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.”

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