Wednesday, January 19, 2011

Eight simple things that caused the financial meltdown

I am pissed off. “Inside Job” pissed me off. It’s a great documentary about the root causes of the financial services industry. In a sense the root reasons are complicated, but in another they are very easy to understand:

1. Pro-Risk culture - Lenders were paid commissions on how many loans they gave, not whether the loans were safe or even realistic. They were encouraged to take risks with other people’s money, but were not held personally accountable if things went wrong.

2. Regulators in bed with the finance industry - The government regulators charged with regulating the finance industry were **all** former CEOs and execs in the finance industry. Should they be trusted to regulate their old company? Besides being asleep at the wheel and not investigating companies that even the FBI was worried about, they, with the help of congress, loosened regulation and made oversight even weaker.

3. Disconnect between borrowers and lenders - If I loan you money, I obviously want to keep tabs on you and make sure I get my money back. But the finance industry will resell these loans over and over again, each person making a commission when they resold the loans. So soon the person who actually held the loan was so far removed from the borrower they couldn’t even tell that the loans were terrible and bound to fail.

4. Loan ratings companies were frauds - The above scenario never should have happened, because loans are rated in terms for strength and stability. These loans comprised many subprime loans (high-interest loans given to people who couldn’t pay) and should have received a shit rating (like a D). But instead they received AA or AAA, the highest ratings only given to things as stable as the U.S. GOVERNMENT. So why did shitty loans get good ratings? Because at the time loose regulation had allowed the creation of lots of subprime loans, all of which needed to pay to get rated. And rating agencies realized when they gave good ratings to crap loans, people who patronize them again. So they paid people to give fake ratings, and duped investigators.

5. Credit default swaps - Exacerbating the problems above was the creation of complex financial instruments created by brilliant mathematicians and physicists who were trying to make some money. They created an unregulated, $50 TRILLION dollar system where people can bet against almost anything, from the performance of a stock to what the weather will be. This means that you can bet for a investment to fail, and make money when it does. This obviously isn’t good for the customer who took out that investment, but it gets worse: The big finance companies - Merryl Lynch, Lehman Brothers, Bear Sterns, and others - sold people loans and then bet against these loans to fail. So they were making money off both sides, and the borrowers lost big time.

6. Academic frauds - Usually when things go bad, we look to the experts for advice. Obviously we couldn’t rely on the Wall Street types, so we co to trusted Academic, right? This failed (and continuous to fail) for two reasons: First many economists at Harvard, Columbia, and other places were FORMER FINANCIAL SERVICE VIPs. So they bring their own business philosophy of anti-regulation to new generations of students. Rather than advancing knowledge, they just peddle their own philosophy. But even worse is that academics who are consultants for the financial services industry AT THE SAME TIME THEY ARE TEACHING. So they are making hundreds of thousands of dollars consulting, and then publish academic papers praising these companies and their practices. Conflict of interest, anyone?

7. Not creating anything - Many of the financial instruments like credit default swaps don’t actually create wealth, or anything else for that matter. They don’t create an end product, just money. Since they don’t create anything, they are essentially ponzi schemes where the last person (a.k.a. the sucker) left in the system loses everything. An expert in the movie put it nicely: Traditional engineers get paid to make things, real things that people use. Financial engineers get paid much more to create nothing. Which profession deserves a better salary?

8. Corrupted board structure - I’ve known about this for a long time. American CEOs are the most highly paid in history, making thousands or even millions times the salary of their rank and file. Why are they so lucky? CEO payments come from the board of directors, who are the ultimate bosses. But what happens when a CEO handpicks their board of directors, and gives them $200,000 a year? Amazingly, the board members will vote to increase CEO compensation, while the CEO keeps them on the board for big money. It’s a closed system with no accountability. This allows CEOs to take unreasonable risks and face no accountability, since they get a golden parachute when they leave.


michelle said...

You should listen to the Planet Money podcast and read their blog:

Jonathan Rubin said...