The Financial Crisis in Under 400 Words – Part II

“Why it Happened “ Or “Other People’s Money”

So I’m following up to the excellent response I’ve received to Part I of this by expanding from a simple “what happened” to the why in a non-partisan, summary sort of way. This one is more than 400 words, but I’ll keep it short.

Here goes:

Looking at economic history, financial crises are preceded by asset “bubbles” or over-pricing that’s followed by a crash that wreaks havoc in the system. This applies across the board from the US in the 20’s, Sweden and Japan in the 80’s, Asia in the 90’s, to Dutch Tulipmania in the 1600s.

It follows 3 stages:

1) A loosening of credit standards and an over extension of credit. Demand increases too fast along with prices = bubble.

2) Something causes the price bubble to burst and prices drop quickly.

3) Borrowers default in droves, leading the lending institutions to fail.

Um… Sound familiar.

But let’s discuss why this happens.

The main reasons are “moral hazard” the “agency problem” and “risk shifting”.

1) The “agency problem” is simply the idea that other people don’t care what they do with your money as much as you do.

A person will take risks and pay a higher price with someone else’s money than they would with their own. They don’t care because the risk is mostly “shifted” to the lender. It’s inherent in any relationship where you give someone else your money and is a problem found throughout finance and economics.

So, borrowers with easy, unfettered access to mortgages will make reckless decisions with the money if they are not monitored correctly. Hell, it’s not their money, right? As a result, people began paying ridiculous prices for houses they really couldn’t afford with bad adjustable rate loans.

But the banks are supposed to stop this sort of behavior from happening by verifying the quality of the borrower and their future ability to pay, right? Why wouldn’t they?

2) The answer is “moral hazard” which is the idea that a person will behave in a risky fashion if there are no consequences to their behavior. The banking system is the ultimate moral hazard. Why?

The banking system cannot be allowed to fail. If it does we all suffer. Government intervention is the only route to save the economy in a financial crisis. It’s the last line of defense. That’s a fact and those who propose letting the system fall apart for “punishment” are completely ignorant of history. (See notes below) It’s cutting your nose off to spite the face. Like it or not, the government has to step in during a financial crisis.

The banks are run by people. People who’s pay is tied to their company’s performance. During the last seven years, because of the amount of risk taken making these loans and trading risky derivatives and securities related to them, financial services made record profits that were passed along to the people who ran the companies.

Now when the bubble bursts as a result of these people’s choices they still walk away with those millions and who gets to clean up the mess? The government. The risk is shifted from the banks and their executives to the government . And the government is paying with your money.

3) So ultimately, banks are unique in that profits are privatized and passed to the executives and shareholders and the losses are shifted to the government and by association, the taxpayer.

There is risking shifting down the line:

Borrower to Bank to Government to Taxpayer. Agency problem, moral hazard and risk shifting.

I don’t want this blog to be political and I’ll just say, I’m a shameless capitalist myself, but those who propose that a lack of laissez faire is what caused this is ridiculous.

When the risk shifting ultimately lands on the taxpayer, the government has to make sure that prudence and care is being taken to maintain the integrity of the system. There’s no other way, or this will inevitably happen… as it just did.

Two Big Notes

1) This is not meant to demonize the banking industry. My next post is going to be “Why you should still love the banking industry”. But the fact is there are unique moral hazards in banking unlike anywhere else.

2) For a very readable economic summary of bubbles and a simple historic explanation why governments need to intervene based on recent case studies of Scandanavia and Japan read:

Allen & Gale (1999) “Bubbles, Crises and Policy”, Oxford Review of Economic Policy, Vol. 15, No.3, pp 9-18

Cliff notes: Scandinavian countries intervened and recovered in a year. Japan didn’t and suffers arguably to this day…

READ PART I HERE