Introduction
The biggest equity bubbles and subsequent market crashes in the 20'th century were:2) 1965 post-WWII crash in USA
3) 1989 Japan equity market crash and the following 15 year slump
Before I proceed to the causes of the financial meltdown I would like to use a metaphor to describe the current situation. The heart is not pumping strong enough. The blood circulation slowed down. The patient is almost unconscious. We need to get the blood circulating again. As a first step towards recovery we need to accelerate the circulation of money. The stimulus spending by the government is not enough. The circulation rate (velocity) of money will pick up only when the credit reaches the consumer again. The credit markets will be fundamentally different in the new economy but independent of the credit markets there has to be a sound mechanism to provide credit to the average income earner.
Factors Contributing to the Global Financial Meltdown
Brokers provide leverage to traders and money management firms. The institutions providing leverage to others were not supposed to be leveraged but they were. Just to name one institution, Lehman Brothers was leveraged by a factor of 35 before its bankruptcy.
The Fund-of-Funds are not supposed to be leveraged because they invest in other hedge funds that are already leveraged. The sad fact was that the Fund-of-Funds were leveraged. The traditional banks are not supposed to be leveraged but they were leveraged as well.
USA Borrowing Too Much and Other Excesses
USA government was borrowing too much and Americans were addicted to the higher standard of living. The total gross debt will exceed 10 trillion dollars in 2010. We also had excesses in the money supply and loan growth.
US budget deficits are mostly financed by the Chinese government. Comparison of China and US in terms of percentage of GDP spent on capital improvements and percentage of GDP spent on internal consumption: US 19%, %70, China 39%, 37%.
Mispricing of Risk
There was also a belief that if you took larger risks you would automatically receive more reward. This may be true in normal markets but it is not true in the markets where risk is mispriced. In the years leading to the 2008 financial meltdown the risk was under priced. Many blame the quants (quantitative analysts in the financial industry) for this mispricing. The fact is that many quants and economists warned the business leaders about the possible mispricing of risk in the market but the business leaders did not listen to them.
Career Risk and Timing Problem
Business people who saw it coming still had to go with the flow and play the game. Reducing leverage, or changing the risk limits would have cost them their careers and jobs. They experienced this during the dot-com bubble. Everyone knew that the dot-com bubble was going to burst someday but everyone kept buying those dot-com stocks until the bubble burst.
Even the economists like Nouriel Roubini who kept saying that the bubble was forming and it was going to burst could not guess the timing of the burst. I would like to remind you that Ravi Batra actually saw this coming 20 years ago but he was completely wrong about the timing as well. In my opinion Ravi Batra deserves a lot of credit for his foresight.
Nobody Knew the Size of the Bubble
Nobody knew the size of the problem, let alone the timing. Only governments have the tools to estimate the size of the bubble but they refrained from interfering because governments and politicians want to give the impression that they are the engineers of wealth creation.
Systemic Weakness for Bubble Formation
Politicians are unwilling to deal with bubbles as they form. We understand this. They want to be re-elected and they play down the excesses in the financial system. In addition to the political weakness there was a systemic weakness against the formation of bubbles. There was a lack of oversight and regulation.
Unregulated CDS Market
As an example we can mention the CDS (Credit Default Swaps) market. The CDS market was totally unregulated which was a very dangerous situation. This was probably the biggest contributing factor to the financial meltdown.
Massive Securitization
Derivatives based on the US Housing Prices
Various options and other derivative contracts were written based on the housing prices. As long as the housing prices were increasing these derivative contracts were generating huge paper profits. When the housing price increases decelerated and finally reversed the derivative contracts (toxic papers) blew up.
Before the meltdown the US housing market prices were at least 30% above the previous very stable trend. The US housing prices are now reverting to normal. When the housing prices reverted to the mean the prices of the housing derivatives collapsed to zero, triggering massive financial earthquakes.
Tightly-Coupled Economies
Bubble was Global
The excesses existed in European economy as well. The bubble in the housing prices was a global phenomenon.
Asymmetrical Compensation of Money Managers
Typically money managers earn a percentage of the profits. If the account he is managing makes 100 million dollars profit he may get between 10-20% of the profit. When the account shows 100 million dollars loss he does not lose any money from his pocket. He may lose his job but he does not have to pay the 10 million dollars he earned the previous year back to the firm. This is known as the asymmetrical compensation of money managers. This encourages the money managers to take bigger risks because the risk-reward equation is very asymmetrical. The effect is magnified by the behavior of thousands of money managers in the market.
Non-Bank Players
Compared to the other crashes, this time the Hedge Fund industry is huge. Redemptions from the hedge funds were a contributing factor to the meltdown. Previously we used to talk about run-on-the-bank, now we have a new concept: run-on-the-hedge-fund.
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