2008 Financial Crisis: Analysis of Causes and Implications - Research Paper Example

2008 Financial Crisis: Analysis of Causes and Implications Introduction The global economy was hit by a series of financial crises that, like a volcano, started erupting on August 9, 2007. For many years, business and economic factors have converged to this point, which is why this crisis had several causes that could not be reduced to a single individual, institution, nation-state or financial instrument. Unlike most failures, the 2008 financial crisis had many fathers, and it is the object of this paper is to identify who/what they are and how they contributed to one of the most serious financial crisis in human history. Given the event’s significance, it helps to know its causes and impacts on stakeholders in order to learn and suggest ways to avoid a similar future occurrence. This paper then addresses the following research questions: What caused the 2008 financial crisis and what are its implications on stakeholders of the global economies? Methodology This paper is an exploratory study on the causes and implications of the 2008 financial crisis. An exploratory study is a valuable way of discovering new insights, asking questions and assessing phenomena in a new light to find out what is happening. This method of research is appropriate when a researcher wants to clarify the understanding of a problem. There are three basic types of questions this paper would address. The first question is “causal” in order to determine the variables that caused or affected the crisis and the stakeholders in the global economy. The second question is “relational” in order to look at the relationships between two or more of the variables identified. The third question is “descriptive” in order to describe what is going on or what exists. This paper will attempt to ask all three questions. Given such a theoretical framework, this paper is an exploratory study that investigates the causal, relational and descriptive aspects of the research question. The researcher would base the analysis on two types of data: quantitative and qualitative. Quantitative data includes economic data in summarized form that are available in the academic and journalistic documents to be used in the literature review. Due to limitations, these data would be accepted at their face value without econometric modeling to verify data accuracy and eliminate academic or professional biases inherent in every study. Qualitative data includes position papers, articles from academic journals and business media that shed light on the crisis, its causes and its impact on the various stakeholders. The quantitative and qualitative data were analyzed to understand the causal, relational and descriptive aspects of the research question: 1. What are the causes of the 2008 financial crisis? 2. How are these causes related? 3. How did the crisis affect the major stakeholders of the global economy? Literature Review One challenging aspect of writing this paper was selecting from a wide range of available literature on the subject, each one proposing a unique perspective on the causes and effects of the 2008 financial crisis. Included are articles by a wide range of academics, Nobel Prize-winning economists, hands-on managers, legal theoreticians and practitioners, investigative journalists, politicians, accountants, public and private bankers, labor law experts, and engineers. For this paper, the researcher looked at reference books, journal articles and working papers in economics, financial management and accounting, newspaper articles and the Report of two government bodies enacted by law. Many authors, some better known, were not included because they were published later or duplicated the analysis found in the earlier works. The earliest references predicted the economic crises before it happened. University of Chicago economics professor Rajan (345-46) warned in a speech before the Federal Reserve of Kansas in 2005 of “excessive risk taking in financial markets and the possibility of a full-scale financial blowout.” NYU Prof. Roubini followed almost a year later in a speech before the staff of the International Monetary Fund, when he warned that there was “a more than 50 percent risk of a U.S. recession the following year, because over the past several years, U.S. consumers had gone on a spending binge, with many using their home equity as an “ATM” (Loungani). In 2007, the Bank of International Settlements (BIS) reported: “the world economy was in danger of a major slump” (BIS Ch VIII). These first three predictions hinged on two basic causes: more risk-taking by consumers and financial markets because the U.S. and global economies were enjoying sensational growth. In his 2010 book, Roubini (and Mihm) outlined how economic optimism made property developers, bankers, politicians, homeowners, consumers, workers, manufacturing companies and practically every stakeholder in the global economy so confident the economy would keep on growing that they spent and borrowed as if there was no tomorrow. The resulting increase in demand inflated asset prices that came in the form of over-priced home prices, over-valued financial instruments, over-paid bankers and over-priced lifestyles. People borrowed beyond