Finance is not Physics.
A Review of Panic, by Andrew Redleaf and Richard Vigilante
Friedrich Hayek’s 1974 Nobel Prize lecture, “The Pretense of Knowledge,” concerns the “failure of [Keynesian] economists to guide policy more successfully.” Hayek believed that failure was “closely connected with their propensity to imitate as closely as possible the procedures of the … physical sciences.”  Hayek’s point, to simplify, is that the desire to create mathematical models of economic behavior inevitably leads to the exclusion of critical factors that cannot be easily quantified.  The result is an elegant, but not accurate, model. Speaking of the Keynesian policies of the 1960s and 1970s, Hayek hypothesized that “an almost exclusive concentration on quantitatively measureable surface phenomena has produced a policy which has made matters worse.”
Andrew Redleaf and Richard Vigilante make a similar argument in Panic, their account of the mortgage meltdown, financial panic and recession of 2007-09.  To Redleaf and Vigilante, the root cause of the mortgage bubble and its collapse was “the ideology of modern finance,” the belief that prices in financial markets accurately reflect all available information about the value of the underlying assets.  This was coupled with a belief that sophisticated mathematical models could measure, and therefore enable institutions to manage, financial risk effectively.  If the models were wrong, prices in an efficient market should have exposed the errors on an ongoing basis.  Because of these beliefs, most of our political and financial leaders ignored the reality, obvious on its face to Redleaf, Vigilante, and others (but not, at the time, to me), that the residential real estate market was, by the middle of the last decade, wildly overpriced and headed for a fall.  When that fall came, the models of how mortgages would perform turned out to be hopelessly wrong, and as a result the entire financial system was put at risk.
I have two strong personal connections to the issues discussed in Panic.  One is that I attended law school at the University of Chicago, and the “Chicago School” developed modern portfolio theory in the 1960’s.  In fact, I have joked on more than one occasion that “my entire legal education was based on the efficient markets hypothesis.”  And I remain true to my school. Second, the mortgage industry has been a major part of my life since 1990.  During most of that time I practiced law, where the mortgage industry was a large part of my business.  But from 2003-08 I worked for a mortgage company.  I was there at the peak of the market.  And I stuck around for the collapse.  So I know the history recounted in Panic from intense, and sometimes painful, personal experience.
The authors of Panic understand the mortgage market of the boom years and the mechanics of its fall as well as or better than anyone who has written on the topic.  A lot of the language used in discussions of the financial industry, particularly in recent years, is Greek to most English speakers, and sometimes even to those of us fluent in legalese.   This has helped keep the causes and effects of the recent financial crisis from being well understood.  Panic is written in English.  For example, it provides lucid definitions of the terms “securitization” and “structured finance.”  In discussing financial topics, fancy words are frequently used to convey understanding where there is none.  Redleaf and Vigilante don’t do that; they know what they are talking about, and they explain it in plain English.  This aspect of the book makes it both enjoyable and interesting.
But what makes Panic stand out is its perspective.  Many books on the crisis focus on “Wall Street greed,” which is the rough equivalent of saying that water causes tsunamis.  Others focus on influences outside the mortgage industry (monetary policy, international funds flows, etc.).  Still others focus on the regulatory environment, arguing either than the mortgage business got out of control because it was unregulated or that the mortgage business got out of control because it was too heavily influenced by government (the latter is much closer to the truth).  All of these are important issues, and Panic addresses most of them.  But they do not explain why intelligent, supposedly sophisticated investors came to believe that securities backed by mortgages made to borrowers with bad credit histories, or made to borrowers with good credit histories on economically unsustainable terms, were a safe investment.  Why rating agencies, which live in large part off of their reputations for credit analysis (and in large part off of a government-created oligopoly position which gives them the keys to certain very large vaults of investment capital), decided that they could give AAA ratings to 80% or more of the bonds backed by pools of decidedly non-AAA mortgages.  Or why government regulators around the world, charged with protecting the “safety and soundness” of the financial system, permitted the banks under their supervision to invest massive amounts in these same securities, or insurance companies under their supervision to insure these securities, without holding enough capital to protect against the inevitable losses.
The answer, according to Redleaf and Vigilante, is that the key players fooled themselves into believing they understood the risks they were running, based on their underlying beliefs about how financial markets work.  Bankers used sophisticated mathematical models built on data about the historical performance of mortgages to analyze mortgage risk.  These models assumed that mortgages would continue to perform as they had throughout the post-war period, even as the characteristics of the loans and the relationship between housing prices and income changed dramatically.  Bankers, rating agencies and regulators persuaded themselves that the packaging and structuring of the securities had appropriately diversified and mitigated the risks in the underlying mortgages sufficiently to make the “AAA” securities nearly risk free.  Under modern portfolio theory, diversification is the key to creating an investment portfolio that maximizes return for any given level of risk.  All of this analysis and structure was reinforced by the belief that prices in financial markets accurately reflect all available information about value.  When prices for these securities stayed close to their face value despite the rise in housing prices and deterioration of credit standards, it validated the belief that the risks were appropriately understood and addressed.  Redleaf and Vigilante argue this confluence of beliefs enabled the boom to continue until the bubble was large enough to put the entire financial system at risk.
