So yet another week passes and we see ourselves in deeper and deeper into this, as yet named, financial crisis (somehow “Sub-Prime” just doesn’t seem adequate anymore, the generic ‘2007-08 Banking Crisis’ will probably be what we settle on.)

And this topic has certainly been on the minds of many of my fellow classmates (primarily because of recruiting) and faculty members (primarily the value of their 401k’s I guess) here at school.  In fact, our school felt it necessary to host no less than separate 2 discussions on the crisis on consecutive days to given everyone a forum to discuss and share their views and opinions.

To you, the inquisitive reader, I thought I would take a couple of minutes to jot down some of the jumble of thoughts on the banking crisis:

“What is the root cause of the banking crisis?”  A broad and vague question posed to me by my social enterprise professor on the 2nd day of class – prolly more to seek out answers he could reuse by polling the collective intelligence of the class for answers – rather than as part of his lesson plan.

  • My first response was: “Relaxed borrowing standards for home mortgages to the point that any fool and his dog could take out a loan.”  If you inherently believe in  having free markets that are efficient and will allocate resources to areas that maximize economic return of the participants than this has to be your starting point.  I’m not going to blame the banks for their securitization and structuring activities – this made money and therefore was worth doing, this was the invisible hand at work.  Which brings me a corollary:
  • If it’s legal and it makes money (and yes securitizing and repackaging home loans made a boatload of money for them), the investment banks will do it.  The nature and structure of investment banking remuneration (i.e.  focus on big year-end bonuses) rewards bankers for taking risks that pay off in the short-run, long-run risks be damned.  This creates a culture which increases systemic volatility as all the bankers race to get a share of their slice of the pie (in whatever is the latest reward of scene of the day) before the party ends.
  • Profit-driven Debt rating agencies which had massive conflict of interests that corrupted their ability to fairly rate debt and that assigned investment grade ratings to the eventually toxic mortgage-backed securities and CDO’s.
  • The regulatory environment was all of:
    • too outdated (current structure of financial regulation has not been updated since the 1930’s)
    • too slow or cumbersome (perhaps the US’ rules-based regulatory framework should be sunset in favor of the UK’s principles-first regulatory framework to financial innovation can be automatically matched instead of waiting for lawyers to update the books)
    • too weakened by successive cuts in the funding of the regulatory agencies

    • to be able to respond.

What about the issues of low historic yields distorting the markets? I heard this sentiment several times and I agree that this definitely contributed to our problems but I don’t agree its the root cause.  As the Fed (re Alan Greenspan) kept rates artificially low for too long (remember Greenspan’s argument that productivity gains from info tech would allow for lower rates of natural unemployment?) this distorted the capital markets.

Related to  Alan Greenspan’s low-rate management policy of the overnight Fed Funds rate were the lessons learned from the Asian Financial Crisis of 1997-98 which instilled a “best practice” of running current account surplus, stockpiling foreign currency reserves and maintaining weaker currency in order to stave off a repeat of ’97-’98.  Of course this had the unintended consequence of flattening out the rest of the US debt market’s yield curve as Asian countries furiously bought treasuries to park their current account surplus and keep their currency relative weaker.

Asset managers, with their trillions of dollars, could no longer rely on a decent real interest rate from the bond markets to earn a reasonable return for their income-seeking fundholders eventually turned to more risky ‘alternative investments’ fueling a boom in hedge funds and private equity.

(These hedge funds with their “2 and 20” payout structure likely contributed additional volatility in the capital markets by fostering a ‘go-big or go-home’ mentality as these fund managers sought outsize risks in order to make outsize gains for their 20% carry.)

Where do we go from here?

I guess this is where things get interesting.  A lot of folks talked about the notion of ‘delevering’ or essentially borrowing less.

For example – now that Goldman and Morgan are commercial banks, they are going to have to run their operations and balance sheets like them.  Whereas they are currently levered 40 and 33 to 1 respectively, they will now have to come in-line with the rest of the commercial banks at 10.   Which means selling off 66% to 75% of their assets (i.e. loans to their customers).  This does imply that GS and MS are now likely to be less profitable and less valuable as they can only lend (and collect interest income) on 1/4 to 1/3 what they could previously have done?

Broader implications to the US economy is that money supply will be tighter, less money flowing around as regulations will (hopefully?) rein in irresponsible lending.

In the medium run, low-yield market distortion could see itself worked out as foreign investors – re Japan and China switch their target instrument of treasuries into alternate and equity investments and out of US dollars into more diversified basket of currencies – this latter treend is already happening and will likely continue.  This will of course have implications on the alternative investments financial management industry.

Longer-term, of course, there is another looming issue which seems to have submerged back from mass consciousness – that of the twin deficits (budget deficit and current account deficit) triggering US-confidence crisis which result in spiking interest rates and falling US dollar (I guess that is already happening) as foreign investors turn their back on US economy.  The potential saving grace here is that given the risk adversity of these investors and the unsettled state of the world and other economies, the US still represents the safest destination for investors…for now.