Economic Crisis: A reflection

Following is my reflection on risk taking that led to the global economic crisis during 2007-2010

The current financial crisis has taught us many lessons. However, the enduring one that has clearly struck in my mind is the one spelled out so clearly by former Fed chairman Allan Greenspan. The current crisis is neither the first nor will it be the last for it is “human nature” at work in each one of them.

Two millennia ago Gautam Buddha, while laying down the principles of Buddhism said, “Desire is the root cause of all evil”. Gordon Gecko in the movie Wall Street turned that age old wisdom on its head when he proclaimed “Greed, for lack of a better word, is good. Greed is right, greed works. Greed clarifies, cuts through, and captures the essence of the evolutionary spirit. Greed, in all of its forms; greed for life, for money, for love, knowledge has marked the upward surge of mankind”. This notion of greed not just at Wall St but throughout the value chain is what one can attribute as the prime reason for the economic crisis.  This greed was manifested in the form of hefty bonuses for bankers, who, in order to make them, created loans with teaser interest rates to trap the not so innocent homeowners, who claimed false income proofs to get bigger homes that they could not afford. Banks never sold these home loans themselves, instead relying on equally greedy agents who got a fat commission for selling home loans. The bigger the home loan they sold, better the profits they made. Banks’ assumption that home prices never fell led them to believe that their investment could never go sour. In their endeavor to make even more profits, they, in some cases ended up disbursing 100% of the loan amount. In the meantime, banks created complex instruments based on these loans and sold them to greedy international investors who wanted to make more money. Greedy ratings agencies, without much clue of the underlying securities gave good credit ratings to these financial products and got away with their share in the pie. Greedy insurance agencies insured these financial products without understanding them and under the assumption that they would be alright: after all the ratings agencies had rated them, so they had better be good. While the going was great initially, it was never meant to last too long. It was too good to be true. The end was strong and fast. Higher inflation and rising floating rates triggered home loan defaults and everything fell like a pack of cards. The entangled economies of the entire world suffered a shock and proved that no market is completely decoupled from the other.     

Thus, this crisis is a reminder for us. It makes us to analyze and question not just the role of intermediaries but also that of the investors under whose pressure banks took excessive risk and brought many countries to their knees. Deep crisis in Iceland, Ireland and Greece are grim reminders of excesses by banks, financial institutions and investors in general. Big bonuses to bank chief executives whose pay structures incentivized them to take excessive risk has been much talked about in the world, but it is strange that everyone is waking up to this so late. Complex derivative products, dubbed as the “financial weapons of mass destruction” by Warren Buffet, are understood by few and yet have grown into a trillion dollar business. Excessive leverages by storied Investment banks and their inadequately back-tested mathematical models based on very few years’ worth of historical data is another reminder of the risk of “unknown- unknowns” and what-ifs of a worst case scenario. To complete the picture is inadequate regulation of financial instruments which has led Governments around the world to “Privatize the profits and socialize the losses”. Further away, huge trade surpluses and exports by high saving economies like China and Japan on one hand and ever consuming import hungry credit card economies of US on the other has led to huge trade imbalances in the world. The world has to address all these issues soon.

To sum up, I think there are many lessons to learn from the financial crisis and we will have to apply them again, for as long as greed prevails, this will not be our last financial crisis.