Have we learnt any lessons from the 2007-08 Financial Crisis?

The recent financial crisis was the worst seen since the great depression in the 1930s. It has
led to the worldwide tightening of credit, resulting in a surge of unemployment and a
subsequent decline in economic welfare. The crisis can be seen as a massive financial
disaster destroying economies that now need enormous support packages for their
necessary repairs. This article will look into the causes and effects of the financial crisis and
ask what lessons we can learn in order to prevent such a catastrophe from happening again.
Many analysts will track the beginning of the financial crisis back to the American mortgage
market. Financial institutions were overly optimistic about the future value of assets such as
house prices. The optimism that pervaded the public arena came from politicians such as
Gordon Brown, who has been quoted on several occasions claiming that, we will never
return to the old boom and bust situation.
Overconfidence in the future performance of the economy created an over indulgence in
cheap money. This in turn led to a massive increase in credit, which further inflated the
economy, forming a massive bubble waiting to explode. This is where we learn our first
lesson from the financial crisis; human greed.
Mortgages were provided to irresponsible investors; also known as subprime lending. Banks
justified this action with the premise that house prices would continue to rise in an ever
expanding economy. The theory helped formulate an illusion that the principle investment
could always be recovered in the case of default by the homeowner. Of course, an
unprecedented amount defaulted, destabilising property prices and causing the bubble to
burst. Securitisation and the derivative market compounded the effect and thus the 2007-08
crisis was created.
One could argue that such greed was on display throughout the entire financial industry. For
example, irresponsible homeowners over leveraged and reckless bankers ignored risks all in
pursuit of the American dream. Initially results were positive, which reinforced managers
and traders convictions that they must be doing the right thing, adding fuel to the fire.
Former chairman and CEO of Citigroup captured this brilliantly when he said They had to
keep dancing till the band stopped, which it did in summer and autumn 2007.
By the mid noughties the rise in the power held by the financial industry was becoming
increasingly evident. In 2006 financial institutions created 40% of profits on the S&P 500.
Meanwhile, groups of savvy speculators positioned themselves for the inevitable market
crash.
Wealthy speculators such as hedge funds and investment banks made enormous profits by
betting against complex derivatives called CDOs and CDS. Hedge fund manager John
Paulsen made $12 billion betting against the mortgage market. When he ran out of
securities to bet against, he worked with Goldman Sachs and Deutsche Bank to create more.
These derivatives were often sold to investors as investment grade material, when in reality
the banks who were selling them considered them to be junk!
We therefore have to question the incentives of certain banks and the service provided to
customers. The Financial Crisis revealed that banks will manipulate and deceive the public in
search of supernormal profits and exuberant bonuses. In 2009 Morgan Stanley were sued by
the government retirement fund of the Virgin Islands for fraud. The Lawsuit alleges that
Morgan Stanley knew the CDOs were junk even though they were rated AAA. These
situations developed a lack of trust in the banks by the general public, further tightening the
money supply and exaggerating the crisis.
This leads to our second lesson from the financial crisis; the complacency of the regulators.
For instance, the Icelandic government privatised its three largest banks, allowing them to
borrow $120 billion, which was ten times the size of their economy! However, some would
argue that the Icelandic government where just following the capitalist approach adopted
after the appointment of the Reagan administration, which led to thirty years of financial
deregulation. The combination of deregulation and regulator incompetence has been a
major contributor to Americas last two financial meltdowns: the savings and loans crisis
and the dot.com bubble. This creates many questions about the relationship between
regulators, politicians, banks and their roles in 2007-2008 Financial Crisis.
The Clinton administration continued deregulation culminating in the 1998 merger of
Citicorp and Travelers group creating Citigroup which was then the largest bank in the
world. The Glass-Steagall Act created after the Great Depression was all that stood in the
path of what would become a monopolistic industry. Alan Greenspan along with Robert
Rubin, who was then the United States Secretary of the Treasury, advocated Citigroup
receive exemption from this law for one year. This gave them enough time to pass the
Gramm-Leach-Bliley Act. Robert Rubin would go on to make $126 million as the Vice
Chairman of Citigroup.
Wealthy investment banks use fruitful incentives that create deep conflicts of interest
amongst government officials. This raises the question of who do the politicians really serve,
the average citizen or the corporations who fund their campaign? In the year 2000 congress
passed the Commodities Futures Modernisation Act, effectively banning the regulation of
derivatives. Phil Gramm and Larry Summers were both keen supporters of the bill and went
on to work for financial institutions after it passed. The former became Vice Chairman of
UBS and later made $20 million as a consultant to a hedge fund that relied heavily on
derivatives.
Action has now been taken and regulators are now encouraged to enforce rules that
increase the capital requirements of banks through legislation such as Basel III. Having more
capital relative to assets reduces the banks risk of failure by lowering the banks ability to
leverage. Although industry representatives argue that such legislation has an adverse effect
on the banks flexibility and therefore potential profits.
Nevertheless, the financial crisis has also given rise to the grim reality that regulators are
beginning to lose their grip over the financial services industry. Banks will often headhunt
regulators best employees then use their extensive knowledge of the law to their advantage.
