GLOBAL CRISIS

The global financial crisis, brewing for a while, really started to show its effects in the middle of 2007 and into 2008. Around the world stock markets have fallen, large financial institutions have collapsed or been bought out, and governments in even the wealthiest nations have had to come up with rescue packages to bail out their financial systems.
On the one hand many people are concerned that those responsible for the financial problems are the ones being bailed out, while on the other hand, a global financial meltdown will affect the livelihoods of almost everyone in an increasingly inter-connected world. The problem could have been avoided, if ideologues supporting the current economics models weren’t so vocal, influential and inconsiderate of others’ viewpoints and concerns.
This article provides an overview of the crisis with links for further, more detailed, coverage at the end.
The betting of practically anything helped create enormous sums of money out of almost nothing. However, as former US Presidential speech writer, Mark Lange, notes, “because [derivatives are] entirely unregulated and trade on no public exchanges, their originators can deliberately hide their vulnerabilities.”

Securitization and the subprime crisis

The subprime crisis came about in large part because of financial instruments such as securitization where banks would pool their various loans into sellable assets, thus off-loading risky loans onto others. (For banks, millions can be made in money-earning loans, but they are tied up for decades. So they were turned into securities. The security buyer gets regular payments from all those mortgages; the banker off loads the risk. Securitization was seen as perhaps the greatest financial innovation in the 20th century.)
As BBC’s former economic editor and presenter, Evan Davies noted in a documentary called The City Uncovered with Evan Davis: Banks and How to Break Them (January 14, 2008), rating agencies were paid to rate these products (risking a conflict of interest) and invariably got good ratings, encouraging people to take them up.
Starting in Wall Street, others followed quickly. With soaring profits, all wanted in, even if it went beyond their area of expertise. For example,

• Banks borrowed even more money to lend out so they could create more securitization. Some banks didn’t need to rely on savers as much then, as long as they could borrow from other banks and sell those loans on as securities; bad loans would be the problem of whoever bought the securities.
• Some investment banks like Lehman Brothers got into mortgages, buying them in order to securitize them and then sell them on.
• Some banks loaned even more to have an excuse to securitize those loans.
• Running out of who to loan to, banks turned to the poor; the subprime, the riskier loans. Rising house prices led lenders to think it wasn’t too risky; bad loans meant repossessing high-valued property. Subprime and “self-certified” loans (sometimes dubbed “liar’s loans”) became popular, especially in the US.
• Some banks evens started to buy securities from others.
• Collateralized Debt Obligations, or CDOs, (even more complex forms of securitization) spread the risk but were very complicated and often hid the bad loans. While things were good, no-one wanted bad news. Side Note»

High street banks got into a form of investment banking, buying, selling and trading risk. Investment banks, not content with buying, selling and trading risk, got into home loans, mortgages, etc without the right controls and management.
Many banks were taking on huge risks increasing their exposure to problems. Perhaps it was ironic, as Evan Davies observed, that a financial instrument to reduce risk and help lend more—securities—would backfire so much.
When people did eventually start to see problems, confidence fell quickly. Lending slowed, in some cases ceased for a while and even now, there is a crisis of confidence. Some investment banks were sitting on the riskiest loans that other investors did not want. Assets were plummeting in value so lenders wanted to take their money back. But some investment banks had little in deposits; no secure retail funding, so some collapsed quickly and dramatically.
The problem was so large, banks even with large capital reserves ran out, so they had to turn to governments for bail out. New capital was injected into banks to, in effect, allow them to lose more money without going bust. That still wasn’t enough and confidence was not restored. (Some think it may take years for confidence to return.)
Shrinking banks suck money out of the economy as they try to build their capital and are nervous about loaning. Meanwhile businesses and individuals that rely on credit find it harder to get. A spiral of problems result.
As Evan Davies described it, banks had somehow taken what seemed to be a magic bullet of securitization and fired it on themselves.

