Efficient Stupidity Hypothesis and Mark-to-Market

[The Minsky Moment]

The Efficient Markets Hypothesis is a staple of finance theory - it states that stock prices adjust nearly instanteously to reflect new information.  In its stronger forms the EMH is used to support claims concerning the impossibility of riskless arbitrage, or the efficacy of fundamental or technical analysis as a means for "beating the market"

In a sense the EMH is a truism - because in an era of nearly instanteous communication and electronic trading - of course stock prices are going to relect available information as soon as it becomes available.  And because the market as a whole cannot "beat" itself, individual instances of what seems to be arbitrage opportunities or outperformance can be explained away as outliers or temporary phenomena

The problem is that information is only as good as peoples' ability to rationally understand and make use of it.  If information is misconstrued, or interpreted in an irrational manner, the resultant stock prices will blindly reflect that mis-interpretation or irrationality.  Garbage in, garbage out.  The fact that there are so many participants in the market doesn't eliminate this possibility - indeed at times it exacerbates it.  The great mass of traders and stock market participants are not a calm, deliberative assembly - they are more like an unruly mob, and ever since the Tulip Bulb mania we have many examples concerning the madness of crowds.

The recent change to mark-to-market accounting rules and the market reaction brought this back to mind.  The effect of this chage - first felt on April Fool's day appropriate enough - was a big instant leap in the KBW index of US bank stocks, which in turn fuelled the recent overall market rally.  But in fact, the relaxation of mark-to-market does absolutely nothing of substance.  It doesn't change a single item on any bank balance sheet or add additional capital.  To the contrary, it gives the banks the ability to bury and obfuscate further problem assets on the balance sheet.  It is as if the government has given the banks the power to say that 1+1 = 3, and the market -- knowing this fact -- bids up shares in anticipation of the "2" becoming a "3".  Efficient stupidity in action.

The purported justification is that the change will allow banks "flexibility" in addressing their bad asset problems.  But what this flexibility really amounts to is the flexibility to lie - to call a spade a diamond, to call a "2" a "3".   I can see why the banks might want such flexibility.  What I can't see is why a rational investor would conclude that such flexibility renders the assets of the bank a more attractive investment.

[Oexmelin]

Do all the modern analysis of the flow of information take into account the «packaging» of the info ? How it is presented, by whom, etc.? Obviously, when I look at the flow of information between négociants and merchants of the 1750s, it is easy enough to do - and I can see how nowadays, the multiplicity of information is supposed, or assumed to render such concerns meaningless, but I am not convinced.

[The Minsky Moment]

Do all the modern analysis of the flow of information take into account the «packaging» of the info ?

I don't know about "all" - there is far more literature out there on these issues than I could ever hope to read.  There is an argument that given the muliplicty of media sources and sheer size of the markets that any "spin" will be seen through by enough as to render it ineffective.  There are plenty of good example for that - market analysts are used to discounting and seeing through statements made by CEO/CFOs in investor calls for example.  But herd behavior can counteract that process.

[Jos Theelen]

The purported justification is that the change will allow banks "flexibility" in addressing their bad asset problems.  But what this flexibility really amounts to is the flexibility to lie - to call a spade a diamond, to call a "2" a "3".   I can see why the banks might want such flexibility.  What I can't see is why a rational investor would conclude that such flexibility renders the assets of the bank a more attractive investment.

It is not about the value of the stock, but about how others think about it. Clearly many investors think that others will see those stocks as more attractive. So they think those stocks will rise.

John Maynard Keynes said that picking shares was like a beauty contest where 'it's important to choose not who you think is the prettiest girl, but who the judges will think is the prettiest girl'. One of the key lessons I've learnt over the last 30 years or so of being an investment manager is that, although perception and reality are both factors in choosing investments, perception is probably the more important.

[Admiral Yi]

Doesn't the change have ramifications for government regulation/intervention that in turn affect rational investor expectations?

[dps]

The Efficient Markets Hypothesis is a staple of finance theory - it states that stock prices adjust nearly instanteously to reflect new information.  In its stronger forms the EMH is used to support claims concerning the impossibility of riskless arbitrage, or the efficacy of fundamental or technical analysis as a means for "beating the market"

In a sense the EMH is a truism - because in an era of nearly instanteous communication and electronic trading - of course stock prices are going to relect available information as soon as it becomes available.  And because the market as a whole cannot "beat" itself, individual instances of what seems to be arbitrage opportunities or outperformance can be explained away as outliers or temporary phenomena

The problem is that information is only as good as peoples' ability to rationally understand and make use of it.  If information is misconstrued, or interpreted in an irrational manner, the resultant stock prices will blindly reflect that mis-interpretation or irrationality.  Garbage in, garbage out.  The fact that there are so many participants in the market doesn't eliminate this possibility - indeed at times it exacerbates it.  The great mass of traders and stock market participants are not a calm, deliberative assembly - they are more like an unruly mob, and ever since the Tulip Bulb mania we have many examples concerning the madness of crowds.

The recent change to mark-to-market accounting rules and the market reaction brought this back to mind.  The effect of this chage - first felt on April Fool's day appropriate enough - was a big instant leap in the KBW index of US bank stocks, which in turn fuelled the recent overall market rally.  But in fact, the relaxation of mark-to-market does absolutely nothing of substance.  It doesn't change a single item on any bank balance sheet or add additional capital.  To the contrary, it gives the banks the ability to bury and obfuscate further problem assets on the balance sheet.  It is as if the government has given the banks the power to say that 1+1 = 3, and the market -- knowing this fact -- bids up shares in anticipation of the "2" becoming a "3".  Efficient stupidity in action.