New employees then search for regulatory loopholes, in contrary to their previous role of
clamping down on them. This was a major issue in Iceland where one third of financial
regulators went to work for banks due to lucrative wage increases. Regulatory reform
concerning wages may have to be implemented if we are to prevent similar mishaps from
occurring in the future.
By researching the effects and causes of the financial crisis we have managed to gain an
intriguing insight into the role of academics and their influence over economic policy. Many
academics privately made fortunes directing public debate and policy in the interest of their
financial sponsors. For example, Fredrick Mishkin scooped $124,000 from the Icelandic
Chamber of Commerce by co-authoring an enthusiastic paper that explained away many of
the factors that would soon implode the countrys economy.
If we are to learn from our mistakes, inquests need to be made into the ethical standards of
academics that provide false information in the interest of third-party donors. Unfortunately,
the reverse situation already seems to be in motion, with Larry Summers former president
of Harvard University becoming Director of the National Economic Council. A man who was
paid $135,000 for a talk at Goldman Sachs on April 16
th
, months before he was assigned the
most influential financial office in the U.S. Government.
We also learnt about the conflict of interest between corporations and their rating agencies.
Credit rating agencies would charge the debt issuers, rather than investors, for their ratings
with some using blackmail tactics in an effort to guarantee payment. This has led to
accusations that credit rating agencies provided misleading information. A good example
would be Enrons rating remaining at investment grade four days before it went bankrupt.
Many corporations relied solely on the information provided by these rating agencies, and
wouldnt conduct their own research into the risk financial instruments posed. However,
rating agencies can deflect criticism for their work by hiding behind the smokescreen that
this information is just their opinion. William Gross, founder of Primo, recommended that
investors ignore credit rating agencies, describing them as an idiot savant, with full
command of the mathematics, but not idea of how to apply them.
This was a major issue contributing to the financial crisis, but new regulatory enforcements
in Basel III will require larger banks to produce their own credit rating, as well as higher
capital requirements. This is positive news for the economy as such regulatory reform works
to prevent such a disaster happening again in the future. However, the recent LIBOR
scandal questions the banks ability to act responsibly when constructing self-appraisals.
Furthermore, they could use the opportunities presented to them in Basel III as another
chance to manipulate the economy.
On January 20
th
2009 Barrack Obama was inaugurated as the 44
th
President of United States.
His advertising campaign promised change, and proved very popular with the masses, by
appealing to the anguish many suffered at the hands of financial institutions. However,
Obamas second highest donor for his campaign was Goldman Sachs, contributing $994,795.
Situations such as this have led many to believe that America is now run by a Wall Street
Government.
However this problem doesnt rest with the president and instead echos throughout the
entire American political system. But have the people learnt from their mistakes in electing
such incompetent representatives? Data suggests they havent with voters returning 91% of
House incumbents to power in the last election. A surprising statistic considering a New York
Times/CBS news poll found that 80% of Americans believes that members of congress are
more interested in serving special interests than the people they represent. These beliefs
are well founded as 47 out of 51 Goldman Sachs lobbyists have previously held government
positions.
The chances of forthcoming change remain slim, as 40% of eligible voters in America dont
cast a ballot. Surveys have shown that less than a third of American citizens can recall the
name of their representative and even fewer remember anything he or she has done for
their district. So why are these representatives being re-elected? There is a strong case
arguing that the financial backing received from institutions provides officials with the
necessary capital to fund campaigns that obliterate their competitors.
There is increasing evidence that suggests the ease of credit leading up to the financial crisis
was necessary to supplement the growing imbalance in the distribution of wealth. As the
rich became increasingly powerful, middle to low income families were encouraged to take
on debt in order to live the glamorous lifestyles sold to them by their favourite celebrities on
TV. Despite all the spending, for the first time in history average Americans have less
education and are less prosperous than their parents.
The crisis has led to many tax cuts and incentives designed to encourage spending in the
economy and increase the money supply. A good example would be the scrappage scheme
introduced in the UK in an effort to encourage the purchase of new cars. This opened the
door to families who otherwise wouldnt be able to purchase a new vehicle, whilst also
providing essential support to the UK car industry.
The recent financial crisis has provided us with many opportunities to learn lessons.
However there are still questions regarding our reaction to these experiences. There has
been some regulatory reform in the form of Basel III, as well as new political leaders in both
the UK and US economies. Despite this there is still a cloud of smog surrounding financial
institutions and their tight grip on economic governance. Many believe that such institutions
have not been punished enough for their incompetence leading up to the collapse. Bankers
continue to command large bonuses whilst the remaining economy suffers from the trickle
down effect of their actions. Public unrest has to some degree resulted in political pressure
towards high earning individuals, encouraging them to waive their bonuses. But have we
learnt our lesson, or is this just another recession caused by the greed of financial
institutions in a similar fashion to the savings and loans crisis? I argue that history will
continue to repeat itself into the future until governance is taken away from the corporate
elite on Wall-Street and given back to the citizen on Main Street.