Friday, October 12, 2007

Whatever Happened to the Efficient Market Hypothesis?

The Wall Street Journal has a front page story today about the lack of transparency in securities. Remember, one of the great accomplishments of the market is to provide accurate information to allow for something akin to perfect efficiency. Milton Friedman would tell us that there will be inefficient speculators, but the market will ruthlessly purged them, leaving only the great ones who can guide the economy efficiently.

Financialization and securitization was supposed to distribute risk even more efficiently. Unlike most fairytales, I suspect this one will not have a happy ending. Well, here is the article:

Pulliam, Susan, Randall Smith and Michael Siconolfi. 2007. "U.S. Investors Face An Age of Murky Pricing: Values of Securities Tougher to Pin Down." Wall Street Journal (12 October): p. A 1.

"Since the invention of the ticker tape 140 years ago, America has been able to boast of having the world's most transparent financial markets. The tape and its electronic descendants ensured that crystal-clear prices for stocks and many other securities were readily available to everyone, encouraging millions to entrust their money to the markets. These days, after a decade of frantic growth in mortgage-backed securities and other complex investments traded off exchanges, that clarity is gone. Large parts of American financial markets have become a hall of mirrors."

"The hazards of this new age of uncertainty became clear at Dillon Read in March, when rising defaults by homeowners were hammering the value of mortgage securities. John Niblo, a hedge-fund manager at the firm, acted fast. He twice slashed his fund's valuation of securities tied to "subprime" mortgages, knocking them down by about 20%, or nearly $100 million, say traders familiar with the matter. But managers at UBS AG, Dillon Read's parent company, were irate. The Swiss banking giant was carrying similar securities on its books at a far higher price, the traders say. In conference calls, the UBS managers grilled Mr. Niblo on his move. "I'm marking to where I could reasonably sell them," Mr. Niblo responded during one call, according to the traders familiar with the conversations."

"Today, "way less than half" of all securities trade on exchanges with readily available price information, according to Goldman Sachs Group Inc. analyst Daniel Harris. More and more securities are priced by dealers who don't publish quotes. As a result, money managers can no longer gauge with certainty the value of some assets in mutual funds, hedge funds and other investment vehicles -- a process known as marking to market. An official at the Securities and Exchange Commission said recently that some bond mutual funds might be using outdated or unrealistic prices to value their portfolios."

"Billionaire investor Warren Buffett advocates more transparency in pricing. "Some marks can be pretty imaginative," he says. "They call it 'marking to market,' but it's really marking to myth." He says that before funds publish financial statements, they should sell 5% of hard-to-value positions to gauge values."

"Some Wall Streeters have a motive to inflate marks: Their bonuses often are tied to the value of their holdings. A Lipper & Co. hedge-fund manager, Edward Strafaci, earned bonuses of $3.9 million between 1998 and 2001 based on improperly marked convertible bonds, according to the SEC. Mr. Strafaci overstated the value of the bonds he managed, despite warnings from his traders, according to a civil complaint charging securities fraud. The value of a $722 million Lipper hedge fund later was cut in half, and Mr. Strafaci pleaded guilty to criminal securities fraud."


Myrtle Blackwood said...

And then, as if these dodgy securities weren't enough, there's the 'private equity' rort. The following information came from:
Debt and greed fuel this boom, by Allen Kohler.


Private equity is another term for 'leveraged buyouts'.

It involves re-leveraging the corporate world 25 years after it last happened [1982] and 19 years [1988] after the corporate world 'hit the rocks'.

The difference between now and then is:

(1) the enormous fees charged by the modern LBO funds. The normal fund managers just get a flat fee and get to keep their jobs if they do well. The standard deal for all three "alternatives" categories (infrastructure funds, hedge funds and private equity funds) is 2+20 - that is 2 per cent base management plus 20 per cent of the profit.

a) Performance fees. 20 per cent. Some of the more popular LBO funds charge more - for example Bain Capital asks for - and gets - 30 per cent of the profits. ...That determines who gets to "drink from the well first", as Ovidio Iglesias puts it. If it's a $1 billion fund that ends up being worth $3 billion after 10 years, the investors get their $1 billion back plus 80 per cent of the $2 billion profit.

b)the management fee, which is meant simply to cover overheads and salaries, was 1.5 to 1.75 per cent three years ago, now it is 2 per cent and a source of profit, especially as most private equity firms raise new funds. Each new one increases costs marginally, while bringing in a full 2 per cent fee. During the first five years the management fee applies to committed capital, whether it's invested or not. This is known as the "investment period".During the second five years - known as the "harvest" period - it applies only to invested capital, which means there is a huge incentive on the fund to invest all the money within five years. The performance fees kick in after an 8 per cent preferred IRR to investors. New, untried operators usually have to offer a 10 per cent hurdle, while some of the more established funds are driving it down to 6 or 7 per cent.

