perfect market and financial crisis

8/3/2019 PERFECT MARKET AND FINANCIAL CRISIS

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Test the hypothesis that the economists perfect market model provides the underlying concepts, theories and paradigm of finance against the evidence of the reportof the Financial Crisis Enquiry Commission.

Amit H Panchal

11/24/2011

IntroductionStarted in middle of 2007, the global financial crisis is considered to be the worst 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 hadtriggered the financial crisis. Attempts were made by the Financial Crisis Inquiry Commission (FCIC) to record the facts that cause the financial crisis to makeit available to general public to better understand the crisis.The report of the FCIC is a wonderful piece of work which collects the numbers of facts that causes the crisis. However, they fail to relate it with economists theory which could help to better understand he crisis. As the majority of the commission believes that the catastrophe was avoidable, arises the question: whatcaused the crisis? In this essay an attempt is made to identify the cause of thecrisis using the perfect market hypothesis against the evidence of the FCIC inorder to check the dominance of the perfect market theory. Although the idea ofthe efficient capital market can not be found in reality, the assumptions are used 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 evaluate the efficiency of the economy, and than relate the key features with the commissions report.

Perfect marketIn economics, the term perfect market refers to the market where no participants(buyers and sellers) are huge enough to influence the price of homogeneous product. 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. There are only few perfectly competitive markets. Buyers and sellers in commodities market or stock markets are the most closest to the perfect market. As said earlier, the model serves as a benchmark to evaluate the economys efficiency.

Eugene Fama (1970s), defined an efficient financial market as one in which pricealways fully reflects available information.In perfect market, every participant is price taker, no individual buyer or sellercan influence the market price of the product it buys or sells. An investor that 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 that is new firms are free to enter in the industries or exit barriers for existingfirms. This kind of market can be found where there is large number of small producers producing homogenous product and it can not be unregulated. The conditions for perfect competition are:1. The industries contain so many buyers and sellers that no single one caninfluence 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 worthwhile to distinguish the product of one firm from that of another in the industry.


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4. No barriers obstruct entry into or exit from the market; that is there is 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 overall production of an industry, no firm in the industry can sell its product atthe 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 theindustry output.Firms under perfect market only earn economic profit in the short run just enough to stay in the market by covering the variable cost and to some extent cover the fixed cost of plant and equipments if possible. But in the long run the economic profit will be eliminated by the entry of new firms into the market when themarkets are in equilibrium; price and marginal cost will be equal.

The perfect market is an economy in which all markets are unregulated other than market participants and intervention and regulation by the government is limited to tax collection and bank bankruptcy. And due to the lax regulation and free competition, price of the product or service tends to decrease and quality to increase.

In perfect market, deregulation has been essential in permitting financial institutions to offer the new services. There are numerous arguments in favor and against regulation and these are worth reviewing.One of the major is the need for investors protection. Investors needed to be protected against misinformation which encourages them to invest in products that are unsuitable and they need to be protected against the misuse of their funds once they have been handed over.Having reviewed the perfect market, here are some key points that are derived from 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. realityAfter reviewing the perfect capital market theory, the next section discuses howdeep it goes in the reality and try to identify the dominance of the theory. Having gone through the FCIC report, I found the numbers of evidence that help meto build my essay.When you see the Inside job documentary, it says that the deregulation period started in 1982 by Regan administration supported by economist for savings and loancompanies and moving towards the self regulatory nature of the market instead ofgovernment regular intervention in the market which according to market participants, cause the market inefficiency. But because of this reason the regulator never 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 acceptedfaith in the self-correcting nature of the markets and the ability of financialinstitutions to effectively police themselves. (FCIC Conclusion Report, pg. xviii)

We do place special responsibility with the public leaders charged with protecting our financial system, those entrusted to run our regulatory agencies, and thechief executives of companies whose failures drove us to crisis. (FCIC ConclusionReport, 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.


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Commissioners agreed that investment bank holding companies were too lightly (barely) regulated by the SEC leading up to the crisis and that the Consolidated Supervised Entities program of voluntary regulation of these firms failed. (FCIC Dissenting Statement, pg 430)

They thought that for the firms to offer wider range of financial services, deregulation has been essential in permitting financial institution to offerthe 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 kind of attitudes leads to many irresponsible behavior in the market. The following fact reflects the irresponsible behavior of regulators:Securities and Exchange Commission could have required more capital and halted risky practices at the big investment banks. It did not. The Federal Reserve Bankof New York and other regulators could have clamped down on Citigroups excesses in the run-up to the crisis. They did not. Policy makers and regulators could have stopped the runaway mortgage securitization train. They did not. (FCIC Conclusion Report, pg. xviii)

And it was not that they lack of power to regulate them. As said Warren Buffettto 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 they didnt.Federal Reserves pivotal failure to stem the flow of toxic mortgages, which it could have done by setting prudent mortgage-lending standards. The Federal Reservewas 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 regulatorynature in financial firms and did nothing to prevent the prudent mortgage lending standards. They assumed it to be correct and stuck to their belief. In many cases they were ill prepared for the crisis and never understand the system of financial system. They couldnt take the appropriate measures when things started going 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 ReserveBoard, and the Federal Reserve Bank of New Yorkwho were best positioned to watchover our markets were ill prepared for the events of 2007 and 2008. Other agencies were also behind the curve. They were hampered because they did not have a clear grasp of the financial system they were charged with overseeing, particularly as it had evolved in the years leading up to the crisis. (FCIC Conclusion Report, pg. xxi)

