What Good Is Modern Finance

Many, particularly the media and elected officials, blame financial institutions and new, sophisticated products for the current financial crisis. Congress will look to pass legislation to increase the oversight of derivatives and financial intermediaries. Additionally, there is the prospect of new regulations for the firms in this industry.

Modern finance added something to the traditional methods of finance. It improved banking, corporate governance and investment risk management. However, it is not foolproof.

A primary objective of modern finance is about improving efficiencies of capital markets, by lowering the costs of raising capital and investing. Modern finance is also descriptive, mathematically and economically.

Modern finance shows why for example owning no load, low expense ratio mutual funds with holdings in a wide breadth of industries is safer that putting all your money in one company and why the low cost fund gets better returns than a fund with high investor expenses. By the way, mutual funds are more than stocks and bonds. Investors buy participation in an entity that owns investments, such as stocks and/or bonds. They are very similar to mortgage back securities, or collateralized mortgage or debt obligations.

Modern finance also allowed the development and issuance of TIPS, US Treasury inflation protection securities. These securities do not lose value if future inflation increases.

A few of the theories that allow for these improvements are the Black-Scholes-Merton option and contingent claim pricing model, the Sharpe-Lintner capital asset pricing model, and Markowitz mean-variance. There are also many other significant concepts, theories and research in other important areas of modern finance that have also helped in improving banking, corporate governance and investment risk management. Such as work by Akerlof, Spence, and Stiglitz on information asymmetry in markets. Work by Samuelson and Fama on efficient markets and many others in many other important areas of finance.

The ability to lower the costs of issuing debt or equity has been one of the most important benefits of modern finance. It also includes lowering the costs of obtaining information, including information about risk, about debt and equity that has tremendously benefited our economy. The lower cost alternatives to traditional banking has been the reason high cost banks' market share of corporate financings has decline significantly since 1950.

Improvements in information about debt and equities include improvements in corporate governance. While the public, a populist president and populist elected officials may object to high corporate salaries, bankers and corporate bondholders could stop this practice almost immediately if they felt it was a cause of concern about either the business health of the company or the company's ability to meet it debt obligations. I do not believe there is a single debt covenant in any public company's loans or bond agreements that prohibits competitive salaries to senior management. If these high salaries did broad based economic harm to our economy in other ways, every corporate bond covenant would have a clause prohibiting the practice to protect bondholders to reduce the risk of an economic downturn and the corporate inability to pay debt holders.

Derivatives exist because they are lower cost than alternatives to these types of transactions. Without options, one would have to use futures, which are more expensive because they require purchasing the underlying. Without futures, one would have to use forward contracts, which are even more expensive than futures. Without forward contracts, one would need partners or vertical business integration.

As an aside, mutual funds use a tiny portion of their funds to buy some options or futures that mimic the fund, to offset the zero return of cash they hold to meet redemptions or they have received from investors but they have not yet been able to invest.

The most surprising thing about the topic of the benefits from modern finance is how much knowledge macro-economists will impart about general equilibrium, GDP, Keynes, etc., but how little of their knowledge (I presume) they have about capital markets and derivatives they are willing to show. For some reason, many macro-economists become populists and resort to public perceptions instead of financial economic wisdom about markets.

Home Values Were Not In A Bubble

Houses are like other assets that are bought and sold in a marketplace. The prices of the transactions in the housing market reflect the economic value to the buyers and the sellers and value is based on future expectations about the economic fundamentals of housing.

In the US and worldwide there has been a noticeable decline in the value of homes. Some argue that home prices were artificially inflated due to a "bubble." Others believe in efficient markets and that the decline in home values is a rational response to a change in economic circumstances and expectations.

Houses are a multi-generational asset in that they are a consumer durable that can been passed on from one generation to another. In a rational expectations, efficient market world which is the world economic research finds we live in, house price changes are due to changes in the expectations of the economic fundamentals related to the need, demand and value of houses. Thus, current house prices reflect their true economic value and homes are not undervalued whether due to the unavailability of credit or for other reasons. Arms-length housing market transactions, of which there are still many, occur at the true current price of housing.

Much recent academic work supports the idea that a sharp price rise and decline in "bubbles" is actually a rational economic response and markets are efficient even in so called "bubbles". For example, see the Wikipedia article on tulip mania and a 2004 article in Slate, Bulb Bubble Trouble [Weblink updated].

So, instead of trying to use government money to artificially shore up house prices, a more rational response to the decline in the value of homes, is to ask what is the price change in the housing market telling us about the future value of housing and to see if that is something that is undesirable. If the expected outcome is not what we would like to see happen and is changeable, then we should do the things to change that outcome in our economy.

Some of the possible future scenarios which would decrease the current value of a home are:

1. a significant and long-term decline in household formation.
2. a significant and long-term decline in population growth in the US due to changes in birthrate or immigration policies.
3. an increase in adult children living in their parents home (including after marriage or cohabitation).
4. an expectation of an increase in mortality or a shortening of life expectancy due to war, disease or natural or man made disasters.
5. a change in our preferences so as to prefer multi-family or apartment type dwellings as opposed to single family homes decreasing the need for single family homes.
6. a significant increase in the costs of owning and maintaining a home which lowers its economic value to a purchaser because of the expected increase cash outflow during ownership.
7. a decline in both household income or the expected growth rate of household income.
8. an alternative technology for building homes which will dramatically reduce the costs of building new houses.
9. a change in home related taxation such as a denial of mortgage interest or real estate taxes deductions.
10. a substantial expected increase in real estate taxes.
11. other possibilities that affect the economic value of a home that I have not mentioned.

Some ideas mentioned above are testable. For example, I was going to mention global warming but a recent paper about house price declines in California observed that the decline is greater in central California than along the coast which is contrary to what would happen to house prices along the coast due to rising sea levels due to global warming. See the paper by OFHEO, "Recent Trends in House Price", pages 4 and 5 and note 6 at http://www.ofheo.gov/media/research/pricesandfinancing.pdf [The Office of Federal Housing Enterprise Oversight (OFHEO) no longer exist and I am unaware of an updated weblink to the paper.]

The point of this post is that to most economists who believe in economic value, efficient markets and rational expectations, the current decline in home prices is a rational response to a change in expectations about the value of homes. If there were not this belief that current homes are fairly valued, then buyers would be buying up and warehousing the depressed priced homes, the foreclosed homes and abandoned homes. The fact that buyers are not rushing in shows that the current prices of homes are fair and homes are not undervalued.