The fund operators, such as KKR, Bain etc, get 2 per cent a year of the $1 billion invested (total: $100 million) plus 20 per cent of the profit ($400 million). Investors happy, KKR thrilled. If the IRR is less than 8 per cent, the whole profit goes to the investors and the fund operator has to scrape by on 2 per cent.


2.the reasons why this is occuring which are:

a)Low interest rates combined with market stability which has promoted risk-taking;
b) Super fund portfolios (ie compulsory retirement contribution funds in Australia) growing more quickly than traditional avenues for investing them (super funds invest 10 to 20 per cent of their assets in what they collectively call "alternatives" - infrastructure funds, hedge funds and private equity funds);
c)Arbitrage between the value of the assets and their market prices;
d)Over-regulation of public corporations, so going private creates higher value;

- Boards are recommending private equity because the Internal Rate of Return (IRR) is at least 20% over 3 years.

- The high return indicates that the Board is selling the company at too low a price or giving up on their own responsibility to get the best out the company, ie underperforming the corporation so that the sale price is kept low.

- In fact, managers of the corporations often drive the process. This is called Management Buy Outs (MBOs)Example. For example, the Australian Flight Centre deal.

- Management Buy Outs are a fundamental conflict of interest.

- The Australian Securities and Investments Commission and the Australian Stock Exchange don't compell CEOs to release to the market the management strategy and internal rate of return forecasts when the CEOs are involved in a management buy out of their own company. That is, it doesn't appear to be part of the ASX continuous disclosure regime because CEO Graham Turner was not required (apparently) to provide this information when he persuaded Pacific Equity Partners to join him in buying Flight Centre.

-Private equity gets better returns from a given set of assets than a public company board for three reasons:
a) drastic transformation and cost cutting in private with no disclosure;
b) giving the management the chance to get very rich ..richer than they're already getting; and
c) high gearing - up to 80 per cent debt.

If you have time it would be helpful to check out the strong networks established between the CEOs of these financial institutions and respective governments. The 'Australian Davos Connection', the 'Bilderberg Group', the American 'Council on Foreign Relatons' the 'Trilateral Commission'.

Anonymous said...

I think it was Charles Dickens who mentioned in one of his stories that the merchant always has an advantage over the customer because the merchant knows the "true" price of an item and the customer does not.

even with the published price, the trading price, the customers don't know the true value of a stock.

Anonymous said...


No doubt. And further:

Friday, October 12, 2007

The Citi Bailout: "Master-Liquidity Enhancement Conduit"

Here is more on the Citi SIV bailout plan from the WSJ: Big Banks Push $100 Billion Plan To Avert Crunch

BruceMcF said...

Excellent reference.

There's also the point that the Value at Risk method of pricing risk is generally sub-additive if the risks are not normally distributed. Since systematic risks are by no means IID (independent and identically distributed), and all financial assets are exposed to substantial systematic risks because the global economy is an interconnected system of interconnected systems, there is no "Law of Large Numbers" reason to expect the systematic risks that financial assets to be normally distributed.

If VAR(A)+VAR(B) less than VAR(A+B), then Value at Risk pricing of risk actually understates the appropriate level of diversification of a portfolio.

And that, of course, is on top of the point that using market volatility in pricing risk will understate the warranted price of risk when the market is less volatile because it is a strong bull market, so that heavy reliance on VAR type pricing models will tend to amplify economic instability over and above the amplification of economic instability from the reliance on liquid, well-organized financial markets prone to booms and busts.

Anonymous said...

I'll readily admit that this particular conversation is getting a bit obtuse for my limited understanding. One aspect of the conversation that is unclear is the confoundiing of the term price with the term value. It brings back to mind the idea of "knowing the price of everything and the value of nothing." I hear in these posts the discussion of value as it relates to the likeliest price someone would pay for an instrument, and this being commpared with some established price of that instrument. It sounds something like some have the "inside scoop" on what the actual price something can fetch versus the "published" price of that something. I don't think I'm reading anything in these posts regarding the real underlying value of the instruments. Would someone take a moment to clarify these factors: published price; price/value(real price that is likely to be paid; and underlying value(the actual assets that underlie the instrument?

Anonymous said...


the conversation is abstruse. _I_ am obtuse.

but the price of anything is what someone pays for it. the value is maybe what he would have paid if he had to, or what he would have sold it for if he had to. i can't think of any other way to think of "value" in an economic sense... but that may only be because i am not thinking.

that said, people over value the "price" of something, tending to think of it as not only carved in stone, but carved in stone in heaven. which is why you have economists and accountants telling you the "value" of a stock, or a dollar bill, thirty, seventy-five, years into the future.

none of those things has any meaning except as guesses, or as agreements between parties as to the guess they each will accept (each thinking he his getting more value than the value he is giving up.

and most of the time they don't have any clear idea about that.

