I was watching the BBC documentary “The Love of Money” which covered the financial crisis. So far, I think this documentary offers the best inquisition to the unforgettable event. In this post, I attempt to bring the gist of it to you.
Swiss cheese
Before we go onto the crisis, we shall examine the concept of human error. James Reason derived the “swiss cheese” as a model to explain how accidents happened. I remembered watching National Geographic’s “Seconds From Disaster” and it shows that accidents are never caused by one factor. Accidents happen because there is an alignment of several factors and the fusion of these factors created the accidents. If any of the factor was not present, the accident will not occur. This is what Reason is saying with his Swiss Cheese concept. Looking at the picture, the holes of the individual pieces of cheese must be aligned in order for the event to go through. If one of the cheese is not in line, the event will be “stopped by that piece of cheese”. Likewise for financial crisis, it is a series of factors that created it, not one person and definitely not one bank.
The hole in the first piece of cheese: Deregulation
The American government kick-started the growth of this crisis by creating a favorable environment for it. For the past 20 years, the American economic policies were made by Alan Greenspan, who’s central belief is that market works best on it’s own. Hence, the American government deregulated the market and the idea of free market was realised. This created a great boom to the American economy, leaving other countries in envy of her rapid and successful development. After the crisis, Greenspan acknowledged his idealogy was wrong, as he mentioned during the testimony, “I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms.” But the feedback given to him was the opposite. America was successful under the free market system and the truth was hidden from everyone for 20 years. Greenspan said, “You know, that’s precisely the reason I was shocked, because I have been going for 40 years or more with very considerable evidence that it was working exceptionally well.” Talk about long term effects. This is a black swan in hiding and having the last laugh.
The hole in the second piece of cheese: Oversupply of money
Kept interest rates too low too long: The Fed was also criticised for keeping interest rates too low and for too long. After the Sept 911 attack, the Fed decrease the interest rate to as low as 1% to give the economy a lift. It stayed at this rate till mid-2004. This period would have promoted banks to lend recklessly and firms to over-borrow, without keeping risks in check.
One effect of globalization and cheap money: The rapid rise of China destabilised the already shaky American economy. China was making goods and exporting to many countries in the world. It became the factory of the world. The Chinese went to invest in US and their banks with the surplus money they earned. With this influx of money, the American banks have to find people to lend to in order to profit from the capital. Money was chasing after people, urging them to overconsume.
The hole in the third piece of cheese: Greed
A Home of your Own: Instead of curbing the exuberance in the property market, the US government added fuel to the fire, urging Americans to own their homes. Bush set a goal of increasing the minority home ownership by an additional 5.5 million by 2010. Bush did not want to throw a wet blanket, which would affect the support from the Americans.
Greed, competition and subprime: Humans are greedy by nature. During the property boom, the Americans fear losing out to their friends and relatives who were moving into bigger houses. Coupled with available cheap loans, they were borrowing to own homes they cannot afford. The banks were looking agreesively for more people to lend to. They forgo credit ratings and lend to anyone that wants to take up the loan. Many of them are poor and stretched themselves to own the subprime properties. These are risky customers that would usually fail their credit ratings. Since there were no rules, banks diversified the risks by securitizing these mortgages into derivatives like Collaterized Debt Obligations and buying Credit Default Swaps (CDS) from insurers. Banks like Lehman Brothers were borrowing more and more money to invest in mortgage-related assets. Their debt gearing increased from 21:1 in 2003 to 34:1 in 2007.
The house of cards collapsed
It will be fine as long as the property prices keep going up. But this exuberance cannot be sustained. When more people began to default home loans, the dominoes started falling. Banks that recklessly lent money became dangerously exposed. Lehman Brothers whose debt gearing was too large to be contained, had to declare bankruptcy. This also led troubles to insurers who sold CDS, and AIG is one good example. The rest of the story you should be familiar with.
Greenspan: There will be more crises
Alan Greenspan said, “Crises will happen again, but it will be different. It’s human nature. Unless somebody can find a way to change human nature, we will have more crises and none of them will look like this, because no two crises have anything in common, except human nature.” Listen to him here.
You may also like:
- Downfall of Financial Giants
- My STI ETF Survived the Sub-prime Crisis
- Investing from the Money Lending Perspective
- 3 Simplicities to Financial Freedom
- Now, you can be the bank!
Discover the Secrets of Singapore Trading Gurus!
Interviews with Singapore stocks, forex, futures and options traders and trainers! This book is written for you:
- learn how professionals trade
- discover their strategies, money management and approach to the markets
- understand their stories and motivation behind trading
- know your trainers before attending their courses
{ 4 comments… read them below or add one }
Interesting , thanks. The developed world, created a monetary regime that is unstable and unsustainable. Free trade brought its own sets of benefits all over but also at the same time invented a Frankenstein of sorts. This is a bubble that took 40 years to break. Leverage, asset bubbles are just the consequence of the present monetary regime. The present monetary regime is not ‘flexible’ enough to defuse imbalances. If the renmimbi were to be floated right now, instantly it will trade higher and that will have repercussion over China’s competitiveness. That will limit the size and speed in which it can grow. It will act as a release valve. Unfortunately, that’s not the case right now. And as one asset bubble deflates (in U.S., EU, UK) another develops somewhere else. We can’t build on a foundation that is flawed if we have the betterment of future generations in mind.
Interesting , thanks. The developed world, created a monetary regime that is unstable and unsustainable. Free trade brought its own sets of benefits all over but also at the same time invented a Frankenstein of sorts. This is a bubble that took 40 years to break. Leverage, asset bubbles are just the consequence of the present monetary regime. The present monetary regime is not ‘flexible’ enough to defuse imbalances. If the renmimbi were to be floated right now, instantly it will trade higher and that will have repercussion over China’s competitiveness. That will limit the size and speed in which it can grow. It will act as a release valve. Unfortunately, that’s not the case right now. And as one asset bubble deflates (in U.S., EU, UK) another develops somewhere else. We can’t build on a foundation that is flawed if we have the betterment of future generations in mind.
“Alan Greenspan said, “Crises will happen again, but it will be different. It’s human nature…”
there you are, markets are nothing but human nature in action.
know yourself, know the market, you will “win all trades”.
“Alan Greenspan said, “Crises will happen again, but it will be different. It’s human nature…”
there you are, markets are nothing but human nature in action.
know yourself, know the market, you will “win all trades”.