Rational Market

Justin Fox has written a book called “The Myth of the Rational Market.” As one might imagine, it's carefully aimed at the recent financial ex/implosion. Fox thoroughly describes the theory and history of the rational market, that is, the theory that “markets” will tend toward behavior that will prevent them from collapsing. Fox shows the holes in this theory, but his assumptions and conclusions are only partially correct.

Markets are not homogeneous entities. They operate on multiple levels, with different levels exercising differing degrees of control over market behavior. Those in control of financial markets acted rationally. As financial markets expanded, they required more and more product. Derivatives, specifically those whose value were based on second and third order extensions to sub prime mortgages, filled the need for product. The beauty of these second and third order derivatives was that they required no additional entities of value in order to be created; they were based purely on faith in the value of the mortgages themselves, and on the underlying derivatives that were based on the underling mortgages. Still with me? Those creating these derivatives were well aware of their worthless nature. The goal was to sell the products quickly, getting them off the books, and in the process, generating a sales commission on every transaction. This made the originator of the product wealthy, while removing any responsibility for the product's future value from the originator. The originators had no need for future market health, as they no longer required a stake in the market. The new owners were just typical semi-passive residents of the back end of a speculative bubble. The entire rationale for the market's existence was simply to generate sales commissions, not to serve as a place where derivatives were traded. That trading was just a vehicle. In another time, the same traders might have dealt in precious metals (though they are problematic from a speculative point of view, since they do have some intrinsic value), tulip bulbs, or fictional railroad shares. It doesn't matter what the product is; whatever the product is, it simply has to exist at some existential level.

Ironically, investors in mortgage backed securities had ample opportunity to learn of their lack of worth. While brokers hyped these products, Gretchen Morgenson and Joe Nocera, of the New York Times, were accurately describing them as junk, at least two years before the crash. In another remarkable twist of irony, the banks and brokerage houses ended up caught with billions of dollars worth of these worthless securities (now so appropriately named toxic assets), while many of their own traders walked away with fortunes enough to retire to the French Riviera.

So, here we had the freest of free markets, wholly unregulated, thanks to the lobbying efforts of the investment houses and banks themselves. The investment houses could work with these derivative products in any way they saw fit, short of out and out fraud. The result? A web so tangled, with assets so arcane, that the CEOs of these investment houses couldn't understand them. They do conduct risk management at those brokerages and investment banks, don't they? Well no matter, the criminals who perpetrated this crime-less crime were made whole, their fortunes intact. Those who were sold this crap saw their fortunes, however slim, evaporate. The free market was very free indeed, punishing idiots, while rewarding those who understood the territory. The irony continues. Congressional windbags have had much to say about how bad things were, but they can't agree on regulation to prevent another blow up. The financial lobby still wants an unregulated derivatives market. Now that's the best Congress money can buy, and it's a market that has preserved itself. Caveat emptor? O tempora, o mores!