Sunday, February 13, 2011

The Origin of the Financial Crisis

"The financial crisis that has been wreaking havoc in markets in the U.S. and across the world since August 2007 had its origins in an asset price bubble that interacted with new kinds of financial innovations that masked risk; with companies that failed to follow their own risk management procedures; and with regulators and supervisors that failed to restrain excessive risk taking."

From The Origins of the Financial Crisis
Martin Neil Baily, Robert E. Litan, and Matthew S. Johnson,
Brookings Institure, 2008

In hindsight it is always easy to understand a crisis. In the case of the financial crisis of 2008, the rise in housing prices exceeded the owners ability to repay the mortgages.

But there is also a  more fundamental cause to this crisis. It is is innate human tendency to believe in anything that exalts our own sense of worth or self. Humanity wants to believe in esoteric ideals of kindness, value, goodness, and progress. These ideals are embedded in our religious concepts, our family values, and our political system. Trust in our fellow human beings is an essential part of the social organization. Without these ideals political and economic systems fail and mankind degenerates into a paranoid state of fear.

Thus, it is not surprising that in 2008 a crisis developed in global financial markets. Individuals and the market suspended their rational minds in the hopes that economic prosperity, ushered in by Ronald Reagan's presidency and the fall of Soviet Communism, would continue indefinitely. This crisis is not a singular historical event. As economists and historians remind us, a recent parallel was the Great Depression of the early part of the 20th Century. But, that economic disaster was by no means the only historical incident in which the irrational exuberance of investors exceeded the value of goods they purchased. There have been several economic crises since the stock market crash of October 1929. Likewise, the historical evidence is that markets operate in cycles of boom and bust as investors leap into a market boom in order to take advantage of profits only to find that their speculative judgments are just that, speculation and not rational judgments.

Companies fail to follow management procedures because of the opportunity for profit. There is no disincentive for managers to avoid excessive risk taking other than the potential for corporate bankruptcy. But such a risk is born not by the manager, but by the corporation. And all too often, a corporate manager has previously feathered his own nest before the death knell of economic doom sounds for the company.

Regulators and supervisors also fail to restrain excessive risk taking. Either they are too often beholden to the managers, or themselves part of a system that rewards short term advantage over long term survival. Congressional over site plays an important part in regulating economic behavior. After all, Congress establishes the rules by which corporations play. The history of Congressional action from 2000 on reveals that Congress not only ignored the signs of instability in the market, but itself played an instrumental role in fostering loans to individuals who had no business borrowing, and to banks and corporations who lent money to such individuals. Fannie Mae and Freddie Mack failed because Congressional leaders permitted bad practices.

Is financial crisis inevitable? Perhaps it is because we are all driven to succeed, and we all have a disincentive to question our own judgments when events suggest that success is just around the corner. But perhaps we can lessen the risk of failure by creating better oversight of risk management, by increasing the risk to the decision makers, by separating regulator from corporate management, and by increasing the turnover in supervision so that new eyes and new ideas review the conduct of others. A little sunshine goes a long way to brighten the day.

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