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Examining the financial crisis with professor Eugene Fama

Student group hosts Q&A with the “father of modern finance”

The financial crisis of 2008, still fresh in the psyche of many in the fields of finance and economics, easily lends itself to scrutiny on how efficient the financial markets were during that time. What role did the government play? What role does regulation have in efficient markets? What have we learned about debt and the idea of being "too big to fail"? These questions were some of the issues students discussed with Eugene Fama, Robert R. McCormick Distinguished Service Professor of Finance, on October 15 at Gleacher Center.

Fama is recognized the world over as the "father of modern finance," whose "research is well known in economics and the investment communities," said deputy dean Mark Zmijewski, Leon Carroll Marshall Professor of Accounting, who served as host for the Q&A event presented by part-time student group Chicago Booth Finance Club (CBFC). In the mid-1960s, when such research didn't exist, Fama "brought empirical rigor to the study of finance," Zmijewski said. In addition to being one of the most decorated and most often cited researchers in finance, Fama is chairman of the Center for Research in Security Prices at Chicago Booth, and previously served as director of research at Dimensional Fund Advisors, founded by David Booth, '71.

Fama however, is best known for developing the Efficient Markets Hypothesis, which, in its simplest form, states that market prices accurately reflect all available information within the market. This hypothesis served as the foundation for much of the open conversation on Efficient Markets, Economic Growth, Market Volatility: Where do we go from here? between Fama, Zmijewski, and more than 100 members of the CBFC.

"The biggest misconception is that [the Efficient Market Hypothesis] implies low volatility," Fama said. "It doesn't. It implies high volatility. Prices adjust quickly to new information. When uncertainty is very high, you expect volatility to be very high."

One of the most volatile times in recent economic history occurred during the events surrounding the 2008 financial crisis. In Fama's view, although many blame the real estate "bubble," and in particular the subprime mortgage financing of real estate as the cause of the recession, it was in fact a policy fostered by the government "to allow people to have a mortgage with very little down payment." There is no empirical data to suggest that finance was to blame. Instead, "finance was a casualty of the recession," he said. "You have to face the following fact: all assets declined by about the same amount, and real estate around the world by the same amount, even in places where there were no subprime mortgages. Cause and effect is not very easy to disentangle."

Regulation, according to Fama, in and of itself is not in conflict with the Efficient Market Hypothesis. In fact, in an efficient market, regulation, such as disclosure regulation, is good because the hypothesis rests on the premise that "all available information is available at low cost," he said.

Massive regulation, he felt, could not possibly work because it's too complicated for regulators to implement. But, during the crisis, the government responded to a financial system that had highly leveraged itself by employing complicated regulation. "Too big to fail is an anathema," said Fama, and something that should be taken off the table.

Instead, the government essentially wrote the notion of "too big to fail" into legislation. What followed, according to Fama, was to have the debt of financial companies "priced as though it's riskless," allowing them to "finance themselves at below-market interest rates given the risk of their assets."

Fama believed higher capital requirements, in the order of at least 25 percent, would have taken too big to fail off the table. "The complaint that higher capital requirements are going to hurt the banking system flies in the face of Modigliani and Miller (M&M)" theorem, which states that capital structure is irrelevant, said Fama.

In the end, did the government do the right thing in bailing out financial companies during the crisis? If it prevented the collapse of the global financial system, then it was good, but Fama was quick to point out an alternative: If the government had not provided a bailout, "it might have taken a few months to unscramble, reform all firms as different firms and start over again," he said.

"'Too big to fail' would then be off the table, and financial firms would have financed themselves differently, and that would have been healthy."

— Kalliope Dimitrakopoulos
Photo by Beth Rooney