Creating more risk by trying to manage risk

Securitization was an attempt at managing risk. There have been a number of attempts to mitigate risk, or insure against problems. While these are legitimate things to do, the instruments that allowed this to happen helped cause the current problems, too.
In essence, what had happened was that banks, hedge funds and others had become over-confident as they all thought they had figured out how to take on risk and make money more effectively. As they initially made more money taking more risks, they reinforced their own view that they had it figured out. They thought they had spread all their risks effectively and yet when it really went wrong, it all went wrong.
In a follow-up documentary, Davis interviewed Naseem Taleb, once an options trader himself, who argued that many hedge fund managers and bankers fool themselves into thinking they are safe and on high ground. It was a result of a system heavily grounded in bad theories, bad statistics, misunderstanding of probability and, ultimately, greed, he said
What allowed this to happen? As Davis explained, a look for way to manage, or insure against, risk actually led to the rise of instruments that accelerated problems:
Derivatives, financial futures, credit default swaps, and related instruments came out of the turmoil from the 1970s. The oil shock, the double-digit inflation in the US, and a drop of 50% in the US stock market made businesses look harder for ways to manage risk and insure themselves more effectively.
The finance industry flourished as more people started looking into how to insure against the downsides when investing in something. To find out how to price this insurance, economists came up with options, a derivative that gives you the right to buy something in the future at a price agreed now. Mathematical and economic geniuses believed they had come up with a formula of how to price an option, the Black-Scholes model.
This was a hit; once options could be priced, it became easier to trade. A whole new market in risk was born. Combined with the growth of telecoms and computing, the derivatives market exploded making buying and selling of risk on the open market possible in ways never seen before.
As people became successful quickly, they used derivatives not to reduce their risk, but to take on more risk to make more money. Greed started to kick in. Businesses started to go into areas that was not necessarily part of their underlying business.
In effect, people were making more bets — speculating. Or gambling.
Hedge funds, credit default swaps, can be legitimate instruments when trying to insure against whether someone will default or not, but the problem came about when the market became more speculative in nature.
Some institutions were paying for risk on margin so you didn’t have to lay down the actual full values in advance, allowing people to make big profits (and big losses) with little capital. As Nick Leeson (of the famous Barings Bank collapse) explained in the same documentary, each loss resulted in more betting and more risk taking hoping to recoup the earlier losses, much like gambling. Derivatives caused the destruction of that bank.
Hedge funds have received a lot of criticism for betting on things going badly. In the recent crisis they were criticized for shorting on banks, driving down their prices. Some countries temporarily banned shorting on banks. In some regards, hedge funds may have been signaling an underlying weakness with banks, which were encouraging borrowing beyond people’s means. On the other hand the more it continued the more they could profit.
The market for credit default swaps market (a derivative on insurance on when a business defaults), for example, was enormous, exceeding the entire world economic output of $50 trillion by summer 2008. It was also poorly regulated. The world’s largest insurance and financial services company, AIG alone had credit default swaps of around $400 billion at that time. A lot of exposure with little regulation. Furthermore, many of AIGs credit default swaps were on mortgages, which of course went downhill, and so did AIG.
The trade in these swaps created a whole web of interlinked dependencies; a chain only as strong as the weakest link. Any problem, such as risk or actual significant loss could spread quickly. Hence the eventual bailout (now some $150bn) of AIG by the US government to prevent them failing.
Derivatives didn’t cause this financial meltdown but they did accelerate it once the subprime mortgage collapsed, because of the interlinked investments. Derivatives revolutionized the financial markets and will likely be here to stay because there is such a demand for insurance and mitigating risk. The challenge now, Davis summarized, is to reign in the wilder excesses of derivatives to avoid those incredibly expensive disasters and prevent more AIGs happening.
This will be very hard to do. Despite the benefits of a market system, as all have admitted for many years, it is far from perfect. Amongst other things, experts such as economists and psychologists say that markets suffer from a few human frailties, such as confirmation bias (always looking for facts that support your view, rather than just facts) and superiority bias (the belief that one is better than the others, or better than the average and can make good decisions all the time). Trying to reign in these facets of human nature seems like a tall order and in the meanwhile the costs are skyrocketing.