their means. International banker Davis (AIM 2008) traced the crisis to the government, specifically the decision of Clinton to help homeowners with cheap housing loans, a policy that Obama continued. While the intention was good, it led to abuses by bankers (who would be penalized if they did not lend) and borrowers (who borrowed even if they could not pay). The ensuing moral hazard rested on the belief that government could always rely on taxpayers to foot the bill, which happened with the bail-out of private (AIG, Goldman Sachs) and public (Freddie Mac and Fannie Mae) institutions. On the other hand, Foster and Magdoff (2009) identified the capitalist system structure as the culprit. The current capitalist structure in the U.S., they argued, is based on a close and unstable alliance between political and economic interests focused on private gain, and suggested that a solution is a more humane, socialist system. Erkens et al. (2009) identified corporate boards as a cause of the crisis, arguing that companies with independent boards were more prudent than those with institutional owners who tended to take more risks and approved risky investment decisions, because institutional owners such as pension funds were under pressure to declare short-term, instead of long-term, gains. Campello et al (2010) looked at companies affected by financial constraints due to the crisis and concluded they cut down their spending plans on technology, employment and capital spending, sold more assets and bypassed attractive investment opportunities. Many of these companies held off their planned investments in Europe and Asia, resulting in the spread of the financial contagion to other economies. Fidrmuc and Korhonen (2010) studied the impact of the global financial crisis on business cycles in Asian emerging economies. While there were wide differences in the synchronization of business cycles, they found a significant link between trade ties and dynamic correlations of GDP growth rates in emerging Asian countries and the OECD. Gao and Yun (2009) studied the effect of the financial crisis on non-financial firms such as the manufacturing industry and discovered a link between creditworthiness of firms and their ability to tap financial markets. They concluded that low default risk firms sustained their operating, investment and inventory levels because of high pre-crisis asset levels, basically due to machineries and finished goods, which helped them weather the storm in comparison with financial firms with paper assets and firms that spent for assets nobody was willing or could afford to purchase. Blanchard (2009) identified four causes for the crisis: the underestimation of risk, opacity of derivatives, the connectedness of financial institutions, and the high leverage of the financial system. He suggested that there would be a need to sell assets to satisfy liquidity runs and reestablish capital ratios to trigger world economic activity. He showed how the crisis spread to other assets, institutions, to Europe and emerging countries through amplification mechanisms that need regulatory and policy measures to limit these mechanisms. Cecchetti (2008) and Taylor (2008) blamed the Federal Reserve that encouraged imprudent risk-taking through mistaken monetary policies and then, when the crisis hit, hesitated in providing short-term liquidity to solvent financial institutions in need. Cecchetti argued that liquidity was the central problem and injection of liquidity was the solution. Taylor argued for tighter financial market regulation since the problem was more of a counterparty risk. Beyer et al (2010) argued that poor governance caused the crisis due to information asymmetries and agency problems between investors, entrepreneurs and managers. Reinhart and Rogoff (2008) argued that the current crisis is similar to past ones in that they exhibited similar characteristics. Obstfeld et al (2009) looked at dollar reserves of U.S. trading partners. The remaining question, both asked, is the severity of the recession that would depend on what the government, especially the Fed, would do. Rose et al (2009) used a Multiple Indicator Multiple Cause (MIMC) model to study a cross-section of 85 countries with international trade and financial linkages to trace where the crisis originated (the U.S. was a most likely natural origin, although they identified six other sources) and how it spread through other economies via holdings of American securities, financial channels, or trade channels. While they established a linkage between the U.S. and other economies, using among their variables the changes in real GDP, stock market prices, country credit ratings, and the exchange rate, they concluded that, if anything, countries seem to have benefited slightly from exposure to the American economy. Murphy (2008) traced the crisis to a “theoretical modeling based on unrealistic assumptions that led to serious problems in mispricing the massive unregulated market for credit default swaps that exploded upon catalytic rises in residential mortgage defaults” (Murphy 1). Demyanyk et al (2008) identified the deterioration in the quality of loans, characterized by borrower characteristics, loan characteristics and macroeconomic conditions, six years before the crisis, with the