The Financial Meltdown

August 20th, 2010 by under Business and the Economy. No Comments.

It is hard to find the words to express my disappointment with business leaders in the financial industry.  Are we business school faculty partially responsible for the financial crisis of 2008 to the present?  Did we fail to teach our students of twenty years ago that Adam Smith’s invisible hand assumed market participants had some sense of ethics?  Have my colleagues in Finance Departments across the world created such arcane products of great mathematical complexity that buyers, sellers and regulators did not really understand the risks involved?  How can a firm purposely create an investment instrument designed to fail and sell it to one of its customers so that a different customer could gain by betting against it?  And an MBA graduate from a top business school is at the center of this scheme.

I have to wonder where boards of directors have been the last few years.  They certainly have not been representing shareholders.   Board members at banks and other financial institutions did not look very closely at the breakdown of underwriting standards for mortgages.  How could they miss what was going on?  It was documented in numerous news articles; I remember reading about a woman with a $30,000 a year income who was given a $300,000 mortgage.  I predicted the mortgage market would crash, but not to the extent that it did, and not that it would bring down the economy with it.  Did no one on Bank of America’s board realize what kind of losses the bank was taking on when it bought Merrill Lynch? Were boards at Lehman and Goldman Sacs comfortable with leverage ratios of 30 to 1?  Or did they even know about them?

I was on the board of a manufacturing company for three years, and when there were no profits, there were no management bonuses.  Yet on Wall Street it seems that whether or not the company makes a profit, and wether or not their actions destroy value for stockholders, people should still receive their bonuses.  A friend who works in Finance in New York said that I did not understand these bonus agreements.  That is true.  I do understand that people who participated in almost starting a depression insisted on getting lavish bonuses while cities were laying off teachers.  I have a hard time understanding that logic.

I have an old-fashioned view of banks.  To me a bank is there to provide loans for individuals and business and to pay interest to individuals who have accounts there.  Individuals need credit to purchase items they want to enjoy now rather than wait, items like houses and cars.  Businesses need credit to finance their operations, to expand their business and to merge or acquire other businesses.  No place in my model of a bank does it say the bank should gamble with the shareholder’s investment by betting on derivatives, foreign exchange, or other instruments.   It is interesting that states regulate casino gambling, but no one before now thought about regulating financial institutions that were gambling billions of dollars.

Despite the financial crisis and the behaviors that created it, there are still people calling for less regulation of financial products and markets.  I personally don’t like to be regulated, but as a consumer and investor I am more than a little afraid of leaving the financial industry on its own.  Past and recent history have shown that these markets are not the perfectly efficient markets of economic theory.

My worry about regulation is whether or not the regulators can keep up with the people who are trying to evade them.  Technology can help by providing information and computational power to a regulatory group charged with looking at the entire economy, not just one part. But how do you find out about a new, stealth derivative or other financial product that puts the economy at risk?  The challenge is not just the products we know about, it is the ones that no one has dreamed up yet.