Besotted by easy profits and rising share prices, CEOs failed to make hard decisions. By Jeremy J. Siegel, Contributing Columnist June 1, 2009 As a professor at the Wharton School, I'm aware that many critics claim the financial theory we teach business students may be responsible for the current credit crisis. We are accused of espousing the models that created faulty mortgage securities and induced rating agencies to declare them triple-A. But financial theory didn't create this crisis. One such theory, the capital asset-pricing model, highlights the importance of diversification and teaches that financial firms should have purchased hedge assets to offset their risks. The Black-Scholes formula has proved to be invaluable to understanding how put options could have been used to neutralize real estate exposure. And the much-maligned mortgage-backed securities that have been blamed for sparking a great deal of the current crisis were, in the 1970s and 1980s, the very instruments that greatly increased the flow of credit to the mortgage market and lowered the cost of homeownership for millions of Americans. Sponsored Content Business professors also teach that all of these models have limitations. It is well known, for example, that asset prices become far more correlated in times of crisis. As a result, in a severe bear market diversification does not reduce risk as much as it would during a normal market. Spotty records. Most statistical models have been notoriously bad at spotting bubbles. That's because the concept of risk is usually confined to volatility over a short period of time, and deviations from a long-term trend are often lost. For instance, if you were a Japanese statistician and you watched the Nikkei stock average rise almost every year for decades to reach an all-time high of 39,000 in 1989, you would have concluded that stocks had little downside risk. Yet today the Nikkei average has dropped about 80% from its peak. Likewise, the rise of tech stocks in the late 1990s, and their subsequent collapse, caught many investors -- and statisticians -- by surprise. Advertisement The recent real estate bubble also fooled the statistical models. The historical data showed that on a nationwide basis, average home prices almost never fell after World War II. Therefore, these models concluded, securities that were based on house prices and were diversified across regions should be very safe. Once the safety of the underlying asset was taken into account, it mattered little whether the borrower had income; the investor could take possession of the house in case of default. But if you stood back and plotted house prices, you saw that something very unusual was happening. Between 1978 and 2002, the ratio of average home price to average family income remained in the narrow band between 2.5 to 1 and 3.5 to 1. But in 2002, home prices, fed by low interest rates and easy credit, breached that level, and in 2006 prices reached nearly five times family income -- about 50% above their long-term average. It didn't require an MBA or a PhD to figure out that real estate had a case of speculative fever. Recent graduates aren't ready to analyze the big picture or provide the wisdom and perspective that highly remunerated senior management brings to the table. The chief executives of major financial firms are the ones who should have realized that taking large leveraged positions in real estate during a time of rapidly rising prices would put their companies at risk. Besotted by seemingly easy profits and rising share prices, CEOs failed to make the hard decisions that could have saved their firms. Advertisement Markets are made by humans, not machines, and are subject to all of the limitations and contradictions that characterize human behavior. Veteran managers, not newly minted MBAs, failed to recognize this and paid the price, not only by destroying their firms but also by driving the U.S. economy into a deep recession. Columnist Jeremy J. Siegel is a professor at the University of Pennsylvania's Wharton School and the author of Stocks for the Long Run and The Future for Investors.