knowledge of the securitizers, led to a classic, unsustainable lending boom-and-bust cycle, leading to market collapse. Whalen (2008) identified three root causes of the crisis: an odious public policy partnership to enhance the availability of affordable housing through creative financing, the rapid growth of over-the-counter derivatives and securities, and the use of fair value accounting by the Securities and Exchange Commission and the Financial Accounting Standards Board. Ivashina et al (2009) attributed the crisis to a run by short-term bank creditors that made it difficult for banks to roll over their short-term debt. Tett (2009) traced the history of the credit derivative obligation (CDO) designed by J.P. Morgan in 1994. The CDO morphed into financial instruments marked by increased return and lower risk, freeing up capital, increasing profits and diversifying risk. Many financial institutions and governments (like banks and municipalities in Ireland, the U.K. and Iceland) became so dependent on CDOs that when the defaults began, they all suffered. Ironically, J.P. Morgan knew this financial instrument could not be sold forever, so it reduced it reliance on CDOs way before the crisis hit. Chari et al (2008) presented three myths about the financial crisis and three under-appreciated facts about the financial system that led to mistaken inferences about the real costs of borrowing and mistaken moves such as government intervention. Their findings were refuted by Cohen-Cole et al (2008) who showed that Chari et al would not have reached those conclusions if they looked more closely at the underlying composition of financial aggregates to evaluate the common claims about the impact of financial sector phenomena on the economy. Verick et al (2010) argued that contrary to popular belief, the global economy was unstable before the crisis due to widespread wealth inequality, even in developed countries, and other indicators. The EU (ALDE 2008) identified the causes of the crisis as increased innovation in structured financial products, willingness to take excessive risks, low interest rates and the greed of investors. They argued the need to improve transparency, resolve conflicts of interest and achieve close cooperation among market participants and supervisory systems. Stiglitz (2010) identified the failure of markets in managing risk, flawed financial models, and the mixed motivations of rating agencies that led to information asymmetries negating the spread of risk from securitization (people had no idea what they were buying). He identified the deregulation in the 1980s and 1990s and the belief of the Fed in self-regulation as the seeds of financial crisis. The solution is stricter regulation that would lead to the design of a new global financial architecture. Krugman considered the crisis a recurrence of the economic mistakes in the past. In his book, Krugman (2010) blamed regulatory failure to keep pace with a crazy financial system and suggested a wave of tighter regulation and additional government spending as solutions to the crisis. The findings of the Financial Crisis Inquiry Commission (FCIC 2011) in January 2011 and the U.S. Senate Permanent Subcommittee on Investigations (USS 2011) in April 2011 run parallel. The FCIC argued the crisis was caused by human action and inaction and avoidable; that the leaders of the financial system and the regulatory agencies failed to manage evolving risks and police themselves; there was a failure of greed-driven corporate governance; consumers were fooled to take on risks; and a breakdown in accountability and ethics in government, public and private financial and business institutions. The Senate Report was scathing and specific in blaming financial institutions, regulatory failures, inflated credit ratings and high risk, poor quality products sold by investment banks. It identified the faults of a failed bank, the office that supervised banks, the two largest rating agencies, and the investment banking leaders in designing, marketing and selling mortgage-related securities. Analysis The review of literature showed that the financial crisis was caused by human and systemic factors that are interrelated. Among the human factors are the relentless drive for profits that stem from a capitalist-based political system where private enterprise is facilitated and rewarded by financial means. Human beings at all levels – consumers, government officials whether they be regulators, politicians, supervisors, or managers of public financial and business corporations – were all at fault. Private sector rating agencies and financial institutions were also to blame, because inherent in their transactions and business dealings were a wide range of conflicts of interest where ratings, financial remuneration of managers and stakeholders, and other forms of entitlement that blinded them to the vicious cycle of greed. As the documents showed, many of the players in the unfolding drama were blinded by the prospect of higher profits, whether it be houses, consumer goods, financial products, or political power. Despite warnings from academics and economists at multilateral financial institutions such as the IMF or BIS or think tanks like those at the Federal Reserve Banks or Universities, everyone was