Financial crisis of 2008 – Jury is still out

The worst financial crisis since the great depression of 1930s touched the life of every single citizen of the globe. Collapse of the financial giants, mega scale bail out efforts by the governments, collapse of asset prices specially housing and the resultant foreclosures, evictions and wiping out the employment in the sector and substantial decline in economic activities characterized this. The Financial Crisis Inquiry Commission of USA, appointed by President to examine the causes, concluded in its Jan 2011 report that “The record is replete with evidence of failures. None of what happened was an act of God”. The report mentioned that Goldman Sachs collected $2.9 billion from the American International Group as payout on a speculative trade for its own account after AIG received bulk of it out of taxpayer’s money. The major findings related to ignoring the warning signs, failures in financial regulations and supervision, less capital with investment bankers compared to their risk profile, inadequate supervision of mortgage securitization train by the regulators, failure of corporate governance and risk management, short termism taking control of compensation system, key agencies like The Treasury Department & The Federal Reserve Board, remaining behind the curve, main actors in toxic mortgages not having enough skin of theirs in the game and failure of credit rating agencies etc.

The commission did not give any recommendation to fix the system for its mandate was limited but even in terms of diagnosis of the problem; its findings were a mix of causes and symptoms. Proximate apparent causes (which are in essence symptoms) were highlighted with lesser effort to reach at the epicenter(s) of the problem. Treatment of symptoms cannot be a lasting cure. It is futile to ask economic entities about their organization being full of opportunistic wolfs for every other organization also employed (and rewarded liberally) similar trait animals. This is best illustrated in the words of Citigroup‘s chief executive, Charles O. Prince who used an interesting metaphor to describe his company’s situation as a major provider of financing for leveraged buyouts -  “As long as the music is playing, you’ve got to get up and dance and we are still dancing”. The partying banks were overseen by indulgent fellow party animals (regulators) which explained their blurred vision failing to notice deployment of leverage ratio of more than 35:1 by some failed banks.

Here is an attempt to examine some of the problems at the epicenter(s) of the crisis.

1.   Currency pegging by China:

China’s boarding of manufacturing bus in 90’s, saw huge number of low income workers becoming available for manufacturing. The manufactured goods became very cheap which resulted into low and stable inflation numbers. The “maestro” Greenspan kept interest rates very low without being bothered for the risk of high inflation. This resulted into series of global asset bubbles. To make the problem more complex, china pegged the currency to USD which implied benign inflation scenario because of absence of appreciation in Chinese currency. The profitability of the corporates increased and people got paid more which made their housing dream reachable. The banks were quick to extend loans and shift their risk through financial engineering in the form of securitization.

Simultaneously, with some lag, US manufacturing became uncompetitive and jobs got lost. This also caused inflation in China- as their export to US gave them more of local currency because of exchange rates being pegged. The absence of free floating of Chinese currency led to disequilibrium – recession in US and low standard of living in China because of low wages and inflation. The correct policy response on the part of US should have been to nullify the effect of artificial pegging of Chinese currency by levying higher import duty.

2.   Capitulation of constitution and the government by corporates:

The right of electing governments lies with voting public. This right, though legally intact, has been diluted with the advent of multi-national giant corporations. The constitution is generally expected to serve two entities – public and the government and it had largely remained so in earlier times. In the post multi-national era, the corporates got enormous clout to enforce and (even extend) their sphere of rights – many times at the cost of reduced well-being of the public. The recognition of corporates as citizens diluted the accountability of the government solely to public. The elections are now effectively fought only by those who get campaign contributions by the corporates and public gets to elect only one of those corporate nominees. Since there is no free lunch, the elected government pays back the industry. US defense industry in the last decade got paid back in the form of two wars and enormous amount on defense expenditure. Financial industry was paid back in the form of de-regulation which became a contributory factor to financial crisis whose grand opening was showcased in 2008. Further, it got super dividend in the form of socialization of the liabilities of the rescued banks as they all enjoyed tax payer’s money to keep them afloat. Out-of-the-box thinking is required to grant legal superiority to general public rights over the rights of corporates. The exact modus operandi to implement this is a matter of enormous intellectual and social debate which calls for a separate discussion.

