Sunday, February 24, 2013

The 2008 Financial Crisis.

The 2008 Financial Crisis.

This article is compiled from Rand Corporation article, articles from Wall Street Journal and my own research.

The crisis was faced in 2007-2008 and it occurred in U.S and with effects all over the world , still in 2013 we have not recovered. Since the Great depression of U.S the Government and Financial industry of U.S boomed consistently for about 40 years, till 1980s.In 1980s U.S had few big companies who controlled a lot of capital and in the term of Bill Clinton regulations were relieved to advantage of the big companies and investors so risking society's safety and benefits. Later in 1990s the Financial Services Authority in Washington relieved laws for big investment banks i.e UBS, Goldman Sachs and Lehman Brothers which is a criminal act in a legal terms.

Citi Bank was financing the Iran's weapon supply and also took part in sales of Mexico's Cocaine market for high profits. The rich investors started to invest in U.S because of lack of proper regulations and high interest rates. Government made laws lenient to attract investors from all over the world and thus increasing the systematic risk in U.S Financial market. Then came the era of hedge funds and derivatives, derivatives is the riskiest financial instrument. Hedging techniques and the models for derivatives were being practiced in almost all major banks .The models were mathematical and complex, even the use of High Frequency Computing in trading floor was practiced. Graduates with PhD in Mathematics , Physics or Computer Science were being hired to handle these complex derivatives. Many Noble Prize winners started their own Hedge Funds and attracted big investors to make profits, the models were so complex that only a few can grasp the understanding. Derivatives traders were using mathematical models to manage the derivatives and securities. These quants were playing with high risk/high return financial derivatives and were at that time confident of the models being used by them.

Nouriel Roubini, the first economist to warn against the crisis and is against the use of derivatives.

 The other big cause was the imprudent mortgage lending, as house prices boomed in later 1990s many people were unable to afford homes and so they required home loans and Government facilitated them by home loan scheme. Many banks started giving loans to these people and later investment banks came to give mortgage loans. These big banks preferred sub-prime loans for higher interest rates. Sub-prime loans increased 10 times from 1996-2006 , Lehman Brothers were biggest gainers from such mortgage loans. In fact  mortgage loans are a sort of derivative which is traded in financial system and it is prone to both systematic and default risk. Rating agencies started to give even the financially weaker companies a AAA credit rating so they can attract mortgage loans customers. So sub-prime loans were packed as AAA bonds. Credit rating agencies gave AAA ratings to numerous issues of sub-prime mortgage-backed securities .

The big companies and investment banks who controlled the most of world's money were involved in such derivatives and mortgage loans. Risk management was poorly handled by companies and firms separated analysis of market risk and credit risk This division did not work for complex structured products like derivatives. Complexity of financial instruments at the heart of crisis had two effects: 1. investors were unable to make independent judgements on merits of investments, 2.regulations were baffled.  Investors do not always make optimal choices as they suffer from bounded rationality and limited self-control and even regulators did not help them to manage complexity through better disclosure.

Quants ruled Wall Street in 1990s and 2000s

The computer models used were bad , expectations of the performance of complex structured products linked to mortgages were based on only a few decades worth of data. In the case of sub-prime loans. As complex instruments like derivatives were new and so not much data was available as well for forecasting.Low interest rates and abundant capital forced investors to borrow funds to boost the return of their capital, excessive leverage magnified the impact of housing downturn. Excessive leverage leads to mispricing of risk and credit bubble. Even the regulation laws were relaxed for excessive leverage. New laws in 1990s and 2000s i.e. GLBA and the CFMA permitted financial institutions to engage in unregulated risky transactions on vast scale. Over the counter derivatives which are largely unregulated  began to get exercised extensively. CDOs ,an investment-grade security backed by a pool of bonds, loans and other assets. CDOs do not specialize in one type of debt but are often non-mortgage loans or bonds. CDOs are sort of derivatives used by banks for profits , they are actually derivative based loans. The last cause was use of Gaussian curve for risky and low probability instruments in financial industry i.e if you use Bell curve in top stocks,derivatives and genetic measures, extreme events if calculated by Bell curve may cause disaster. Head -tail on a coin is a random walk (left or right or win or loose) is a mediocre event so we use Gaussian curve.This idea was popularized by Nassim Nicholas Taleb who stated this as "Black Swan theory". He suggested that markets are non-linear , random and highly complex and chaotic and so the events with low probability and high impact i.e Black Swan events are not calculated by Gaussian curve.These events are outliers with massive impact and economic advisers were not aware of this and so were unable to forecast these events.

