Subprime Winners: Rational Herds & Decision Researchers

US capital and derivatives markets in mid-2008 provide a real-time laboratory for behavioural finance analysts who want to understand the madness and wisdom of crowds.  The past week’s case studies include the implosion of the US bank IndyMac and the market volatility triggered by fears that Fannie Mae & Freddie Mac are highly exposed to liquidity risk.

As financial reporter Michael S. Rosenwald notes in The New York Times, these recent events appear to fit the behavioural finance hypothesis that individual investors who make fear-driven and risk-averse decisions can trigger pricing shifts as an aggregate rational herd.  Guillermo A. Calvo and Enrique Mendoza found in a 1997 paper that globalisation counteracts the emergence of rumour markets based on imperfect information and country-specific knowledge, although not in emerging markets due to uncertainties.

However the recent events have different conditions that set delimits on Calvo and Mendoza’s model: the United States is the epicentre of the bear market triggered by the 2007 subprime crisis, Fannie Mae and Freddie Mac have psychological primacy as major financial institutions with US Federal Government backing, and investment media firms such as Bloomberg and CNBC use globalisation to create de facto rumour markets amongst day-traders and others.

Readers interested in rational herds should also check out Christopher P. Chamley’s book Rational Herds: Economic Models of Social Learning (Cambridge University Press, Cambridge UK, 2004), excerpt here.

Decision researchers are the other early winners of the 2007 subprime crisis, due to the failure of many quantitative models to predict the Black Swan event.  Rosenwald mentions Harvard University’s new Bio-Behavioral Laboratory for Decision Science which conducts ‘conducts research on the mechanisms through which emotional and social factors influence judgment and decision making.’  He also refers to the Oregon-based nonprofit group Decision Research.  An Australian-based counterpart might be the Capital Markets CRC, an R&D consortia that focuses on ‘new technologies and improvements in market design’.

Investment analysts still have divergent opinions on recent events.  However the research agenda above prompts several new questions:  What happens to rational herds and rumour markets when bio-behavioural methods of decision-making are no longer ‘imperfect information’ but are widely understood and integrated into investment choices?  How will markets be redesigned to cope with this eventuality, and who will take on this responsibility?  What new financial instruments, markets and products will emerge generativity?

Errors In Quantitative Models & Forecasting

Could the roots of the 2007 subprime crisis in collateralised debt obligations (CDOs) and residential mortgage-backed securities (RMBS) lie in financial analysts who all used similar assumptions and forecasts in their quantitative models?

Barron’s Bill Alpert argues so
, pointing to a shift of investment styles after the 2000 dotcom crash from sector-specific, momentum and growth stocks to value investing.  Investment managers who prefer the value approach then constructed their portfolios with ‘stocks that were cheap relative to their book value.’  In other words, the value investors exploited several factors — the gaps in asset valuation, asymmetries in public and private information sources, price discovery mechanisms and market participants — which contributed to mispriced stocks compared to their true value.

However, the value investing strategy had a blindspot: many of the stocks selected for investment portfolios also had a high exposure to credit and default risk.  The 2007 subprime crisis exposed this blindspot, which adversely affected value investors whose portfolios had stocks with a high degree of positive covariance.

Alpert quotes hedge fund manager Rick Bookstaber who believes that financial engineers have accelerated crises and systemic risks via the complex dynamics of new futures contracts, exotic options and swaps.  These new financial instruments create interlocking markets (capital, commodities, debt, equity, treasuries) which have the second-order effects of larger yield curve spreads and trading volatility.  Alpert and Bookstaber’s views echo Susan Strange‘s warnings a decade ago of ‘casino capitalism’  and ‘mad money’ as unconstrained forces in the international political economy.

Quantitative models also failed to foresee the 2007 subprime crisis due to excessive leverage, difficulties to achieve ‘alpha’ or above-market returns in market volatility, and the separation of risk management from the modelling process and testing.  Other commentators have raised the first two errors, which have led to changes in portfolio construction and market monitoring.  Nassim Nicholas Taleb has built a second career on the third error, with his Black Swan conjecture of high-impact events, randomness and uncertainty (see Taleb’s Long Now Foundation lecture The Future Has Always Been Crazier Than We Thought).

Alpert hints that these three errors may lead to several outcomes: (1) a new ‘arms race’ between investment managers to find the new ‘factors’ in order to construct resilient investment portfolios; (2) the integration of Taleb’s second-order creative thinking and risk management in the construction of financial models, in new companies and markets such as George Friedman’s risk boutique Stratfor; and (3) a new ‘best of breed’ manager who can make investment decisions in a global and macroeconomic environment of correlated and integrated financial markets.

US Accounting Rules & Global Governance

The Securities & Exchange Commission (SEC) in the United States plans to adopt the International Financial Reporting Standards (IFRS) in order to enhance US competition in global markets.  The IFRS would be harmonised with, and may even replace the existing US accounting rules, the Generally Accepted Accounting Principles (GAAP) that the Financial Accounting Standards Board (FASB) oversees.


Critics are concerned the shift from GAAP to IFRS is an ill-fated intervention by US regulators comparable to the administrative burdens of Sarbanes-Oxley (SOX) compliance.  The perceived ‘institutional creep’ taps deep US fears on the potential for global governance institutions like the United Nations to interfere with US legal jurisdictions, Administration policies and national will.


To manage this resistance the SEC released a public roadmap and conducted a roundtable in December 2007.  However the Federal Reserve Chairman Ben Bernanke and US Treasury Secretary Henry Paulson upstaged this initiative in the issues-attention cycle due to their attempts to dampen the fallout in financial markets from the 2007 subprime crisis.  Collectively the SEC, Federal Reserve and US Treasury proposals signal major changes to the US financial system’s regulatory framework.


The SEC’s initiative has (at least) three possible side effects.


The planned harmonisation with IFRS will increase the tension between the SEC and US business leaders and policymakers over gaps in the IFRS, cultural differences, and the compliance mechanisms for regulatory oversight.  The coevolution of the US financial system and global governance will need to be reframed as a systems-level opportunity to overcome partisan interests.


The Australia-US Free Trade Agreement (AUSFTA) may be the ‘test case’ for US implementation of IFRS accounting rules.  AUSFTA establishes a bilateral framework on intellectual property rights and strengthens the positive correlation between the US and Australian financial markets.  If it’s really ‘outsourcing’ the US accounting/taxation regulatory regime as its critics believe the SEC is doing so to a ‘friendly’ nation-state.


Enterprise Resource Planning vendors such as Infosys and SAP could also benefit in the SEC’s shift to IFRS.  ERP systems enable trans-national corporations to be scalable and integrate their subsidiaries’ financial reporting through a centralised database, called master data management.  SAP for instance has business rules that harmonise the taxation reporting of different countries.  If the SEC’s roadmap unfolds then SAP and other ERP vendors will have to update their configurable platforms.  IFRS rules could reinvigorate the ERP market for enterprise application integration which uses systems architectures to integrate different computer systems, software, and data.