What Really Lies Behind the Financial Crisis?

Published: January 21, 2009 in Knowledge@Wharton

Ken’s Take: Jeremy Siegel (a heavyweight finance prof) dismisses gov’t programs that encouraged sub-prime mortgage lending and pins the tail on investment banks, etc., that undermanaged a few “smart guys” who took large, over-leveraged bets on assets that had fatal levels of hidden risks.  His value add: pointed out that when IBs were privately held they managed risk more prudently because they were playing with their own money.  After going public, they were playing with shareholders’ money …

I think he underestimates the impact of “action one” — the origination of fundamentally bad loans.  But, I hadn’t heard the argument that public ownership of IBs enabled the problem.

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What was the true cause of the worst financial crisis the world has seen since the Great Depression? Was it excessive greed on Wall Street? Was it mark-to-market accounting? The answer is none of the above, says Jeremy Siegel, a professor of finance at Wharton. While these factors contributed to the crisis, they do not represent its most significant cause.

While angry investors and taxpayers are anxiously looking to assign blame for the current state of the economy, it’s important to know not only which factors led to the meltdown, but which ones did not. The government programs encouraging home-buying by low- and middle-income families and short-selling of financial stocks — which was halted for a time last fall — have little to do with the crisis on Wall Street.

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Betting the house on mortgage backed securities

Here is the primary reason: Financial firms bought, held and insured large quantities of risky, mortgage-related assets on borrowed money.

The irony is that these financial giants had little need to hold these securities; they were already making enormous profits simply from creating, bundling and selling them.

“During dot-com IPOs of the early 1990s, the firms that underwrote the stock offerings did not hold on to those stocks … They flipped them. But in this case, the financial firms decided mortgage-backed securities were good assets to hold. That was their fatal flaw.”

There was a massive failure, not only by traders, but by CEOs of financial firms, their risk management specialists and the major rating agencies to recognize that an unprecedented housing-price bubble began building after 2000.

Their faulty reasoning was that the inability of homeowners to pay their mortgages — and the consequent foreclosures — would not pose a threat to their mortgage-backed securities. They believed that as long as home prices kept rising, the underlying value of the real estate would provide a hedge against the risk of such defaults.

They failed to realize that this reasoning was based on the assumption that home prices would go in just one direction — up. In fact, these assets became enormously risky once the housing bubble burst and home prices began their inevitable decline.

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Under-managing the (few) smartest guys in the room

Many troubled banks and insurers continued to prosper in almost every other aspect of their businesses right up to the 2008 meltdown. The exception was the billions of dollars in mortgage-backed securities that they bought and held on to or insured even after U.S. home prices went into a free-fall more than two years ago.

AIG —  the insurer that received an $85 billion federal rescue package last September — is a prime example. Some 95% of its business units were profitable when the company collapsed. “AIG has 125,000 employees … Basically, 80 of them tanked the firm. It was the New Products Division, which had an office in London and a small branch office in Connecticut. They came up with the idea of insuring mortgage-backed assets, and nobody at the top decided it wasn’t a good idea. So they bet the house — and the company went under.”

Ultimately, the buck stops with corporate CEOs who didn’t ask hard enough questions about the risks posed by mortgage-backed assets.

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Playing with other people’s money

Firms like Lehman Brothers, Bear Stearns and Morgan Stanley  survived the much more severe Great Depression of the 1930s but collapsed during 2008. Why? One reason: back then, these firms were organized as partnerships. In such an organizational structure, the partners would have to risk their own capital. When the partnerships were reorganized as widely held public companies, however, they no longer had such constraints. “Back when it was a partnership, you had your life invested in that company.” Investment banks began making higher-return but higher-risk investments in recent years as public ownership increased.

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By many important measures, the economy is not nearly as battered as it was during the early 1980s, when unemployment, inflation, and interest rates were all considerably higher than they are today. Stocks — as evaluated by their price-to-earnings ratios — are undervalued to the point where they could draw enough investors to spark a recovery before the end of 2009.

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Full article:

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