Test the hypothesis that the economists perfect market model provides the underlyi ng concepts, theories and

paradigm of finance against the evidence of the report of the Financial Crisis Enquiry Commission. Amit H Panchal 11/24/2011

Introduction Started in middle of 2007, the global financial crisis is considered to be the w orst after the great depression. Stock markets were going down all around the wo rld, failure of giant banks and collapse of the large financial institution had triggered the financial crisis. Attempts were made by the Financial Crisis Inqui ry Commission (FCIC) to record the facts that cause the financial crisis to make it available to general public to better understand the crisis. The report of the FCIC is a wonderful piece of work which collects the numbers o f facts that causes the crisis. However, they fail to relate it with economists t heory which could help to better understand he crisis. As the majority of the co mmission believes that the catastrophe was avoidable, arises the question: what caused the crisis? In this essay an attempt is made to identify the cause of the crisis using the perfect market hypothesis against the evidence of the FCIC in order to check the dominance of the perfect market theory. Although the idea of the efficient capital market can not be found in reality, the assumptions are us ed to examine the efficiency of economy and financial markets. To do so, first w e need to review the perfect market theory, which serves as a standard to evalua te the efficiency of the economy, and than relate the key features with the comm issions report. Perfect market In economics, the term perfect market refers to the market where no participants (buyers and sellers) are huge enough to influence the price of homogeneous prod uct. The perfect market can also be termed as free market or perfect competition . In reality, the perfect market does not really exist in this global society. T here are only few perfectly competitive markets. Buyers and sellers in commoditi es market or stock markets are the most closest to the perfect market. As said e arlier, the model serves as a benchmark to evaluate the economys efficiency. Eugene Fama (1970s), defined an efficient financial market as one in which price always fully reflects available information. In perfect market, every participant is price taker, no individual buyer or seller can influence the market price of the product it buys or sells. An investor tha t is price taker considers the market price that is something beyond its control . Perfect market only exist when there are no entry barriers for new entries tha t is new firms are free to enter in the industries or exit barriers for existing firms. This kind of market can be found where there is large number of small pr oducers producing homogenous product and it can not be unregulated. The conditio ns for perfect competition are: 1. The industries contain so many buyers and sellers that no single one can influence the price of the produce. 2. All participants have access to all relevant knowledge. Each buyer or se ller is perfectly informed about the prices and the quality of the product. 3. The product is homogeneous; that is, it is not possible or even worthwhi le to distinguish the product of one firm from that of another in the industry.

4. No barriers obstruct entry into or exit from the market; that is there i s complete freedom of entry and exit. (Source: Roy J. Ruffin & Paul R. Gregory (2001) Principles of Economics 7th ed, Addison-Wesley) Because the production of a firm in the industry is a very small part of the ove rall production of an industry, no firm in the industry can sell its product at the price higher than the market price. At the same time it also can not change the market price by varying its production as it has a very small effect on the industry output. Firms under perfect market only earn economic profit in the short run just enoug h to stay in the market by covering the variable cost and to some extent cover t he fixed cost of plant and equipments if possible. But in the long run the econo mic profit will be eliminated by the entry of new firms into the market when the markets are in equilibrium; price and marginal cost will be equal. The perfect market is an economy in which all markets are unregulated ot her than market participants and intervention and regulation by the government i s limited to tax collection and bank bankruptcy. And due to the lax regulation a nd free competition, price of the product or service tends to decrease and quali ty to increase. In perfect market, deregulation has been essential in permitting financial insti tutions to offer the new services. There are numerous arguments in favor and aga inst regulation and these are worth reviewing. One of the major is the need for investors protection. Investors needed to be pro tected against misinformation which encourages them to invest in products that a re unsuitable and they need to be protected against the misuse of their funds on ce they have been handed over. Having reviewed the perfect market, here are some key points that are derived fr om the theory: Perfect information No entry and exit barriers Every participants are price taker, no effect on industry by single actor Self regulated in most efficient way Standard product No transaction costs. All transactions are mutually beneficial. Theory vs. reality After reviewing the perfect capital market theory, the next section discuses how deep it goes in the reality and try to identify the dominance of the theory. Ha ving gone through the FCIC report, I found the numbers of evidence that help me to build my essay. When you see the Inside job documentary, it says that the deregulation period star ted in 1982 by Regan administration supported by economist for savings and loan companies and moving towards the self regulatory nature of the market instead of government regular intervention in the market which according to market partici pants, cause the market inefficiency. But because of this reason the regulator n ever bothered about what was going to come, and allow the market to move freely. And this can be easily seen in FCIC report supported by number of the evidence: The sentries were not at their posts, in no small part due to the widely accepted faith in the self-correcting nature of the markets and the ability of financial institutions to effectively police themselves. (FCIC Conclusion Report, pg. xvii i) We do place special responsibility with the public leaders charged with protectin g our financial system, those entrusted to run our regulatory agencies, and the chief executives of companies whose failures drove us to crisis. (FCIC Conclusion Report, pg. xxiii) It seems clear that the belief in self regulatory nature of many financial firms , gone to deep in regulators mind which leads us to the crisis.

