First, over-reliance on mathematical models is part of the problem. Black Scoles works…. except when it does not(and please take no offense if you are related to Fischer Black). Several of the people in the Chicago school have admitted that EMH has its limits.

Models have some value, as one of many indicators. Since I took my first class in economics 40 years ago, I have been puzzled by economists who assume that all buyers and sellers are perfectly rational. I worked in the economics reading room at college, and had opportunity to look at a lot of student dissertations on econometrics, and I was troubled by their over reliance on the quants. I have grown more troubled by the increasing numbers of physicists who are trying to bring the mindset of the physical sciences into economics.

A number of years ago quants were trying to predict human psychological behavior using computer models, and they came to the conclusions that there were no constants, or certainly not enough constants to make their models work.

When pricing stocks, combine the models with a prediction of herd mentality.

Consider something simpler-energy costs. One gallon of gasoline produces 124,000 BTU. I would need 1.25 ccf of natural gas to produce the same energy. A gallon of gas in western Iowa costs about $2.80 right now, 1.25 ccf of natural gas costs $.87, delivered to my house. So if we all had vehicles that could burn both, everyone would use natural gas until the point that natural gas and gasoline prices moved to some equilibrium.

My point is that the price of a gallon of gas should be determined by its replacement cost, whether that is electricity, diesel, CNG, etc. But in the short term, that is not possible because we do not have the technology in place to move back and forth between energy sources. In the long run, for instance a decade, if that price difference continues, technology will give us the ability to use natural gas in our vehicles, and we can move to equilibrium.

Another way is to look at the price of a barrel of oil. Oil industry execs have said that oil should be around $60 per barrel, based on the cost of replacing the last barrel produced, but oil continues to hover around $80 to $85. Two years ago, it was at $140. Why so high? Herd mentality. Two years ago we were all led to believe that oil was going to hit $200, so to a petroleum buyer, $140 seemed like a good buy.

My point. Pricing is not a science, especially in the short and near term. Quantitative modeling can give me some insight, but the idea of a computer using a model to do all our trading is not a sensible thing to do.

So, pricing the stock of financials is especially hard, because there is so much blue sky value there.

The markets froze up because no one wanted to take even the smallest risk which is not surprising given a major broker dealer went bankrupt, another was bought in a hurry and a third nearly went to the wall whilst **money market** funds broke the buck.

The issue wasn’t that there was a lack of clarity in the market, it was that under the circumstances no one wanted to take the slightest bit of risk.

As a matter of curiosity, why do you think these products are somehow innately harder to price than say the common shares of Citigroup? The difference is liquidity, not that the products are somehow “more complex”. If you can come up with a good pricing model that consistently works for shares, many billions and a Nobel are waiting for you….

The senators, and the Wall Street cheerleaders on CNBC are missing a central point. Remember in October of 2008, the credit markets froze up. Why? Because nobody trusted the information they were getting from counterparties. Congress passed Tarp with the idea of buying large numbers of mortgage backed securities and CDO’s, but that idea was quashed because nobody, not even the Goldman alum Henry Paulsen, could figure out what was in them, let alone price them.

The muddier the water, the more profit opportunity for speculators.

Let me say it another way. Goldman led the way to remove clarity from the market in financial securities. That lack of clarity froze the credit markets, which brought commerce in America to a standstill. The situation was very close to spiraling out of control to a second great depression, or something worse.

Blankfein, Geithner, both Paulsons, etux, need to be asked if they understand that our free market cannot function well when there is lack of clarity, poor quality information, people intentionally muddying the waters. Keep asking them over and over to explain how a free market can work when so many powerful players are muddying the waters.

Sure they did — when men were warriors, women were damsels and Wall Street investment bankers were financial advisors; then les sans culotte started to default on mortgage debt, AIG stopped selling CDO insurance, and the GS krewe cannabalized them to bulk up the tranches in their new line of synthetics,
and strung plastic replicas into necklaces to give out to their buyers.

This, to me, was the weakest part of the Senators little theatrical revue — why couldn’t even one of them have probed GS on the architecture, substandard construction material and filler that went into making the Abacus1 tower, as well as why only certain floors ended up getting developed and their collapse hedged against?