Anonymous said...

Perhaps the value of an item derives from whether it is to be exchanged or used. That, it seems to me, is the question. So please excuse me, while I go pour myself a bourbon and water before I try to figure this matter out.

Anonymous said...

Well in fact obtuse is what I meant to say. The point is to emphasise the wide range of meaning in the words being used, price and value. it seemed to me that the discussion of value was less than sharp and to the point, lending a sense of obscurity to the conversation. Hence, obtuse for what's being said as well as whose reading what's being said.

What I'm asking for is a differentiation in the use of the term value. A financial security represents and asset. The underlying asset has a value which relates to its price. That in turn effects the value and price of the security. The problem is that the result is two levels of value and two levels of price. Now the original post seems to be inferring that there are two levels of knowledge regarding value and price. Valuing a security seems to be getting obtuse, as I said. I'm looking for clarity. Is there any?

Anonymous said...

jack, since i guess that you're referring to 'capital markets' -

'published price' = market price, but there are also unpublished prices that are realized off-market or at least off-exchange, additionally, some derivatives are so customized that they have no market as such and are priced strictly by model. This last allows for contradiction to develop between price as modeled and booked and price of same if actually offered for sale, which is what has happened with multiple hedge funds etc over the last months. Forced sales - 'discovery' that actual market bids were/are far below the marked-to-model price.

somewhat aside from that, the efficient market hypothesis, depending on which version - strong, semi-strong, weak - argues that 'the price is right', i.e. all relevant information is in the price which is, then, equivalent to 'fair market value'. There can be no under or over valuation, investor rationality reigns and mr market knows best.

marx, keynes, and those still holding would very much disagree.

Anonymous said...

But juan, my concern has to do with the implication that while Mr. Market
knows best and there can be no over or under valuation, who is it that Mr. Market is talking to first and most clearly. No, I'm not suggesting that there are those who have a better ear for the market place. It seems more likely that either Mr. Market is being manipulated, or is sharing his knowledge in an unequal manner. Worse yet, might Mr. Market be acting like a ventriloquist's dummy and saying what he's told to say.

Anonymous said...


That's why I added the last sentence -' marx, keynes,...would very much disagree [with the efficient market hypothesis]' -- or, market price does not contain all relevent information and there can be large gaps between price and value. But this takes us back to questions of what is value and from that an assortment of valuation methods/models, the most primitive of which is a price/earnings ratio or discounted free cash flow models. Different broad asset classes require different valuation methods but it has seemed to me that most attempt to estimate "value" of Claim(s) on the basis of what the holder(s) of such Claim(s) can expect to gain - and/or prevent from being lost - over some forward period(s).

It's more than an opinion that the quality of financial accounting deteriorated* from the early 1980s on, with listed firms increasingly presenting results distinct from their realities, with the financial press and msm not sufficiently questioning but, rather, all 'getting with the program', as did most analysts, politicians, etc etc as the Grand Casino was built up and as price(s) failed to capture gross inefficiencies but instead depend on them. corruption and mispricing became endemic with investors, if that's the proper word, of all sizes being taken to the cleaners while constantly fed a stream of easily digested 'always up' pablum.

You see, we are on exactly the same side but the whole subject can become very difficult, especially for one such as myself who continues with a supposedly discredited labor theory of value rather than neoclassical economics subjectivities and so often failed analytics.

*see, e.g., Walter Cadette, David Levy, and Srinivas Thiruvadanthai, Two Decades of Overstated Corporate Earnings: The Surprisingly Large Exaggeration of Aggregate Profits , The Levy Institute Forecasting Center, September 2001.
Or - Robert Kuttner; The Market Can't Soar above the Economy Forever, Business Week, 15 April, 2002. (clip: "For two decades, stock prices have outstripped corporate profits and the growth of the economy.")
Or, 'down and dirty' on particular firms such as Microsoft and Cisco - Bill Parish, 'Cisco Systems Watered Stock Pyramid Analysis' or 'Accounting masterclass: how Cisco and MS avoid tax'; or multiple others by same accountant.
Or, dozens and dozens of others which seperately and together leave little question.

Anonymous said...

I'm not doubting what you say. I guess I'm trying to make the point in a rather back handed manner. The issue is akin to combating the tar baby. The more you seek out an understanding that might leas to some corrective measure, at least in theory, the deeper you sink into a quagmire of complex inter-relationships. A corporate economy led by a managerial strangle hold, in complicity with a revolving door political class.

