Originally posted by: mathematalef0
Originally posted by: jmonteiro
The most important unsolved problem in todays finance is "permanent irrational behaviour" of market participants.
Current crisis illustrates this problem once again pretty well.
Everyone knew CDOs and Co where a pure irrational product and, dispite that, every prop trading rooms were buying them (even Merrill traders!).
Now that they exploded everybody is attributing the fault to someone or something else (like sub-prime or Fed or recession).
CDO buyers created this crisis.
They are to blame.
Can finance theory solve this kind of problem?
I think even if someone could solve this problem, he wouldn't do it because that's the way profit is made. By taking advantage of other people irrationality! I like it that way
It's a bit more complicated than that...
As far as CDOs, the products themselves were not irrational at all; they simply repackaged credit risk in a way that market participants who wanted to take more or less risk than 1:1 of the credit pool by buying / keeping only the slices that suited them best -- and as a result of this, the capital from these slice buyers became available to borrowers for whom credit markets were not so liquid before. What most arguably may have been the bigger problems / irrational steps in the CDO process (according to some at the time, but according to more in hindsight) were how these tranches were rated, how these rated pieces were treated by institutional mandates and regulations, or how they may have been used by investors who did not understand these concepts. The last point is simply a statement that there exist investors who buy financial instruments beyond their ability to understand them, which may be irrational, but does not say how big or significant a part of the market they are/were. The question of ratings and institutional treatment of these pieces did somewhat shake the foundations of trust in the system, and this shake-up mandates some changes and clean-up to evolve into the next step of financial innovation.
The bigger question of "permanent irrationality" can be far more interesting. Bubbles can be fascinating examples of "temporary irrationality", and extreme market depressions can be because of "temporarily irrational pessimism", lack of liquidity, or arguably a rational expectation of the possibility of a very gloomy future. I have seen these feed into a larger academic statement that markets are more volatile than they should be (the future earnings of the economy does not go up or down by hundreds of billions or trillions and back in a few days like markets trade them to). This sometimes leads to one of my favorite statements of "minimal rationality": prices are set irrationally, but that does not mean they are not efficient nor that there would be excess profit opportunities (leading to a separate discussion of whether those few who made money in busts are statistically significant, etc.). It is also worth debating what is rational or irrational behavior in a bubble or bust cycle: during this latest boom, people bought homes after seeing prices rise double digits for years not because they rationally thought prices would continue to do so, but because they were afraid that if they did, they would be priced out of the housing market and would not be able to afford a place to live - with real consequences to "buy now at any price while you can". Is it "irrational" for someone about to retire to continue to sell out of their risky assets now, or after they have fallen another 20%, for example?