fooled by the positive economic data that turned out to be mostly artificially inflated because most of these turned out to be lacking in their underlying values. In a show that was and continues to be painful to watch, all the stakeholders in the global economy are caught in a bind because, as it turned out, almost everyone in a position to do something, such as temper their drive for financial gain, to question the value of financial instruments, or be critical of managerial decisions, most of them decided not to do anything. What are the implications on each of the stakeholders of the global economic system? Politicians and government leaders such as parliamentarians and legislators, executives and members of the judiciary system must design and implement laws that protect the good of all, and not just those of a privileged few. They should start by reviewing the laws that were not properly implemented and to sharpen the teeth of these laws. Government regulators and supervisors that includes agencies like the Federal Reserve or Central Bank, the Securities and Exchange Commission, and bank supervisors should do their jobs well and help the legislators, public executives and the judiciary to uphold and, if necessary, revise those laws that do not protect the public welfare. Financial institutions like investment and commercial banks, insurance companies, both public and private, must temper their greed and upgrade and uphold their professional competence so that they can protect the interests of their customers and shareholders. Stockholders of listed corporations must fulfill their role as part of an intricate check and balance mechanism against the excesses of managerial greed and incompetence. They must also be aware of the so-called agency problem, the conflict of interest between the shareholders as principals and owners of the business and their hired agents, the managers who make the day-to-day decisions that could either make-or-break the corporation. Managers of businesses must act responsibly and see their role as agents of corporate owners, instead of giving in to their greed and making decisions that benefit them primarily to the detriment of their shareholders, customers and suppliers. Consumers, workers and professionals must never take anything at face value. The financial crisis has shown everyone an important lesson: if people can get away with murder, they will. Academics must continue working like the prophets of old, warning against the excesses of business and society and reminding the public the consequences of bad behavior. They should not give up, following the examples of the prestigious lights of the academic world who warned of the crisis. They may not be heard, and they may not be right most of the time, but their repeated warnings serve as a collective social conscience that could help those who cannot afford high risk levels to make important decisions. Multilateral financial institutions like the IMF and the BIS must work objectively at avoiding financial and economic crises, which is among their most important function as lenders of last resort to the global financial system. They must also work at minimizing the moral hazard inherent in any economic system by being more transparent and intellectually daring, if need be. Conclusion The 2008 financial crisis highlights the importance of learning the following lessons that apply to the major stakeholders of any economy. First, laws should protect everyone, not just the capitalists, bankers and businessmen who have greater political influence and advantage over the common shareholders and consumers. While the law of caveat emptor (or buyer beware) is a basic law of commerce, the government should exploit its authoritative position to temper the greed and abuses of powerful business interests. Second, shareholders should better exercise their right to demand accountability and transparency from their agent-managers. They should participate in corporate governance in the limited scope they are allowed by law, attending shareholder meetings and studying well the financial reports that are released by managers to look for potential conflicts of interests and improper practices, such as excessive compensation and opportunities for selfish interests. Third, every consumer must realize that financial rewards are commensurate to risk, and that there is no such thing as a free lunch. This means that there is no substitute for hard work and doing one’s homework to avoid getting fooled by good marketing and selling tactics, whether these be from a dubious business or a prestigious investment bank such as Goldman Sachs. If something sounds too good to be true (high return-low risk financial instruments), most probably it is. Like most of the victims of Bernard Madoff, one could get large returns for a limited time, so it would be best to get out early and not give in to greed. The 2008 financial crisis could have been avoided, and in fact many investors escaped mostly unscathed by disaster, because they followed norms of prudence and were able to temper their greed. These lessons are simple, but our human nature oftentimes makes it difficult, if not almost impossible, to be satisfied with reasonable profits. 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