Hedge funds did not contribute to the crisis itself but they contributed to high systematic risk (though sysmematic risk is known as risk caused by randomness in financial parameters i.e interest rates, inflation but in generic term it is the possibility of failure of whole financial system i.e a Crisis or a Black Swan event) in financial system.Many top financial engineers attracted investors and spent millions of dollars for high return, but due to the volume of hedge funds in terms of dollar value these caused highest systematic risk  in financial system as compared to any other financial instrument. So, when system fails due to causes like mortgage lending , hedge funds increase the effect of the damage i.e. hedge fund act as a catalyst when crisis happens but do not itself contribute to crisis. Hedge funds make market parameters like interest rates and inflation go random due to their high return behavior, also weak regulatory laws for hedge funds made them even more riskier financial instrument. Hedge fund managers were greedy and traded in high risk/high return funds and thus making financial system more complex and more prone to crisis.John Paulson made billions in trading complex derivatives and mortgage loans.Many people blamed hedge funds for crisis but that is not true , they only increased the damage of crisis because of their systematic risk but never were the cause of crisis.

No regulator had comprehensive jurisdiction over all systemically important financial instructions, the Federal Reserve Bank had role of systematic risk regulator by default but lacked authority to oversee investment banks , hedge funds, nonbank derivative dealers. Even the rating agencies did the worst by giving good rating to risky securities and borrowers, AAA rated firms increased from few hundred to thousands in few years(early 2000s). All in all this crisis was the biggest the world has seen so far in terms of damage, many academics and economic advisors like Nouriel Roubini ,Peter Schiff, Raghuram Rajan , Nassim Nicholas Taleb, Kenneth Rogoff, George Soros,Robert J. Shiller and Andrew Lo warned against crisis and wrote extensively against the deregulation of Financial acts and excessive use of derivatives. At the same time there were advisers like Larry Summers and Frederic Mishkin favored deregulation of financial system and favored use of derivatives and risky financial instruments and even were advisers to such instruments and hedge funds for their own profits. 

Henry Paulson

 Henry Paulson the U.S Treasury Governor along with Ben Bernanke were unable to understand or predict this crisis and gave his precautions and new regulations after four month of crisis. Many CEOs of large companies including Lehman Brothers, Goldman Sachs  went away with billions of dollars inside their pocket after damaging the whole financial system, the U.S Government and the world. Many other Harvard economists and other top university economists made millions by consulting to firms and promoting the deregulation of the financial system. This also contributed to the corruption of economics studies in universities and business schools.

Larry Summers

Computational models need to be more precise and forecasting should be done by taking sufficient amount of data, and if data is not available i.e in case of derivatives then unreliable forecasting should not be made and even the financial instrument with high risk and low data should be banned from financial system.Black-Scholes equation has no flaw,though many went against it and it should be used within its underlying assumptions and limitations.Mathematical models do give accurate results and a bit of error is always involved and only more research can decrease it but the use of Gaussian curve in calculation of complex derivatives and other financial instruments should be banned and other relevant models and distributions should be used(this is a new research field for Probability Theory experts i.e to advance the work of Benoit Mandelbrot). Oliver Blanchard, the chief economist of IMF stated that the Crisis will last for a decade and argues that for supply-side reasons(after the Crisis), government spending should go towards financial infrastructure projects, not cash handouts.

Oliver Blanchard