Thursday, January 22, 2009

Lesson One: What Really Lies Behind the Financial Crisis? - Knowledge@Wharton

It is a simple rule, but like many other rules, there is a great temptation to break it. If you are a financial intermediary you should not take positions (i.e. buy and hold), but merely work as a conduit. You make your profits on transactions not market moves. A mental literature review of this idea goes back at least to Hasbrouck and Sofianos (1993) and Madhaven and Sofianos (1998). (True they were writing about specialist firms but the point is the same.

Why is it worth noting today? Because as Jeremy Siegel noted recently not abiding by the "rule" got many financial giants into a whole heap of trouble.

From Knowledge@Wharton:

Lesson One: What Really Lies Behind the Financial Crisis? - Knowledge@Wharton:
"According to Siegel: Financial firms bought, held and insured large quantities of risky, mortgage-related assets on borrowed money. The irony is that these financial giants had little need to hold these securities; they were already making enormous profits simply from creating, bundling and selling them. 'During dot-com IPOs of the early 1990s, the firms that underwrote the stock offerings did not hold on to those stocks,' Siegel says. 'They flipped them. But in the case of mortgage-backed securities, the financial firms decided these were good assets to hold. That was their fatal flaw.'"

The article, based on a presentation Siegel made as part of Wharton's series on the finacial crisis, went on to include these points:

CEOs needed to understand the risks their firms were taking:
"Siegel pointed to two interlocking issues: One is a massive failure, not only by traders, but by CEOs of financial firms, their risk management specialists and the major rating agencies to recognize that an unprecedented housing-price bubble began building after 2000....They believed that as long as home prices kept rising, the underlying value of the real estate would provide a hedge against the risk of such defaults. They failed to realize that this reasoning was based on the assumption that home prices would go in just one direction -- up. In fact, these assets became enormously risky once the housing bubble burst and home prices began their inevitable decline. Siegel also argued that ultimately, the buck stops with corporate CEOs who didn't ask hard enough questions about the risks posed by mortgage-backed assets."
He also had criticism for The Fed (and particularly Greenspan)
""[Greenspan was] the greatest central banker in history -- he had access to every piece of data," Siegel said. "He could have looked at the balance sheets of Morgan Stanley or Citigroup and said, 'Oh my God -- they didn't neutralize their risk.'"'

No comments: