Revelations of the Financial Crisis

The current financial crisis has already brought about sweeping major changes in the institutional structure of the financial system. Distinguished companies with names that have been with us for generations have been swept away literally overnight. Still, more changes are coming. The current crisis has revealed a number of unpleasant surprises in the form of unsuspected flaws and characteristics of the financial market system that is associated with the current crisis. These emerging revelations will usher in major changes in financial markets not only in the United States but in other parts of the world. I refer to the following:

Failure of risk management: For a number of years academic and financial circles have been bombarded with lectures on the importance of “risk management”. Each year has seen the introduction of new risk management techniques and presentations by risk management “gurus”. Wall Street has hired professors of mathematics to fashion sophisticated models for interpreting risk. The chief executive officer of Lehman Brothers characterized his own job as managing risk. The various rating agencies, such as Standard and Poor’s were paid vast sums to analyze the risk exposure of various capital instruments and institutions. All failed to identify what is probably the biggest risk related crisis in the history of financial markets. The entire approach to the subject will have to be rethought as well as the risk assessment methods of the regulatory agencies.

Failure of executive compensation: It has been estimated that the chief executive of Lehman Brothers took home over 400 million dollars during his career. The company failed but his reward was still, to say the least, very generous. This has put the spotlight on what was already a contentious subject, the high pay that many executives in the financial world receive. But why should they not receive high pay? Are they not as worthy as football stars and Hollywood actors who receive comparable rewards. Yes, they are, if they deliver results commensurate with their rewards. If they do not and they are still compensated to this degree, then something is indeed wrong. There is every likelihood that there will be changes in the compensation schemes of financial companies.

Failure of mortgage lending: In earlier times the institution which loaned money for a mortgage to finance the purchase of a house retained the mortgage for the 20-30 years required to pay it off. The responsibility for receiving payment and assessing the credit worthiness of the borrower remained with the lender. This has not been the case with many of the sub-prime mortgages. A different approach was introduced whereby the lender simply sells the mortgage to another financial institution, receiving the money loaned plus a profit. The link between lending and the responsibility for ensuring that the loan is repaid was thus broken. By selling the mortgage the lender simply turns over the risk and responsibility for collecting the repayment to someone else, a “someone else” who has no knowledge of the borrower. The motivation of the originating lender became one of initiating as many mortgages as possible as quickly as possible. One would think that no sophisticated models would be required to see that there was a potential problem here.

Failure of structured finance: The mortgages secured under the above system were packaged, along with other securities into so-called structured investment vehicles. How does one identify the risk inherent in a complex package of many different types of securities? This has proved extremely difficult to interpret, adding to the overall risky nature of such investments. A different, more transparent method will have to be found.

Decoupling from the American Market: The current crisis has also shown the fallacy of statements to the effect that Europe and other parts of the world are now “decoupled” from the American economy and American stock markets. Europe and Asia were said to be independent of economic swings in the United States. If that were true, the sub-prime crisis would not have had the global impact we have witnessed. Investors will have to reconsider their views on this relationship. Ironically, most foreign stock markets (including our own XAK) have suffered even more than Wall Street.

Failure of the capitalist system: Some say the entire capitalist market system has been shown to be faulty. In particular, the doctrine of “free markets” does not work.

The truth is that financial markets have always revealed flaws and weaknesses over time as new conditions have outstripped traditional regulations and thinking. At one time banks in the United States were even able to print their own money. Since then, the long term trend has been one of increasing regulation. Whatever one might say about other parts of the economy, the United States stock market is probably the most regulated in the world. Predictions of fundamental change in financial markets and the capitalist system, will be disappointed. The current crisis will indeed usher in more regulations and improved governance but the fundamentals of the market system will remain. No one has offered any alternatives.

Winston Churchill’s statement on democracy applies in this case as well, “It is the worse form of government except for all others”.

Dr. Jim Leontiades(The CIIM Business School), October 03, 2008, Financial Mirror

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