My View on the Financial Crisis Pt. 1
By Ichak Kalderon Adizes, PhD.
Like many others, I am listening to the news. What I find as a common denominator is that commentators, analysts, opinion papers authors are all looking for culprits: Who is responsible for the breakdown of the financial institutions?
Some accuse the leadership of the financial institutions and their greed. Others accuse the regulatory agencies that “fell asleep on the job.” Still others point fingers in the direction of the Federal Reserve Bank that should have known better, etc.
I believe that we should look less at the “who did it ” and more at the “how it happened”, at the system that created the mess.
Already twenty-five years ago when I consulted with some of the leading banks, many top executive bankers told me in private, “Honestly, Dr Adizes, we don’t know what is going on anymore.” What they were referring to was that the macro economic theory has not absorbed and adapted to the junk bonds, derivatives, cash equivalents, reverse equity swaps, and God only knows what other financial instruments that were being created. For instance, some expert economists even told me that when measuring how much money is in the market, in order to measure flow, the system did not take into account the cash equivalents, for instance.
In other words, it appears that, reality out paced theory. The economists and the regulatory agencies were in the dark as to what was going on
So, why did they not say so? Because people expect authorities to know and be in control. The authorities could not admit in public that “the king is nude”.
Some years ago I interviewed Michael Milken, the junk-bond king who went to jail. “When did you know that you were in trouble?” I asked him. “Long time before I was sentenced,” he said. “The government was getting scared with the billions of junk bonds floating around. They did not know what would happen if the bonds defaulted. They had to stop me one way or another, and they did.”
In the end, the junk bonds did not sink us. The sub-prime mortgages did. Both do have one thing in common: the market changed so much that it simply out paced whatever capability the existent system had to manage it.
Take banks, for instance. Banks sell mortgages, then they collaterize them and sell them in the market.. In a sense, they sell their risk and increase their profitability. The mortgage-based stock gets sold again, and risk is transferred further down.
Everyone was doing their cost-benefit analysis, following the profit goal, and taking supposedly calculated risks. But estimating risk is a subjective decision, and the further the risk migrated from the source, the “murkier” it got. It became increasingly difficult to know how big the risk really was.
So how much were those financial instruments worth? How much should they be valued on the balance sheet? It is not a calculus of 2 plus 2 equals 4. Two plus 2 could equal 5, or 3, or whatever someone claims it to be. Even the purchase price does not truly reflect value. The purchase price only reflects the relative power of the negotiating parties. The real, true value is only known when the mortgages are collected.
But as the mortgages started to default, the risk became higher and the value of those instruments became lower, and all hell broke loose. But it should not have been a surprise. Years ago, Professor Charles Kindelberger, the famous MIT economist, warned the world that the housing bubble would burst. Even my personal accountant, who is not a luminary, has recommended that I sell all my real estate possessions. For the last four years he has repeated his mantra: “The housing prices are overheated. They must come down.”
Still greed, not of any one person, nor of any certain class of people, was stronger than the fear of impeding disaster. Everyone— those who took mortgages beyond their ability to pay them, the banks that securitized and sold them, and the people who bought these stocks— made their cost-benefit analysis and took the risks.
Capitalism encourages greed; legitimizes it. Pursuing the profit motive exclusively is totally acceptable, even applauded and rewarded.
If a banker would have refused to sell sub-prime mortgages his or her bank would make less profits than the competition, and the banker would have been fired for nonperforming.
There is a folk expression in the Balkans: “When you join the kolo (a circle dance) you have to dance.” Everyone was in the dance of profit seeking.
And where were the regulatory agencies? Why they did not do something?
Do what? The balance sheets did not reveal the problem because the value of mortgages, and all these different creative financial instruments, is determined by subjective evaluation, which is not precise. Thus, I suggest to you, that the regulatory agencies did not know what was happening, and even if they did, they did not have the tools to put a stop to the impeding collapse..
Who is to blame? Everyone, and thus no one.
Disasters like this have to happen so we learn what has changed, and what new system needs to be developed to deal with the new realities.
Stop looking for culprits. Fix the system fast and in an orderly fashion instead.
-Dr. Ichak Adizes