The purported justification is that the change will allow banks "flexibility" in addressing their bad asset problems.  But what this flexibility really amounts to is the flexibility to lie - to call a spade a diamond, to call a "2" a "3".   I can see why the banks might want such flexibility.  What I can't see is why a rational investor would conclude that such flexibility renders the assets of the bank a more attractive investment.

Well, that's always been one of my main problems with a lot of economic models--the assumption that actors in a system behave rationally. 

[DGuller]

But in fact, the relaxation of mark-to-market does absolutely nothing of substance.  It doesn't change a single item on any bank balance sheet or add additional capital.  To the contrary, it gives the banks the ability to bury and obfuscate further problem assets on the balance sheet.  It is as if the government has given the banks the power to say that 1+1 = 3, and the market -- knowing this fact -- bids up shares in anticipation of the "2" becoming a "3".  Efficient stupidity in action.

I'm not sure I entirely agree with this.  Wouldn't falling asset values force the bank to put some of its assets up for fire sale?  That can cause some real losses.

[The Minsky Moment]

I'm not sure I entirely agree with this.  Wouldn't falling asset values force the bank to put some of its assets up for fire sale?  That can cause some real losses.

Changing the accounting treatment doesn't change the actual value though.  Nor does it alter the bank's cash flow (and hence its ability to meet its short-term funding obligations and avoid a fire sale). 

[The Minsky Moment]

It is not about the value of the stock, but about how others think about it. Clearly many investors think that others will see those stocks as more attractive. So they think those stocks will rise.

You are correct that collective delusions can have real economic effect, especially over the short-term.  In that sense, the move could work and investor decisions to buy could be validated.  But if the fundamentals don't catch up, eventually the gap between perception and reality will bite.

[Oexmelin]

Then the interesting question - which goes back to the one I was wondering about earlier - is how collective «delusions» are made, born, transfered, etc. This is why information is much more than spin - it is also about a shared culture of the ideal investor, about how asumptions are made, about who the credible vectors of information are...

[The Minsky Moment]

There is always comfort in a crowd.  One of the dynamics that often comes into play in bull market bubbles is pressure to avoid being "left out".  If everyone else around you is in the market and making gains, envy and peer pressure become motivating factors.  Even if you have some fear about the sustainability of the bubble, you fear that if you don't go in, and the market goes up, you will fall behind your neighbors and peers, have "missed the opportunity" for big gains, and feel regret.  And if the market does crash, at least you will have commiseration.

The contrarian investor is always lonely, and doesn't get invited to cocktail parties.

[Berkut]

I'm not sure I entirely agree with this.  Wouldn't falling asset values force the bank to put some of its assets up for fire sale?  That can cause some real losses.

Changing the accounting treatment doesn't change the actual value though.  Nor does it alter the bank's cash flow (and hence its ability to meet its short-term funding obligations and avoid a fire sale). 

But changing the accounting treatment does change the amount the bank has to keep on deposit to cover their debts.

Granted, it is just playing games with numbers, but that doesn't mean changing the numbers does not change things - it does.

I am not sure it changes them for the better, but the banks apparently think so.

Sure is a good thing we are tightening up regulation on them, and making sure they do not make more high risk decisions!

[MadImmortalMan]

If you're holding a bundle of thirty-year investments, then what they are worth right now isn't really relevant. They don't mature for thirty years. If I buy a $100 savings bond that matures in thirty years, for example, I'll pay less than $100 dollars for it. I'm not sure how much, let's say $60. Is the value of the bond $60? Yes. Is that information useful? No. I don't plan to redeem it until it matures, so its value to me is $100.

Sure, the savings bond is less likely to go into default than a mortgage paper, but the concept is the same from the holder's perspective. I suppose if I had $60 invested in a mortgage security with a high rate of foreclosure in it, say 5%, and a long term maturity total of $100, then I'd say it's not unreasonable that I should be able to rate the value of my holding at $90 instead of $60.

Er...am I defending getting rid of M2M? I guess it kinda looks that way, even though I don't want that precisely. It seems like there ought to be a different rule for valuing longer-term assets than there is for things like stocks.

[DGuller]

I'm not sure I entirely agree with this.  Wouldn't falling asset values force the bank to put some of its assets up for fire sale?  That can cause some real losses.

Changing the accounting treatment doesn't change the actual value though.  Nor does it alter the bank's cash flow (and hence its ability to meet its short-term funding obligations and avoid a fire sale).

The fire sale may be caused by regulations or other things that require minimal capital.

[The Minsky Moment]

Berkut, Guller -

There are two regulatory requirements that could be at issue here.  One is the amount of reserves the bank is required to keep at the Fed.  Reserve requirements are a function of the level of deposits (liabilities) and hence an accounting change that relates to valuation of assets should not have an effect.

The second are min capital requirements, and these are based on assets.  However, the minimum capital requirement is calculated based on the *face value* of the asset, not the actual value.  Were the requirements instead based on actual value, then a revaluation of assets upwards would increase (not decrease) the required regulatory capital.