Monday, December 1, 2008

Top Financial Mistakes

It's easy to be wise after the event. But, it is important to be aware of the many mistakes that were made in creating the current financial crisis. These are some of the biggest problems of the past decade.

Extravagant Mortgages
  • 100% Mortgages. The hope of 100% mortgages is that rising house prices would effectively create a deposit. Of course, when house prices are rising, this is fine. But, when house prices are falling it creates negative equity, meaning any home repossession leaves banks with large losses.
  • Mortgages 6, 7 or even 8 Times salary
  • Interest Only Mortgages with no repayment strategy
  • Adjustable Rate Mortgages which promise low rates initially, but, become very expensive after 2 years. In America in particular, these ARM mortgages were sold often with little explanation of how mortgage costs would rise.
The Assumption of Permanently Rising House prices.

Housing boom and busts are common in both UK and other countries. Yet, in periods of rising house prices, people tend to become myopic forgetting prices can fall as well as rise. It is the assumption of rising house prices, which encouraged the extravagant mortgage lending.

Lack of Mortgage Regulation.

The worst example was the US subprime sector. Mortgages were approved for those who had no realistic ability to repay, even before interest rates increased and the economy declined.

Failure of Credit Ratings.

It is hard to imagine but bundles of subprime mortgage debts were given triple A ratings, just because the debts were sold onto supposedly 'safe, reputable' banks. The financial crisis showed that having a reputable name like Lehman Brothers mean nothing if your business plan was no good.

Complexity of Financial Assets
  • The complex and opaque nature of structured finance assets hid the underlying nature of risky assets. E.g. many banks said they weren't aware of how much risk they were letting themselves in for.
  • Many supposedly 'rock solid' banks got involved in buying risky mortgage bundles that they didn't either check or know what exactly were
Failure to Properly Assess Risk
  • The ease of passing on risk to other financial bodies creating poor incentives to improve welfare and ensure borrowers could repay.
  • Assessment of risk based on past behaviour allowing new practices to be ignored
  • Too much emphasis placed on erroneous credit ratings placed by credit agencies who were too close to the companies issuing debt. Many subprime mortgage debts were getting triple A + ratings.
  • Failure to assess correctly the liquidity of assets and and the assumption credit markets would always remain fully open.
Short Term Gain - Poor Business Models.
  • Too much emphasis was placed on maximising short term returns at expense of sound long term business practices. This is evident in the way many banks borrowed short to lend long. E.g. Northern Rock financed the growth of its risky but once profitable mortgage sector through borrowing on short term money markets. It is no coincidence that new banks (former building societies) like Bradford & Bingley, Halifax, Northern Rock have all suffered from the credit crunch the most. Basically, banks departed from traditional business models and engaged in more extensive lending practices to try and gain market share.
  • Growth of Financial speculation. Derivative trading is often misunderstood. But, many banks exposed themselves to precarious positions by effectively betting on the movement of share prices and other assets. Fine in booming markets, but, the activity is largely non productive and exacerbates risk.
Credit Boom
  • By focusing on inflation, monetary authorities ignored growing evidence of a credit boom, which led to asset price booms, most notably in housing.
  • Monetary Policy Too Lax. Interest rates cut in 2001, in wake of ICT recession. But, interest rates were kept too low for too long. This lax monetary policy, fuelled the credit and housing boom. For instance For instance, John Taylor [1] has calculated that applying his eponymous Taylor Rule in mid-2004 would have pointed to a Federal Funds rate as much as 300 basis points higher.

1 John B. Taylor, ‘Housing and Monetary Policy’ in Housing, Housing Finance and Monetary Policy, Federal Reserve Bank of Kansas City, 2008.

1 comment:

Anonymous said...

It may be because of my advancing years but why does everyone think that this crisis began in 90's. 100%+ mortgages were available in 80's from brokers (I had 1 to pay off ex-wife!). This crisis is a fundamental philosophical failure of 30 yrs of neoliberal economics. The cult of deregulation began with the Big Bang in 86. Please remember the full history or be condemned to repeat it.