What Causes Financial Crises?

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Accounting Management Finance Marketing Business Concept

One of the great ironies of the 2008 financial crisis is that it was sparked by a product created from a historically safe investment asset: residential mortgages. In the past quarter century, delinquency rates of single-family home mortgages hovered below 3% for the most part except for the time around the Great Recession, according to the Federal Reserve Bank of St. Louis. Then Wall Street bundled mortgages of various qualities into complex, opaque securities to be bought and sold, often using debt to turbo-charge the investment. When defaults began on Main Street, the tremors reached all the way around the world.

Today, the financial crisis seems like a footnote in history. But like other crises, it has sparked a period of soul-searching. What signs that a crisis was brewing did experts and regulators miss? Why didn’t regulatory reforms in the past prevent it? How could regulators stop another crisis from happening? What are the lessons from this and other meltdowns? These and other questions were the focus of a panel at the “Financial Markets, Volatility, and Crises: A Decade Later” conference held recently in New York by Wharton’s Jacobs Levy Equity Management Center for Quantitative Financial Research.

While this year is generally acknowledged to be the 10th anniversary of the crisis, in actuality there is “no real consensus about when it all began,” said Wharton finance professor Richard Herring, who moderated the panel. Some point to 2006 as the start, when home prices peaked, while others think it began with the 2007 collapse of two Bear Stearns hedge funds that bet heavily on subprime mortgages. Perhaps it was when BNP Paribas froze withdrawalsfrom $2.2 billion worth of funds in the same year. Still others have argued that “it was manageable until the Lehman … orderly liquidation,” Herring said. That was the start.

Whenever the crisis actually began, panelists said that it bore similarities to other Wall Street meltdowns of the past, such as the 1987 market crash and the 1998 collapse of the hedge fund Long-Term Capital Management. Time and again, the chase for a higher investment return, the creation of new, complex securities, the relative inexperience of young traders, the popularity of a new theory to make money and lagging regulations have brought the financial system to the brink.

Free Lunches and the Illusion of Safety

Bruce Jacobs, principal and co-founder of Jacobs Levy Equity Management, said that while the 1987 crash, Long-Term Capital Management and the 2008 credit crisis were different events, they had similarities. “The common theme is that the strategies promised to make investing safe,” he said. “There is an expectation of protection and safety and at the same time they were sold on the basis of higher returns. They become irresistible.” But these “free lunch strategies” later backfired.

In the 1980s, belief in a trading strategy called portfolio insurance was supposed to take out risk. The strategy called for hedging against market downturns by short-selling stock index futures. Jacobs quoted Nobel laureate Robert Merton — who co-created the famed Black-Scholes-Merton calculation to determine fair pricing for options — as saying that if one literally traded continuously, all the risk would disappear because it is being shifted to someone else all the time. But practically speaking, Jacobs said, one can’t trade continuously in practice.

Portfolio insurance also can fail. “We all know what happened in 1987 — there was a major [stock market] crash, the largest one-day decline in the history of the U.S. markets, greater than the decline in 1929,” Jacobs said. It’s fine to shift risk to someone else, providing there are “counterparties on the other side willing to buy,” he said. But as many investors tried to shift risk at the same time, they could not find enough folks to take it off their hands. “The buyers were not there,” he said. “The markets became fragile. And the decline was over 20%.”

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Author: Mark Joseph Digamon

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