The authors point to their personal experience as investors as well as history and common sense in challenging the conventional wisdom embodied in the “ideology of modern finance.”  Redleaf is a hedge fund manager, and in perfectly efficient markets there would be no role for hedge funds.  In the best part of the book, the authors demonstrate that the idea that investors are primarily compensated for taking risks (plus the cost of their capital), rather than for making judgments in the context of uncertainty, is contrary to the experience of everyone who has ever started a business, or helped a friend or relative finance a business, or invested in a venture fund or a private equity fund.  In the “real” economy, investors are compensated for investing in good people with good ideas, not simply for taking risks.
I never understood the efficient markets hypothesis to mean that nobody could make money by identifying good new ideas and bringing them to market, or even by identifying places where market prices deviated from real value. In fact, it was always my understanding that smart investors made the market efficient by identifying and taking advantage of those opportunities, and made money for themselves in the process.  My understanding was always more limited – that like me, people who do not have any deep insight into or particular knowledge of underlying asset values and prefer to spend their Sunday afternoons watching baseball instead of developing those insights and that knowledge, cannot beat the market.  That’s why I stick with index mutual funds.  Panic clarified my prior understanding in many respects, in particular by demonstrating why, famously, mutual fund managers do not consistently beat the market by enough of a margin to pay their fees, while still leaving room for true hedge funds and value investors to profit from market anomalies.
On the broader points of whether market prices or any given dates are a reliable indication of underlying value and of the utility of quantification and modeling in understanding risk, history is on the side of Redleaf and Vigilante.  From tulips in Holland in the 1630s to homes in the United States (and around the world) in the 2000s, history contains many examples of situations where asset prices reflected not knowledge or information about the value of the underlying assets but speculation about the price of those assets in the near future, when the buyers hope to reap a quick profit.  That speculation has repeatedly taken prices above any reasonable estimate of the true value of the assets, and has repeatedly led to collapses when speculators changed their mind about the likely future direction of prices. Furthermore, statistical analysis of any phenomenon depends on having all of the relevant factors in the analysis and properly predicting the relationship between those factors.  But you can never have all factors in a statistical analysis of human behavior, because, not all factors are quantifiable.  You can never have all the relationships right I a model of human behavior, because they change.  In the case of the models of mortgage behavior, when one critical assumption came unstuck (specifically, that home prices would not fall on a national basis because it hadn’t happened since the 1930s), the models became useless.  The diversification in mortgage pools was illusory.
But the best thing about Panic is summarized by its subtitle, “The Betrayal of Capitalism by Wall Street and Washington.”  The mortgage bubble and resulting financial crisis and economic downturn may undercut the conventional wisdom in finance over the past generation, but they do not constitute a “crisis” of capitalism.  The important thing about markets is not that they are efficient, but that they are free.  That freedom allows people with new ideas to bring them forward and test them, and investors with good judgment about people and ideas to back the good ones.  Stated otherwise, markets coordinate the collective judgments of society in a way that benefits everyone, even though they don’t get every single decision right (or even close).  It is this aspect of markets that enables a Watt, an Edison, a Ford or a Gates to introduce revolutionary changes that improve the lives of everyone, and make a fortune for themselves (and the investors who back them) in the process.  Market prices do not always reflect underlying value.  They sometimes overvalue bad ideas (Pets.com sold for $11 a share in February, 2000; it went into liquidation 10 months later and investor recovered less than $0.25 per share) and sometimes undervalue good ones (the original $100,000 invested in Google in 1998 was worth $1.5 billion in March, 2007).  What they do is enable people to try new ideas, relatively freely, and reward those who through the exercise of diligence and judgment turn those ideas into products and services of value to others.  Markets do not always make specific asset allocation decisions correctly, but neither can any other human institution.  Efficient decision-making was, in the middle of the last century, one of the supposed advantages of socialism.  That didn’t exactly turn out to be true.  The problem is that no human decision-making processes can ever be “efficient,” since humans are not omniscient (at a minimum, we don’t know what the future holds) and cannot make judgments in a completely disinterested manner.  These limitations also falsify extreme versions of the efficient markets hypothesis.  Free markets, through the coordinating mechanism of prices, permit decisions to be tested in an environment that provides incentives for making them well, not perfectly.  That freedom, not efficiency, is why markets promote growth, and are ultimately good for all of us.
Tom Kelly is a partner at Dorsey & Whitney LLP, and Chairman of the Board of the Minnesota Free Market Institute.