Commissioners agreed that investment bank holding companies were too lightly (bar ely) regulated by the SEC leading up to the crisis and that the Consolidated Sup ervised Entities program of voluntary regulation of these firms failed. (FCIC Dis senting Statement, pg 430) They thought that for the firms to offer wider range of financial servic es, deregulation has been essential in permitting financial institution to offer the new services. It made people to do things they knew should never be done. M iserable thing was that there were warning signs but it was ignored. And this ki nd of attitudes leads to many irresponsible behavior in the market. The followin g fact reflects the irresponsible behavior of regulators: Securities and Exchange Commission could have required more capital and halted ri sky practices at the big investment banks. It did not. The Federal Reserve Bank of New York and other regulators could have clamped down on Citigroups excesses i n the run-up to the crisis. They did not. Policy makers and regulators could hav e stopped the runaway mortgage securitization train. They did not. (FCIC Conclusi on Report, pg. xviii) And it was not that they lack of power to regulate them. As said Warren Buffett to FCIC, The biggest failure is they were unable to act contrary to the way human s act. Regulators could have stopped it. Or Congress could have stopped it. But t hey didnt. Federal Reserves pivotal failure to stem the flow of toxic mortgages, which it cou ld have done by setting prudent mortgage-lending standards. The Federal Reserve was the one entity empowered to do so and it did not. (FCIC Conclusion Report, pg . xvii) This evidence shows that the Federal Reserve itself believed in self regulatory nature in financial firms and did nothing to prevent the prudent mortgage lendin g standards. They assumed it to be correct and stuck to their belief. In many ca ses they were ill prepared for the crisis and never understand the system of fin ancial system. They couldnt take the appropriate measures when things started goi ng wrong nor could they anticipate them, which can be seen in the following fact : As our report shows, key policy makersthe Treasury Department, the Federal Reserve Board, and the Federal Reserve Bank of New Yorkwho were best positioned to watch over our markets were ill prepared for the events of 2007 and 2008. Other agenc ies were also behind the curve. They were hampered because they did not have a c lear grasp of the financial system they were charged with overseeing, particular ly as it had evolved in the years leading up to the crisis. (FCIC Conclusion Repo rt, pg. xxi) And as a result of this, many firms had started to operate with more evolving ri sk with very low capital and that led to increase the chances of their failure. The following evidence completely supports this argument: For example, as of 2007, the five major investment banksBear Stearns, Goldman Sach s, Lehman Brothers, Merrill Lynch, and Morgan Stanleywere operating with extraord inarily thin capital. By one measure, their leverage ratios were as high as 40 t o 1, meaning for every $40 in assets, there was only $1 in capital to cover loss es. Less than a 3% drop in asset values could wipe out a firm. (FCIC Conclusion R eport, pg. xix) Even a normal movement could prove disaster with the firm operating with such hi gh leverage ratio and these are not the small banks that it leaves the market un affected. And to add in trouble, information about these ratios was hidden from public investors. As said earlier investors need to be protected from the misinf ormation which encourage them to invest in the instrument that is not suitable a nd they need to be protected from the misuse of their funds. But because of the belief in the self-regulation, the need to protecting the investors interest was never felt. And it was obvious that when information would be reviled, investor might react to it:

And the leverage was often hiddenin derivatives positions, in off-balance-sheet en tities, and through window dressing of financial reports available to the investin g public. (FCIC Conclusion Report, pg. xx) According to perfect market, price reflects all available information bu t it was not in this case as most of the investors were not totally informed or you can say not knowledgeable enough and aware of the condition of the firm they are investing in. if this information was known to the group of investors, they were able enough to understand the risk of investing in such firms. Another assumption of the perfect capital market is that all participants in the market are rational. But the following evidence is totally against this assumpt ion: In particular, CDO buyers who were, in theory, sophisticated investors relied too heavily on credit ratings. (FCIC Dissenting Statement, pg. 426) In that case, investors believed that the ratings provided by credit rating agen cies were totally accurate and didnt think rationally. And the ratings that were provided by the agencies were not up to the standards. They believed that the kn owledge that they have about the market situation was perfect and they were tota lly aware of the operation of the firms, but it was not. Securitizers lowered the credit quality of the mortgages they securitized. Credit rating agencies erroneously rated mortgage-backed securities and their derivati ves as safe investments. Buyers failed to look behind the credit ratings and do their own due diligence. These factors fueled the creation of more bad mortgages . (FCIC Dissenting Statement, pg. 418) Economist believed that by creating the more complex financial instruments- deri vatives- they thought that they made the market safer but instead they made it u nstable. Many banks relied heavily in order to make more money. Many of who trad ed in derivative was not able to understand how this instrument works or you can say that they were not knowledge enough about what they are doing. But few bad things can not affect the whole market and which was also said in de scending statement: Not everything that went wrong during the financial crisis caused the crisis, and while some causes were essential, others had only a minor impact. Not every reg ulatory change related to housing or the financial system prior to the crisis wa s a cause. (FCIC Dissenting Statement, pg. 414) Deregulation, irresponsible behavior, lack sk not alone cause the crisis, which means not affect the whole market, according to upport this assumption tha evidence can be as follows: of transparency and high operating ri that these factors on their own could efficient market assumption. And to s found in dissenting report, which are

