Ethos Perspectives

The Financial Crisis

In the last quarter of 2008, the US credit crunch ballooned into Wall Street’s biggest financial crisis since the Great Depression. By January 2009, advanced economies were simultaneously in recession for the first time since WWII, with emerging markets soon to follow. Some have dismissed the crisis as the consequence of human greed and incompetence, but this is too simplistic an explanation. Harvard economist Jeffrey Frankel contends that easy US monetary policy, underestimated and mispriced risk in financial markets, failures of corporate governance, and low national savings were to blame. These factors resulted in a "perfect storm" of excessive risk-taking, real estate and stock market bubbles, persistent current account deficits in the US, and the failure to detect and mitigate these factors early. We will look at these various explanations more closely in this issue of Ethos Perspectives.

Source: http://ksghome.harvard.edu/~jfrankel/FinancialCrisis2009FebUS.ppt

Incentives and Behaviour of Market Participants
Financial market incentives perpetuated a system that was heavily biased towards short-term risk. Bankers were richly rewarded for large profits or sales growth, but were not fully penalised for the long-term losses and risk of their actions. In what became the "survival of the riskiest", banks competed to underwrite cheap mortgages to subprime lenders. In an ultimately disastrous attempt to hedge this risk, mortgage debt was packaged into collateralised-debt obligations (CDOs) and re-sold. As US home prices rose, so did the volumes of subprime mortgages and collateralised securities.

Such behaviour was dangerous particularly because the risks were not properly priced by the market. Ratings agencies such as S&P and Moody’s, and regulatory bodies such as the Securities and Exchange Commission, underestimated both corporate and product risk. Analysts and regulators could have overlooked transgressions to avoid antagonising powerful Wall Street companies. (Indeed, several SEC enforcement directors later assumed senior appointments at financial institutions.) Incorrect pricing of risk led to excessive investor exposure to mortgage-linked securities in the US and abroad.

Taleb, Nassim Nicholas, "How Bank Bonuses Let Us All Down", Financial Times, 24 February 2009.