Panic By Andrew Redleaf and Richard VigilanteFinance is not Physics.

A Review of Panic, by Andrew Redleaf and Richard Vigilante

Friedrich Hayek’s 1974 Nobel Prize lecture, “The Pretense of Knowledge,” concerns the “failure of [Keynesian] economists to guide policy more successfully.” Hayek believed that failure was “closely connected with their propensity to imitate as closely as possible the procedures of the … physical sciences.”  Hayek’s point, to simplify, is that the desire to create mathematical models of economic behavior inevitably leads to the exclusion of critical factors that cannot be easily quantified.  The result is an elegant, but not accurate, model. Speaking of the Keynesian policies of the 1960s and 1970s, Hayek hypothesized that “an almost exclusive concentration on quantitatively measureable surface phenomena has produced a policy which has made matters worse.”

Andrew Redleaf and Richard Vigilante make a similar argument in Panic, their account of the mortgage meltdown, financial panic and recession of 2007-09.  To Redleaf and Vigilante, the root cause of the mortgage bubble and its collapse was “the ideology of modern finance,” the belief that prices in financial markets accurately reflect all available information about the value of the underlying assets.  This was coupled with a belief that sophisticated mathematical models could measure, and therefore enable institutions to manage, financial risk effectively.  If the models were wrong, prices in an efficient market should have exposed the errors on an ongoing basis.  Because of these beliefs, most of our political and financial leaders ignored the reality, obvious on its face to Redleaf, Vigilante, and others (but not, at the time, to me), that the residential real estate market was, by the middle of the last decade, wildly overpriced and headed for a fall.  When that fall came, the models of how mortgages would perform turned out to be hopelessly wrong, and as a result the entire financial system was put at risk.

