursuing her doctoral degree at Nova Southeastern University. She holds an MBA in finance from the University of Connecticut and a bachelor's of science degree from Central Connecticut State University. She is a certified public accountant (State of Connecticut) and a CFA charterholder. E-mail: mary.mccarthv(a),ccsu.edu (Corresponding author)
Paul Solomon, PhD, has taught accounting for nearly 40 years and is presently an Associate Professor of Accounting and Director of the Accounting Program at Bay Path College in Longmeadow, Massachusetts. He holds a doctoral degree in accounting from the University of Minnesota, an MBA from De Paul University and a bachelor's of science degree from the University of Minnesota. He has been active in the American Accounting Association (AAA), the California Society of CPAs and the Massachusetts Society of CPAs. Paul is best known as the founder and chair of the Colloquium on Change in Accounting Education (Colloquium). E-mail: drpsolomon(5),gmail.com
Paul Mihalek is a Professor of Accounting at Central Connecticut State University. He received his ? A, MBA, and Ph.D. from the University of Connecticut. He is a Certified Public Accountant in Connecticut and Maryland. He teaches Principles of Financial Accounting, Auditing, and the First Year Experience courses. He has worked for the GAO, KPMG, Arthur Andersen, and the Travelers. Paul's research areas of interest are active learning and crosscultural ethics. He is a member of the Connecticut Society of CPAs. He is also on the Innovations in Accounting Education Award Committee and the Shared Experiences Committee. E-mail: mihalekpau(a),ccsu.edu