The possible misdiagnosis of a crisis

Most explanations of the 2007–08 financial crisis—including excessive leverage, subprime mortgages, exotic derivatives, reckless risk taking, and easy money that spawned a housing bubble—are inconsistent with elementary principles of finance. Prof. Richard Roll explains the inconsistencies and suggests an alternative diagnosis that is fully compatible with rationality.

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The illness underlying the 2007–08 economic crisis might have been misdiagnosed, as is strongly suggested by some elementary principles of finance and development economics. Moreover, there is an explanation for the crisis that is fully consistent with rational beliefs and well-functioning markets. If this explanation is true, public policy prescriptions should be reexamined because there is a danger that the attempted cure is worse than the disease.

Various diagnoses have been proposed. They include, but are not limited to, the following:

  • The subprime mortgage meltdown
  • Too much leverage in financial institutions
  • Inadequate regulation
  • Excessive use of complex derivatives
  • Excessive risk taking induced by agency conflicts
  • A housing bubble induced by lax mortgage underwriting standards
  • Easy money (i.e., low interest rates that triggered a housing bubble)

The last of these diagnoses, easy money leading to a housing bubble, is inconsistent with the simple fact that real interest rates were not low by historical standards and actually increased concurrently with real estate prices over the alleged period of bubble expansion.

The other aforementioned explanations are incompatible with the following financial principles:

  1. The total value of all debt is zero.
  2. The total value of all derivative contracts is zero.

Globally, there is a lender for every borrower and a seller for every buyer of a derivative contract. A liability on the balance sheet of some entity, whether it is a person, a business, or a government, is matched exactly by an asset on the balance sheet of some other entity or entities. The same is true for derivatives, including all forms of futures, options, and swaps. Consequently, any change in the value of outstanding debt or of derivative contracts has no direct impact on total real wealth. For example, every default is simply a wealth transfer from lender to borrower. This is true of all “credit” events, including delinquencies in mortgages, insolvencies in banks, and bankruptcies. Similarly, every derivative event, such as an option exercise or a default on a swap, is simply a wealth transfer and has no effect on the combined balance sheet of the two parties to the contract. Yet there is no doubt that real estate prices started falling in 2007, thereby triggering a cascade of credit events. What induced this real estate crash? One possibility that cannot be ruled out is that an irrational housing bubble suddenly burst. But the problem with a psychological diagnosis is the diagnostic difficulty and the danger of prescribing a palliative when a more serious non-psychological malady is actually present. There is an alternative explanation based on the following two principles:

  1. Financial markets are forward looking.
  2. A country’s prosperity is positively related to the extent of economic liberalization.

Economic liberalization is an increase in the fraction of GDP spent by the private sector relative to the fraction spent by the public sector. Markets are forward looking, and in 2007, global market participants began to notice a major sea change washing ashore in many countries. Reversing the trend of at least the previous decade, the private sector’s fraction of GDP began to perceptibly decline relative to the public sector’s fraction.

This new trend suggests a different explanation for the crisis: a 2007 reduction in the anticipated growth rate of private incomes and an accompanying drastic reduction in the value of human capital. Human capital is the most important determinant of real estate values. People will pay what they can afford for housing.

Increased government spending and a decreased role for the private sector are simply going to prolong the malady; indeed, so long as that improper treatment continues, the patient will not improve. Fortunately, beginning in 2009 and continuing recently, there are signs that a better treatment might actually be attempted.

Next Finance April 2011

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Copyright 2011, CFA Institute. Reproduced and republished from Financial Analyst Journal with permission from CFA Institute. All rights reserved.




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