I have two strong personal connections to the issues discussed in Panic.  One is that I attended law school at the University of Chicago, and the “Chicago School” developed modern portfolio theory in the 1960’s.  In fact, I have joked on more than one occasion that “my entire legal education was based on the efficient markets hypothesis.”  And I remain true to my school. Second, the mortgage industry has been a major part of my life since 1990.  During most of that time I practiced law, where the mortgage industry was a large part of my business.  But from 2003-08 I worked for a mortgage company.  I was there at the peak of the market.  And I stuck around for the collapse.  So I know the history recounted in Panic from intense, and sometimes painful, personal experience.

The authors of Panic understand the mortgage market of the boom years and the mechanics of its fall as well as or better than anyone who has written on the topic.  A lot of the language used in discussions of the financial industry, particularly in recent years, is Greek to most English speakers, and sometimes even to those of us fluent in legalese.   This has helped keep the causes and effects of the recent financial crisis from being well understood.  Panic is written in English.  For example, it provides lucid definitions of the terms “securitization” and “structured finance.”  In discussing financial topics, fancy words are frequently used to convey understanding where there is none.  Redleaf and Vigilante don’t do that; they know what they are talking about, and they explain it in plain English.  This aspect of the book makes it both enjoyable and interesting.

But what makes Panic stand out is its perspective.  Many books on the crisis focus on “Wall Street greed,” which is the rough equivalent of saying that water causes tsunamis.  Others focus on influences outside the mortgage industry (monetary policy, international funds flows, etc.).  Still others focus on the regulatory environment, arguing either than the mortgage business got out of control because it was unregulated or that the mortgage business got out of control because it was too heavily influenced by government (the latter is much closer to the truth).  All of these are important issues, and Panic addresses most of them.  But they do not explain why intelligent, supposedly sophisticated investors came to believe that securities backed by mortgages made to borrowers with bad credit histories, or made to borrowers with good credit histories on economically unsustainable terms, were a safe investment.  Why rating agencies, which live in large part off of their reputations for credit analysis (and in large part off of a government-created oligopoly position which gives them the keys to certain very large vaults of investment capital), decided that they could give AAA ratings to 80% or more of the bonds backed by pools of decidedly non-AAA mortgages.  Or why government regulators around the world, charged with protecting the “safety and soundness” of the financial system, permitted the banks under their supervision to invest massive amounts in these same securities, or insurance companies under their supervision to insure these securities, without holding enough capital to protect against the inevitable losses.

The answer, according to Redleaf and Vigilante, is that the key players fooled themselves into believing they understood the risks they were running, based on their underlying beliefs about how financial markets work.  Bankers used sophisticated mathematical models built on data about the historical performance of mortgages to analyze mortgage risk.  These models assumed that mortgages would continue to perform as they had throughout the post-war period, even as the characteristics of the loans and the relationship between housing prices and income changed dramatically.  Bankers, rating agencies and regulators persuaded themselves that the packaging and structuring of the securities had appropriately diversified and mitigated the risks in the underlying mortgages sufficiently to make the “AAA” securities nearly risk free.  Under modern portfolio theory, diversification is the key to creating an investment portfolio that maximizes return for any given level of risk.  All of this analysis and structure was reinforced by the belief that prices in financial markets accurately reflect all available information about value.  When prices for these securities stayed close to their face value despite the rise in housing prices and deterioration of credit standards, it validated the belief that the risks were appropriately understood and addressed.  Redleaf and Vigilante argue this confluence of beliefs enabled the boom to continue until the bubble was large enough to put the entire financial system at risk.

The authors point to their personal experience as investors as well as history and common sense in challenging the conventional wisdom embodied in the “ideology of modern finance.”  Redleaf is a hedge fund manager, and in perfectly efficient markets there would be no role for hedge funds.  In the best part of the book, the authors demonstrate that the idea that investors are primarily compensated for taking risks (plus the cost of their capital), rather than for making judgments in the context of uncertainty, is contrary to the experience of everyone who has ever started a business, or helped a friend or relative finance a business, or invested in a venture fund or a private equity fund.  In the “real” economy, investors are compensated for investing in good people with good ideas, not simply for taking risks.