3.   Skewed orientation of cultural and educational value systems:

The proliferation of ultra-consumerism and flourishing of consumptive society was the result of the exploits of World War II. The elevated standard of living of the Americans since late 40’s has wrongly been attributed only to the American super efforts and achievements. In reality, to a large extent, it was made possible by fall of Europe and therefore forced disentitlement on a large block of humanity. Instead of sober realization, this created army of snobs who dreamt of upper class standard without even having college education. This was fertile ground for imbibing deep sense of entitlements, unbounded irrational optimism and narcissism. The education system was skewed and drenched in false concepts of wealth, economics and entrepreneurship. Money was confused with wealth. Money is merely a convenience (to replace barter trade). An economy based on swapping stocks or real estate back and forth at successively higher prices creates money but no wealth. The house which priced earlier at X and re-priced now at 2X creates money but no wealth. Real wealth gives rise to comfort. The house remained the same irrespective of the increased price tag going with this. Ask a wrecked sailor sitting with a fat wallet about its use – obviously nothing. He needs food, direction map, a rod to fish and possibly a female company to keep him in good spirit till he finds his ways to shore. Americans created money through financial engineering which was mistaken as wealth and splurged. When the bill finally came, there was nothing to fall back upon.

Instead of creating real wealth, their education system taught creating wealth on paper through financial engineering. Finance became the queen of the subjects. The corporates started being run by those who did not understand the technical aspects of their business. MBAs started having supremacy in the organization. The logical extension of this was preference towards inorganic growth. Organic growth through innovation in products and extension of product-lines became casualty. To make the matter worse, press abdicated its role of educating the public. It became propaganda machine of the corporates. All of these led to ballooning into mega-sized entitlements leaning on paper wealth to fructify. The disaster has been the logical consequence.

4.   Breach of social contract:

Ronald Reagan unfolded a deal under which rich and ultra-rich were given the benefit of lowered taxes. The implicit understanding was that lowering of tax would result into higher savings and higher re-investment by rich which would create more quality jobs and increased prosperity for all. They went back on their promise. The extra money available with them was used as play-money. Rather than investing their tax largesse in productive investment, they invested these in high stake risky games and tried to create more wealth by selling risky assets to each other at successively higher prices which in no case can be an endless gain. It did not matter if they lost as it was merely play-money for them and their skin was not really into the game. Progressive taxation requires to be strengthened so that drift towards undesirable risky ventures are not encouraged by government policies. Excessive inequality leading to natural tilt towards risky investment is a demon which requires to be dealt deftly by the governments. 

5.   Conscious inaction by regulators:

The story unfolded over a decade and it did not happen suddenly in 2008. It beats the logic as to how US Fed allowed (through their active internal decision) the banks to use credit default swaps to lower their capital without assessing the counter-party risk of the credit-default issuers. Similarly Fed watched approvingly the big three credit rating agencies doing both the designing of structured products and assigning ratings to them which is such an obvious conflict of interest. Though Fed did not pull the trigger, it did participate in loading the gun. What was the reason behind its deliberate in-action? Is it the case that US Fed, rather than being a truly independent agency, was unduly influenced by Wall Street covertly or overtly? After all it is not uncommon for people from Fed to take up high paying jobs in Wall Street after their stint in Fed.

6.  Inappropriate incentive structure of bankers based upon fake Alpha arising out of tail risk:

Average bonus of the employees of Wall Street banks in the year 2007 was four times the average household American income. Wow!!!! Surely they would have been the creamiest intellectuals and professionals. Unfortunately the subsequent events of 2008 and thereafter points to the contrary. In reality, they were paid obnoxiously for the excessive risks taken. 

Managers of financial assets generally generate return on the systemic risks (Beta risk) for which they do not deserve any incentive. Generation of Alpha by the managers entitles them for extra bonus but Alpha generators are practically non-existent. Wall Street managers generated fake Alpha arising out of tail risks assumed. Deployment of tail risk generates additional returns in the short run which is however counter balanced by heavy negative returns over distant future. A manager who invested in AAA-rated tranches of collateralized debt obligations (CDO) generated many basis points higher return than a similar AAA rated bonds. “Excess” return was in fact compensation for the “tail” risk that the CDO would default. True Alpha is captured when one analyses the return over long periods. Unfortunately managers were rewarded for their short term Alpha generation which encouraged them to deploy excessive tail risks.

The incentive structure should be based upon mechanism to calculate earnings over long horizons. Claw back mechanism is a welcome development in this direction. 

7.   Alan Greenspan

The maestro jumped ship just before the unfolding of the financial meltdown. In his memoir “The Age of Turbulence: Adventures in a New World”, he bared his love for the market (distorted one of course) in the words “……authorities should not interfere with the pollinating bees of Wall Street”. He had massive misguided faith in unregulated markets. He overly celebrated the “rationality of free market” and totally ignored the flaws of humanity which are nevertheless real and common place.