Causes of 2008 Financial Crisis
October 15th, 2008 by Andrew Chen
I come across an article that gives a very incisive analysis on the financial crisis we are experiencing today. It finds the root causes of the financial crisis and makes suggestions on how it should be corrected. The author is YST from Taiwan. Some of the opinions he presented here may be extreme nevertheless it is a good article deserves reading.
The nature of the 2008 financial crisis:
The basic economic principles are simple to understand. Any profound economic theories have to come back to their base to be tested. Because of that anyone who knows some mathematics can have their own evaluation on the economy and the results in many cases are as good as those of professionals or even better.
We can not blindly believe in what the economist says. The very best analysis on economy is based on experience and common sense because economics is very much like psychology. The mathematical models of economics are toys in the academic society which are built upon non-existing assumption. That’s why those models can not be accurate. The economic mathematical models are frequently misleading. Basically economics is a subject that you can tell your story and I can tell mine. That’s why two economists can often reach opposite opinions on the same economic problem.
Theoretically, the United States Government is already bankrupted because it no longer has the ability to pay its debt. But in fact since the debt of the United States Government is denominated in US dollar it can pay its debt by printing money. That is the only way the United States Government to avoid bankruptcy.
There are three causes of this financial crisis:
Greedy
Inability of the government
Influence of the academic society
Greedy is rationalized:
In 1986, Ivan Boesky, CEO of a big corporation said in the graduation ceremony of Business School of University of California, “Greed is alright” It became a classic statement in the business society. Directed by greedy managers of businesses try to maximize profit in the shortest period of time and play with the laws and regulations. The fiercest and the worst are to change the laws of the government to achieve greater advantage in their game.
Financial industry has always drawn the most intelligent people because it offers higher than usual monetary reward. Think about that, a group of the most intelligent people controlling the huge financial institutions, designing all kinds of financial games to pursue short term profit and their personal interest, there must be problems.
The greedy operation of the financial industry: Financial engineering and financial derivatives:
We have to understand that financial industry is a pure servicing industry. It has the most money among all the industries but this money is created by other industries. In the profit pursuing business world, the profit from financial industry is least deserved. Because the only thing the financial industry does is to transfer wealth from one place to another. It does not create wealth. The people working in Wall Street, all they do is to move money from one place to another and make huge profit in that process.
Not like manufacturing industry, financial industry is a zero sum game. Participants make profit from the same pool of money. If a smarter bank comes up with a trick to make more money then another bank has to make less. That is why the financial derivatives, the products of financial engineering has no added value. These financial derivatives are created as a tool for arbitraging. They do not contribute to the wealth of the society. Not only that they are burden of the society and cause harm.
Credit Default Swap (CDS)
Financial derivatives are pure money arbitraging tools. It doesn’t do any good to the society. The financial crisis is caused by a financial derivative called Credit Default Swap.
The original mortgage system is a very good financial system. It requires borrower to down pay 20% of the house to show their own responsibility. The loan amount can not exceed 4 times the borrower’s income. So if you make 100K a year you can borrow 400K.
This is the very basic financial product. This product make many young couples originally can not afford a home to own a house and realize their American dream. More important this product stimulates the economy. Because when you own a home you need some furniture, electronics, remodeling and so on.
This is a good financial product. Why? Because risk and responsibility are clear cut between bank and the borrower and it is very easy to calculated. Borrower can lost its house and the 20% down payment if it can not make monthly payment. The bank knows if bad debt reaches certain level it can be closed by the government. Responsibility and risk achieve balance with each other, the society is operated smoothly.
But the financial industry created a new trick to shift the risk to insurance company (AIG for example), that is credit default swap (CDS). The bank (Washington Mutual for example) pays certain premium to insurance company and the insurance company responsible for the lost if the borrower default the loan. Then bank is sure to make money with no risk. Risk is responsible by insurance company. Sounds like a free lunch.
Insurance companies are not stupid. After selling huge group of CDS to banks they get a revenue stream as the borrowers make mortgage payment. They repackage the revenue stream and sell it to another financial institution for quick profit and shift its risk. It gets repackaged again resold again. The packaging is getting more and more complex and the original risk is being shift again and again.
Since the bank now has no risk it is encouraged to lend to borrower with 0% down payment and even not to verified borrower’s income. So everyone can by a house. Real estate market booms. Price is inflated. The rapid increasing of real estate prices in turn stimulates the real estate market even more. Under 0 down payments one can buy several houses as investment.
The insurance company may hire teams of financial analyst to calculate the risk involved. The higher the risk the more the insurance premium. If the calculation shows profit then the CDS trades in and out without problem. Evaluating the risk involved in those repackaging CDS become extremely complex. Honestly I don’t think those financial analyst can figure it out accurately. However those financial derivatives after repackaging have no problem at all to fool investors especially foreign investors.
Credit Default Swap is a Scam:
The financial industry is where the most intelligent people in US to play tricks. Those tricks are to repackaging those financial derivatives over and over to make money. But you can easily realize that this is a scam without using any calculation because it is in conflict with the basic economic principle.
Theoretically, CDS can keep on circulating based on one assumption: Home price can ever increase. This assumption can not stand. When home price increases faster than GDP a prosperous economy is in fact bubble. Real estate boom is only bubble created by irresponsible lending of banks. The bubble has to bust one day.
From experience we know the ups and downs of US real estate have a cycle and the cycle is about 7 years. So from both theory and experience we know that sooner or later the dropping of the housing market will brings about financial crisis. Insurance company will bankrupt when more and more people can’t make their mortgage payment. When they bankrupt they can not provide the protection to the banks and the banks bankrupt also. And those foreign investors who purchased CDS security has to take lost themselves because those securities no longer worth as much as they did.
In fact the people in the financial industry know about this problem but they can not stop. If fact no body care because they are pursuing short profit and personal interest. The only thing they care is the year end bonus. The bonus for the CEOs of those banks and insurance companies are in tens of millions. They make their bonus as usual before the company bankrupt and left the aftermath to the taxpayer
……
Inability of the government
The author indicates the Inability of the government is another cause of the financial crisis because the government failed to monitor and regulate the financial industry and changed the law in 1999 to allow investment bank to get into real estate investment. Not sure if it is true.
Influence from the academic society.
There is a group of economist in the US academic society specializing in financial derivatives. Four of them won the Nobel Price in economics.
Merton H. Miller and Harry M. Markowitz are winner 1990 Nobel Price in economics
Myron S. Scholes and Robert C. Merton are winder of 1997 Nobel Price in economics
Myron S. Scholes and Robert C. Merton won the price for a new method to determine the value of derivatives.
Their misleading researches help the prosperous of financial derivatives and directly lead to the US financial crisis.
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sorry to say that two of the three listed three are not justified in any sense.
1/ yes, derivatives are supposed to be zero-sum game but you are trying to confuse derivatives with financial industry as a whole. a zero-sum game doesnt mean its worthless. dont overlook their hedging function.
2/ as you have shown your inadequate knowledge of how financial market works & its relationship with society, the last reason can be dismissed easily.
you need thorough understnading of both econ & fina to name the causes. i dont mean to be rude but it is very wrong to accuse those scholars who have contributed so much for something that they didnt do because of your ignorance.
Dear Christina,
I think that was the authour’s opinion. Please, If you have an analysis really I’d like to read it and I will appreciate that if you have a convincing opinion.
Whereas It is my opinion your write-up is on the proper track there are actually some details which i do not believe.