I never understood the efficient markets hypothesis to mean that nobody could make money by identifying good new ideas and bringing them to market, or even by identifying places where market prices deviated from real value. In fact, it was always my understanding that smart investors made the market efficient by identifying and taking advantage of those opportunities, and made money for themselves in the process.  My understanding was always more limited – that like me, people who do not have any deep insight into or particular knowledge of underlying asset values and prefer to spend their Sunday afternoons watching baseball instead of developing those insights and that knowledge, cannot beat the market.  That’s why I stick with index mutual funds.  Panic clarified my prior understanding in many respects, in particular by demonstrating why, famously, mutual fund managers do not consistently beat the market by enough of a margin to pay their fees, while still leaving room for true hedge funds and value investors to profit from market anomalies.

On the broader points of whether market prices or any given dates are a reliable indication of underlying value and of the utility of quantification and modeling in understanding risk, history is on the side of Redleaf and Vigilante.  From tulips in Holland in the 1630s to homes in the United States (and around the world) in the 2000s, history contains many examples of situations where asset prices reflected not knowledge or information about the value of the underlying assets but speculation about the price of those assets in the near future, when the buyers hope to reap a quick profit.  That speculation has repeatedly taken prices above any reasonable estimate of the true value of the assets, and has repeatedly led to collapses when speculators changed their mind about the likely future direction of prices. Furthermore, statistical analysis of any phenomenon depends on having all of the relevant factors in the analysis and properly predicting the relationship between those factors.  But you can never have all factors in a statistical analysis of human behavior, because, not all factors are quantifiable.  You can never have all the relationships right I a model of human behavior, because they change.  In the case of the models of mortgage behavior, when one critical assumption came unstuck (specifically, that home prices would not fall on a national basis because it hadn’t happened since the 1930s), the models became useless.  The diversification in mortgage pools was illusory.

But the best thing about Panic is summarized by its subtitle, “The Betrayal of Capitalism by Wall Street and Washington.”  The mortgage bubble and resulting financial crisis and economic downturn may undercut the conventional wisdom in finance over the past generation, but they do not constitute a “crisis” of capitalism.  The important thing about markets is not that they are efficient, but that they are free.  That freedom allows people with new ideas to bring them forward and test them, and investors with good judgment about people and ideas to back the good ones.  Stated otherwise, markets coordinate the collective judgments of society in a way that benefits everyone, even though they don’t get every single decision right (or even close).  It is this aspect of markets that enables a Watt, an Edison, a Ford or a Gates to introduce revolutionary changes that improve the lives of everyone, and make a fortune for themselves (and the investors who back them) in the process.  Market prices do not always reflect underlying value.  They sometimes overvalue bad ideas (Pets.com sold for $11 a share in February, 2000; it went into liquidation 10 months later and investor recovered less than $0.25 per share) and sometimes undervalue good ones (the original $100,000 invested in Google in 1998 was worth $1.5 billion in March, 2007).  What they do is enable people to try new ideas, relatively freely, and reward those who through the exercise of diligence and judgment turn those ideas into products and services of value to others.  Markets do not always make specific asset allocation decisions correctly, but neither can any other human institution.  Efficient decision-making was, in the middle of the last century, one of the supposed advantages of socialism.  That didn’t exactly turn out to be true.  The problem is that no human decision-making processes can ever be “efficient,” since humans are not omniscient (at a minimum, we don’t know what the future holds) and cannot make judgments in a completely disinterested manner.  These limitations also falsify extreme versions of the efficient markets hypothesis.  Free markets, through the coordinating mechanism of prices, permit decisions to be tested in an environment that provides incentives for making them well, not perfectly.  That freedom, not efficiency, is why markets promote growth, and are ultimately good for all of us.

Tom Kelly is a partner at Dorsey & Whitney LLP, and Chairman of the Board of the Minnesota Free Market Institute.