What's a concerned citizen to do? Power to the people is little more than a catch phrase with a lack of an audience. When things get bad enough for the mass of the working class possibly they will be more demanding of a government that actually provides a criminal justice system that includes corporate and political crimes. What's that they say about ten good men and true?

J.Goodwin said...


As an accountant, I take umbrage with your description of what accountants do :D

Accountants don't project value at all, that would violate several of the primary principles on which the profession operates. Assets have book values that are related to the amount paid for them, allocated over multiple business cycles as appropriate to match them against the future revenues that they are generating.

The "exception" to the historical cost approach is the more modern "mark to market" technique that's being used in some cases to value inventories and certain sorts of financial instruments. Frankly, I regard that as a dangerous trend more suited to the no-holds-barred world of managerial accounting rather than the world of financial accounting.

Even when items are "marked to market," accountants make use of external experts to determine the amounts to record. It's simply not in our field to value that sort of thing. You want a financial or market analyst for that job, presuming that you want it done at all.

Anonymous said...

While a much older phrase, in November of '32, FDR spoke of building a cabinet with 'ten good men and true', and proceeded to help save capitalism from itself.
Given developments since, I'm not sure that can or should be done again. Instead, how to facilitate, ideally smooth, burial and birth.

Anonymous said...

I think Maximillian Robespierre found that cooperation was not always forthcomig from those in positions of power and control. FDR was certainly no revolutionary in spite of what his detractors may have thought. And there in lies the source of Robespiere as a consequence. Even FDR's low key approach to resolving the difficulties inherent in capitalism as it relates to income distribution were regarded by the economic elite as being too over the top. What's a good hearted person to do? History details for us all too clearly that those that's got it ain't givin' it up unless they're challanged to do so.

Anonymous said...

j. goodwin,

Would you agree that FASB guidance fell behind tech enhanced corp. financial engineering. I've wondered, for example, how Enron's mark-to-model energy derivatives were supposed to be accounted, partic. since its m-t-m practice had been of some duration, from the early 1990s I believe.

J.Goodwin said...

FASB guidance is always going to be behind the times because it is theoretically supposed to represent Generally Accepted Accounting Practices.

You don't come to GAAP from the top down, there's supposed to be a consensus determination as to what GAAP is that is then reflected in FASB pronouncements.

So, yeah, FASB was behind, but that was by design. It's not that they "fell behind," it's that they were always behind in the same way that carts are behind horses.

That way of doing things is no longer reflected in the current self-regulatory environment. There is a growing demand for centralized authoritative guidance, and not just in the US, but internationally.

That's why you're seeing so much influence from international audit standards on the more recent SAS statements. Someone is out there leading because everything has gone to hell, and it's not the US.

IMHO, the new guidance and the new way of generating guidance are not going to solve the problem because the bottom line problem in all of these cases has been management override of controls. No matter what internal controls you allegedly have over financial reporting, when you focus the review of internal controls on a single person or small group of people (which is the predominant effect of things like telling the CFO or President to sign off on the company's internal controls), you give them more power to override those internal controls.

The leading cause of fraud is opportunity, so we're just going to see more of it.

Don't get me wrong, I'm a firm believer in documenting and testing internal controls and in many cases companies were not documenting their controls and audit firms were not testing them. However, the new approaches to documentation and testing are ignoring key design considerations, and they're also predicated on the existing relationship between firms and clients, which is flawed to start with.

The assurance that the public gets from CPA firms is always going to be based on the cooperation of companies in the audit process and the assumption that the company is doing the right thing, barring a small amount of professional skepticism. If a firm believes otherwise, then they are supposed to resign the engagement. However, given the money that is on the line, that's a really difficult decision for a firm to make, because you're basically biting the hand that feeds you.

I guess, in summary, the problem has a lot to do with what information the public thinks they are getting versus the job that is actually being done by CPA firms, and then separately the problem of companies documenting, maintaining, and in most cases evaluating their own systems of internal control and financial reporting.

It's a catch 22. Audit firms aren't supposed to write a company's financial statements or create their systems of internal controls, but at the same time you can't trust the company to do it themselves. So there's no REAL monitoring going on, and even if you set up a huge government agency whose purpose was implementing, monitoring, and reporting on all of this stuff, you would still be subject to managerial override of the systems.

It's lose-lose already, and abandoning historical cost just confuses the issue because you're giving the impression that the information provided is something that it is not.

Anonymous said...

Thank you, nice answer and yes, 'fell behind' was a euphimistic way to put what may have to do with a private org. 'being in the pocket' of not CPAs so much as management.

A late friend in Connecticut had a saying that I can't recall but had to do with divergence of principles and standards over the last decades or at least until 2001.