Markets clearly overreacted in the months following the Lehman bankruptcy. The same thing holds true for other financial crisis, such as the 1987 crash and Asian/Russian/LTCM crisis. Market overreaction is not limited to dramatic macroevents. If one looks at implied option volatility, it is clear that market participants predictably overreact/underreact to different types of news. This overreaction is one of the cornerstones of behavioral finance.
Behavioral finance is often seen as the antithesis of the efficient market hypothesis (EMH). One of the premises of the field is that markets cannot be efficient considering markets' tendency to overreact. As behavioral finance as a field of study has boomed in the last two decades, so has rejection of the EMH (a poll showed a strong majority of CFAs reject the theory). Much of the hysteria about the EMH comes from the fact that much financial theory is premised on an efficient market. But behavioral finance should not necessarily threaten this theory outright. The value of the behavioral finance perspective is it helps us figure out which markets are inefficient and why that might be.
It is generally accepted that efficient markets are good for investors. In an efficient market, a buyer can be sure his purchase is at fair value. Markets love certainty. Investors cannot trust markets if they are not efficient. (Check out this recent article in the Financial Times.) For that reason, there should be efforts to create structural changes in finance to make markets more efficient. In the last year, derivative regulation is a step in the right direction. The change in fair value accounting was a move in the wrong direction.
But one structural aspect that has not been addressed is the role of arbitrage. Arbitrage is a driver of efficiency in markets. It is an example of the beautiful way in which the invisible hand of mutual self-interest creates a surprisingly fair market. But in times of stress, arbitrage is no longer a source of efficiency, but a source of inefficiency. This inefficiency comes from the wrong premise that arbitrage requires no capital.
Consider the following example. A hedge fund decides to take advantage of a price differential between S&P500 futures on two different exchanges, buying the cheaper futures and selling the overvalued ones. From an economic perspective, he has locked in the spread between the two exchanges since they are fundamentally the same thing. However, if after the trade the differential increase, technically the transaction has a mark-to-market loss. Because the original price differential was miniscule in the first place, the trader probably levered up to get a better return. As markets are behaving irrationally, the differential could grow further, triggering more accounting losses. These losses require posting collateral, which is why arbitrage is not capital-free. As Keynes said, "the market can stay irrational longer than you can stay solvent," meaning eventually collateral calls can lead to default. (Schleifer and Vishny 1997)
LTCM manager John Meriweather described his arbitrage fund's strategy as "picking up nickels all over the world." Many of these nickels need to be picked up. They make the streets of finance more transparent. When the price differential between S&P500 futures on different exchanges increases, traders should be able to increase their positions and lock in more guaranteed profit rather than having to liquidate trades to post margin. When interest rates on treasuries go negative, as they were briefly after Lehman and during the Great Depression, market participants should be able to clear the nickels and bring yields to reality.
Considering most financial crises are exacerbated by an irrational market causing caustic margin calls, it is interesting to look at how policymakers have fought this effect in the past. The best example comes from the Panic of 1907. The Panic of 1907 was very similar in nature to the 2008 Financial Crisis--caused by a lack of trust in financial institutions, bringing stock prices down 50%. The issue in 1907 was liquidity--bank runs were draining money out of the system. J.P. Morgan famously locked the most important bankers in a room to come up with a solution. The solution was to replace clearinghouse deposits (basically mark-to-market margin) with bonds so banks would have enough cash.
What if this model could be adapted to modern day liquidity crises? (Leveraged) arbitrage is similar in nature to fractional reserve banking. In commercial banking, if every consumer demands their deposits at the same time, the bank will be insolvent. Similarly, if all arbitrage trades go wrong at the same time, a firm will not be able to post margin on all of its trades even though they are economically viable. This example illustrates that for arbitrage to be an effective driver of efficient markets, there must be a mechanism in place that guards arbitrageurs against bank runs. One good step would be counter-cyclical margin requirements like those seen in 1907.