And as a result of this, many firms had started to operate with more evolving risk 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 Sachs, Lehman Brothers, Merrill Lynch, and Morgan Stanleywere operating with extraordinarily thin capital. By one measure, their leverage ratios were as high as 40 to 1, meaning for every $40 in assets, there was only $1 in capital to cover losses. Less than a 3% drop in asset values could wipe out a firm. (FCIC Conclusion Report, pg. xix)

Even a normal movement could prove disaster with the firm operating with such high leverage ratio and these are not the small banks that it leaves the market unaffected. And to add in trouble, information about these ratios was hidden frompublic investors. As said earlier investors need to be protected from the misinformation which encourage them to invest in the instrument that is not suitable and 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 wasnever felt. And it was obvious that when information would be reviled, investormight react to it:


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And the leverage was often hiddenin derivatives positions, in off-balance-sheet entities, and through window dressing of financial reports available to the investing public. (FCIC Conclusion Report, pg. xx)

According to perfect market, price reflects all available information but 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 theyare investing in. if this information was known to the group of investors, theywere able enough to understand the risk of investing in such firms.

Another assumption of the perfect capital market is that all participants in themarket are rational. But the following evidence is totally against this assumption:

In particular, CDO buyers who were, in theory, sophisticated investors relied tooheavily 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 wereprovided by the agencies were not up to the standards. They believed that the knowledge that they have about the market situation was perfect and they were totally aware of the operation of the firms, but it was not.

Securitizers lowered the credit quality of the mortgages they securitized. Creditrating agencies erroneously rated mortgage-backed securities and their derivatives as safe investments. Buyers failed to look behind the credit ratings and dotheir 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- derivatives- 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 traded in derivative was not able to understand how this instrument works or you cansay 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 descending statement:

Not everything that went wrong during the financial crisis caused the crisis, andwhile some causes were essential, others had only a minor impact. Not every regulatory change related to housing or the financial system prior to the crisis was a cause. (FCIC Dissenting Statement, pg. 414)

Deregulation, irresponsible behavior, lack of transparency and high operating risk not alone cause the crisis, which means that these factors on their own couldnot affect the whole market, according to efficient market assumption. And to support this assumption tha evidence can be found in dissenting report, which areas follows:

Low-cost capital can but does not necessarily have to lead to an increase in risky investments. Increased capital flows to the United States and Europe cannot alone explain the credit bubble. (FCIC Dissenting Statement, pg 420)

U.S. monetary policy may have been an amplifying factor, but it did not by itselfcause the credit bubble, nor was it essential to causing the crisis. (FCIC Dissenting Statement, pg 421)

And another evidence from the report that supports the perfect market conditionof zero entry and exit barriers is:


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Nonbank mortgage lenders like New Century and Ameriquest flourished under ineffective regulatory regimes, especially at the state level. Weak disclosure standards and underwriting rules made it easy for irresponsible lenders to issue mortgages that would probably never be repaid. Federally regulated bank and thrift lenders, such as Countrywide, Wachovia, and Washington Mutual, had lenient regulatory oversight on mortgage origination as well (FCIC Dissenting Statement, pg. 423-424)

Human action and their greedy nature also contributed significantly in rising upthe catastrophe.

Massive amounts of inexpensive capital flowed into the United States, making borrowing inexpensive. Americans used the cheap credit to make riskier investments than in the past. The same dynamic was at work in Europe. (FCIC Dissenting Statement, pg 420)

In a market when supply of the product or service increases, in order to balancewith demand, the price tends to decrease without compromising the quality of the 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 causemassive losses to investors in mortgage securities. As early as September 2004,Countrywide executives recognized that many of the loans they were originatingcould result in catastrophic consequences. (FCIC Conclusion Report, pg. xxii)

They made the loan without proper documentation requirements and lend money to borrowers almost meeting their requirements. They thought that in order of doingso they can earn more profit. But when borrowers fail to repay the loans it became 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 even cover interest costs. These exotic mortgage products would often result in significant reductions in the initial monthly payment compared with even a standard ARM. (FCIC Dissenting Statement, pg 423)

By reducing the quality of the mortgage standards, they were not even able to cover the marginal cost which according to efficient market very necessary to stayin the business, but attracted by chances of making more money they didnt even think about that. By saying they reduced the quality the evidence below supportsthe argument:

Mortgage rates were low relative to the risk of losses, and risky borrowers, whoin 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 totheir capacity:

Many borrowers neither understood the terms of their mortgage nor appreciated therisk that home values could fall significantly, while others borrowed too muchand bought bigger houses than they could ever reasonably expect to afford. (FCICDissenting Statement, pg. 424)

One question arises is that Why they made such kind of lending when they knew that 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 more money.


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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 areinfluential like no entry and exit barriers, no effect on industry by single actor but many of them proved dominant which leads to the financial crisis. Reviewing the bullet points that are provided at the end of the first section of the essay, many of them proved disastrous for the financial market, which led to thecatastrophe after the great depression. Assumptions of perfect market like selfregulated in most efficient way in the market, all participants have perfect information, and all transactions are mutually beneficial, standard product in termof quality, all went to deeply in peoples mind that they never imagine that it could 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 warningsignals which asked for regulating the market against the fraud and from moving

towards more risky instruments of finance. The greedy and degree of irresponsibility in many financial institution opened the door for the instability in the financial and economic world.

References: Aneirin Sion Owen, 30th September 2011, Economists perfect market model Internaal Capital Markets, MMU moodle. Documentary, Inside Job 2010 Fama, Eugene F, (1970): Efficient Capital Markets: A Review of Empirical Work.urnal of Finance 25, no. 2 383417. Frederic S. Mishkin & Stanley G. Eakins 2000, Financial markets and institutionsrd 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-Weey WilliamTGeorge, 11 April 2011 Financial Crisis Inquiry Commissioner Peter Wallison Questions Warren Buffet,

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