Low-cost capital can but does not necessarily have to lead to an increase in risk y investments. Increased capital flows to the United States and Europe cannot al one explain the credit bubble. (FCIC Dissenting Statement, pg 420) U.S. monetary policy may have been an amplifying factor, but it did not by itself cause the credit bubble, nor was it essential to causing the crisis. (FCIC Disse nting Statement, pg 421) And another evidence from the report that supports the perfect market condition of zero entry and exit barriers is:

Nonbank mortgage lenders like New Century and Ameriquest flourished under ineffec tive regulatory regimes, especially at the state level. Weak disclosure standard s and underwriting rules made it easy for irresponsible lenders to issue mortgag es that would probably never be repaid. Federally regulated bank and thrift lend ers, such as Countrywide, Wachovia, and Washington Mutual, had lenient regulator y oversight on mortgage origination as well (FCIC Dissenting Statement, pg. 423-4 24) Human action and their greedy nature also contributed significantly in rising up the catastrophe. Massive amounts of inexpensive capital flowed into the United States, making borr owing inexpensive. Americans used the cheap credit to make riskier investments t han in the past. The same dynamic was at work in Europe. (FCIC Dissenting Stateme nt, pg 420) In a market when supply of the product or service increases, in order to balance with demand, the price tends to decrease without compromising the quality of th e product or service. But it was not that in this evidence. They not only reduce d the interest rates but they also reduced the standards of loans. Lenders made loans that they knew borrowers could not afford and that could cause massive losses to investors in mortgage securities. As early as September 2004, Countrywide executives recognized that many of the loans they were originating could result in catastrophic consequences. (FCIC Conclusion Report, pg. xxii) They made the loan without proper documentation requirements and lend money to b orrowers almost meeting their requirements. They thought that in order of doing so they can earn more profit. But when borrowers fail to repay the loans it beca me a big mess for them. These mortgage products included interest-only adjustable rate mortgages (ARMs), pay-option ARMs that gave borrowers flexibility on the size of early monthly pay ments, and negative amortization products in which the initial payment did not e ven cover interest costs. These exotic mortgage products would often result in s ignificant reductions in the initial monthly payment compared with even a standa rd ARM. (FCIC Dissenting Statement, pg 423) By reducing the quality of the mortgage standards, they were not even able to co ver the marginal cost which according to efficient market very necessary to stay in the business, but attracted by chances of making more money they didnt even t hink about that. By saying they reduced the quality the evidence below supports the argument: Mortgage rates were low relative to the risk of losses, and risky borrowers, who in the past would have been turned down, found it possible to obtain a mortgage. (FCIC Dissenting Statement, pg 423) As a result of that, people started borrowing money excessively than compared to their capacity: Many borrowers neither understood the terms of their mortgage nor appreciated the risk that home values could fall significantly, while others borrowed too much and bought bigger houses than they could ever reasonably expect to afford. (FCIC Dissenting Statement, pg. 424) One question arises is that Why they made such kind of lending when they knew tha t it was going to fail? The simple answer to this question could be the one word: GREED, which made lenders not to use a simple common sense in order to make mor e money.

Conclusion: After critically reviewing the prefect market and the FCIC report, it can be see n that most of the conditions or ideas of economists theory of perfect market are influential like no entry and exit barriers, no effect on industry by single ac tor but many of them proved dominant which leads to the financial crisis. Review ing the bullet points that are provided at the end of the first section of the e ssay, many of them proved disastrous for the financial market, which led to the catastrophe after the great depression. Assumptions of perfect market like self regulated in most efficient way in the market, all participants have perfect inf ormation, and all transactions are mutually beneficial, standard product in term of quality, all went to deeply in peoples mind that they never imagine that it c ould go wrong, which made the world to end up to the great crisis of the history . Their reliance on the efficient market condition led them to avoid the warning signals which asked for regulating the market against the fraud and from moving towards more risky instruments of finance. The greedy and degree of irresponsib ility in many financial institution opened the door for the instability in the f inancial and economic world.

References: Aneirin Sion Owen, 30th September 2011, Economists perfect market model Internat al Capital Markets, MMU moodle. Documentary, Inside Job 2010 Fama, Eugene F, (1970): Efficient Capital Markets: A Review of Empirical Work. J urnal of Finance 25, no. 2 383417. Frederic S. Mishkin & Stanley G. Eakins 2000, Financial markets and institutions rd edn, Addison-Wesley. Pilbeam Keith, 2005, Finance and financial markets 2nd edn, Palgrave Macmillan. Roy J Ruffin & Paul R Gregory, 2001, Principles of economics 7th ed. Addison-Wes ey WilliamTGeorge, 11 April 2011 Financial Crisis Inquiry Commissioner Peter Walliso n Questions Warren Buffet, <http://www.youtube.com/watch?v=UqOX2tAvRbU>