The Ubiquitous Modigliani-Miller Model Works in Times of Very Cheap Money Like We Had from 1995 to 2008

As with most of Modem Financial Theory, the flaws in Modigliani-Miller were primarily in the assumptions. Notoriously, taxes exist. Individuals cannot borrow at the same rates as companies, and borrowing rates are not the same as lending rates. However, the greatest problems in Modigliani-Miller’s assumptions lie in ignoring transactions costs and agency issues. While brokerage costs may be low, and borrowing costs for debt relatively so, the cost of bankruptcy, both to the company itself, to the economy, and to the company's employees and customers, is gigantic — far in excess of the minor savings from over-leveraging. Hence, to the extent it works at all, Modigliani-Miller works only in times of very cheap money, when debt is particularly inexpensive and bankruptcy particularly unlikely. Of course, from 1995-2008, that is exactly what we had.³ But even then, Modigliani-Miller was completely at odds with the increasing agency disconnect between management and shareholders, which worsened considerably after 1970.
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³We are not suggesting that Modigliani-Miller is complete rubbish. Were the assumptions valid, then the results in the theorem would follow with mathematical certainty. The issue is what to make of it, and our main criticism is simply that it does not justify high leverage in the real world.

—Kevin Dowd and Martin Hutchinson, Alchemists of Loss: How Modern Finance and Government Intervention Crashed the Financial System (Chichester, UK: John Wiley and Sons, 2010), 67, 67n3.

The “Capital Asset Pricing Model” (CAPM) Dominates MBA Schools Because of Its Relation to the “Efficient Markets Hypothesis”

The CAPM was to dominate academic finance for a long time. The key to its success was its unreserved adoption by the financial economists of the Chicago school, in conjunction with the closely related notion of the Efficient Markets Hypothesis. They defended the CAPM with religious zeal, and most business schools were soon teaching it as established orthodoxy, cranking out tens of thousands of MBAs a year who didn’t really understand the CAPM but who knew nothing better. . . .

In 1977 Richard Roll published a devastating critique that undermined the CAPM by showing that the market portfolio could never be reliably identified. Roll soon had people asking if beta was dead, but still the CAPM orthodoxy dismissed him as a spoilsport and the CAPM party continued for a little while longer.

The end finally came with a study by Eugene Fama and Kenneth French published in 1993, which showed that the beta was not related to stock market returns. This refuted the most basic prediction of the CAPM, namely, that stock market returns should be positively related to their betas. The bloody beta was useless. People were now mischievously asking if beta was dead, again.

From a purely scientific point of view, the Fama and French study was merely the latest in a long series of studies that undermined the scientific respectability of the CAPM. Its significance however was not in its results — although it should have been — but in its authorship. Fama, the inventor of the Efficient Markets Hypothesis, of which more below, was a key figure in the development of the CAPM itself. Thus, one of the key pillars of Modern Financial Theory was renounced by one of its principal creators.

—Kevin Dowd and Martin Hutchinson, Alchemists of Loss: How Modern Finance and Government Intervention Crashed the Financial System (Chichester, UK: John Wiley and Sons, 2010), 71-72.