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Regulation Cannot Depend on Irrational Markets

posted by Christian E. Weller

At this point, it is all too clear that financial markets can get things wrong. This is not an isolated phenomenon. No, getting it wrong tends to be the name of the game for financial markets. Understanding that financial markets regularly underestimate or overestimate the risks of investing is crucial to the proper design of financial market regulations.

We have weathered a heavy storm. The U.S. stock market recorded its worst week ever last week, followed by one of the largest price increases on Monday.

The turmoil of the past month signals that markets do not know how to value the risks and rewards of investments. They don't know how many additional millions of homeowners will be foreclosed on. They don't know if a recession is looming and how bad it will be. They don't know if banks will find the money to lend to each other, never mind to businesses. And they don't know if businesses and families even have the income that would make it worthwhile to lend to them. While financial markets are trying to sort this all out, they will swing wildly from tropical depression to irrational exuberance. Prices for stocks, houses, and other assets are mere guesswork in this situation.

The extreme short-term volatility is not an aberration from markets that tend to accurately reflect the real value of financial instruments, bonds, stocks, and derivatives. On the contrary, it is the normal state of affairs, although typical swings tend to be smaller. Many researchers, among them, for instance, Yale University professor Robert Shiller, have shown that markets tend to follow fads, rather than economic fundamentals, at least in the short run.

The most recent past illustrates this point nicely. Default risk had risen in the U.S. for some time before the crisis hit in 2008. Personal bankruptcy rates had risen to historically high rates in 2004 and began rising sharply again after the passage of BAPCPA in late 2005. Credit card default rates followed a similar pattern, rising again sharply after 2005. And, foreclosure rates -- the share of mortgages in foreclosures -- began to rise in early 2006. This is just a long way of saying that by early 2007, probably earlier, everybody could have known that the mortgage market was going in the wrong direction, that a lot of default risk had materialized, and that lnders were losing big time.

Yet, the clearest indicator of how the market values this risk -- the difference between mortgage rates and risk free loans (Treasury bonds) of the same length -- did not reflect this growing, clearly visible risk until November 2007 as interest rate data from the Federal Reserve clearly show.

How come the "what, me worry?!" attitude was so pervasive? As we know by now, no market participant -- mortgage brokers, banks, securitizers, hedge funds, and so on down the line -- had an incentive to consider the risk on their books. They could always pass it on to somebody else. In economics, this is known as the "theory of the greater fool", to whom the risk can be passed on. This is the problem that needs to be rectified through proper regulation.

Markets, though, are driven by the interaction between human behavior and financial markets, which has a tendency to lead to booms and busts. The further in the past the last downturn lies, the more likely humans will be to assume that the good times will never end and overinvest in speculative projects. The opposite is true now. A sharp market decline will lead a lot of people to put their money in mattresses. Their long-term investment strategies that seemed so solid just a few weeks ago are rapidly going out the window. Human psychology can thus exacerbate market swings.

Inevitably, the U.S., and many other countries, will face a discussion over proper financial market regulation. As the recent history has shown, financial markets and asset prices can be a poor guide. Hence, regulators need to take a long-term view and build regulatory instruments that are not influenced, but rather intended to sooth the inevitable and irrational ups and downs of the market.

To be clear, this is exactly the opposite direction in which accounting rules and financial market regulation have gone in recent years. The lesson from this crisis, though, is that it may be time to rethink the wisdom of hitching our financial safety wagon to the inevitable vagaries of the markets.

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