A Rational Market?

Who noticed when the titans of finance proclaimed absolute mastery over risk? Who stayed up late at night worrying about the outrageous levels of borrowing needed to feed our profit-hungry investment banks? And who noticed when the markets stopped behaving rationally? Markets are supposed to rely on buyers’ and sellers’ complete understanding of the consequences of their actions. High risk investments, like subprime-mortgage-backed securities, are not supposed to be as safe as low risk investments, such as municipal bonds. That’s why their returns are much higher. And since the economic world is supposed to work in a rational and predictable way, high risk investments should fail more often than low risk investments. Yet, when homebuyers, mortgage brokers, lenders, credit rating agencies and investors all stop understanding the risk behind what they are buying and selling, rationality flies out the window. The market failed to warn investors, homebuyers and everyone else about the complexity and risk of these investment schemes. Everyone was happily making money when the bottom dropped out. Along with it went the confidence of the investment bankers, the commercial bankers, the re-insurance industry and the credit rating industry; just about everyone’s jaw hit the floor. And once confidence was eroded, the flow of money through borrowing and lending seized up, causing the current credit crisis. When the market fails to account for the irrational behavior of its...

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