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Home » Opinion » Foreign Views
Fiery high-risk rings lure reckless bankers
February 6, 2009, Friday
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WHAT was the true cause of the worst financial crisis the world has seen since the Great Depression?
Was it excessive greed on Wall Street? Was it mark-to-market accounting?
The answer is none of the above, says Jeremy Siegel, a professor of finance at Wharton.
While these factors contributed to the crisis, they do not represent its most significant cause.
Here is the real reason, 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."
Speaking in Philadelphia on January 20, Siegel, author of "Stocks for the Long Run and The Future for Investors," provided a detailed analysis of the factors that fueled the worldwide financial meltdown.
Explaining his theory further, Siegel pointed out that many troubled banks and insurers continued to prosper in almost every other aspect of their businesses right up to the 2008 meltdown.
The exception was the billions of dollars in mortgage-backed securities that they bought and held on to or insured even after US home prices went into a free-fall more than two years ago.
American International Group (AIG), the insurer that received an US$85 billion federal rescue package last September, is a prime example. Some 95 percent of its business units were profitable when the company collapsed.
"AIG has 125,000 employees," Siegel noted. "Basically, 80 of them tanked the firm. It was the New Products Division, which had an office in London and a small branch office in Connecticut (US state). They came up with the idea of insuring mortgage-backed assets, and nobody at the top decided it wasn't a good idea. So they bet the house - and the company went under."
Siegel said that in many important measures, the economy is not nearly as battered as it was during the early 1980s, when unemployment, inflation, and interest rates were all considerably higher than they are today.
Stocks - as evaluated by their price-to-earnings ratios - are undervalued to the point where they could draw enough investors to spark a recovery before the end of 2009.
"I'm actually an optimist," said Siegel. "I think by the second half of this year, things might turn around faster than people are now predicting."
While angry investors and taxpayers are anxiously looking to assign blame for the current state of the economy, it's important to know not only which factors led to the meltdown, but which ones did not.
He said that government programs encouraging home-buying by low- and middle-income families and short-selling of financial stocks - which was halted for a time last fall - have little to do with the crisis on Wall Street.
Instead, 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.
Their faulty reasoning was that the inability of homeowners to pay their mortgages - and the consequent foreclosures - would not pose a threat to their mortgage-backed securities.
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 said he and others have wondered why firms like Lehman Brothers, Bear Stearns and Morgan Stanley - which survived the much more severe Great Depression of the 1930s - collapsed during 2008.
One reason, he suggested, might be that, back then, these firms were organized as partnerships. In such an organizational structure, the partners would have to risk their own capital.
When the partnerships were reorganized as widely held public companies, however, they no longer had such constraints.
"Back when it was a partnership, you had your life invested in that company," said Siegel, noting that banks also began making higher-return but higher-risk investments in recent years as public ownership increased.
Keynesian plan
According to Siegel, monetary policy has failed to stimulate the US economy. The US faces a situation similar to what happened in Japan during the 1990s when interest rates of zero could not revive the country's moribund financial markets.
The only viable solution now open to American policy makers is Keynesian fiscal policy, a stimulus program that lowers taxes or increases government spending or both.
Indeed, this is exactly the type of program - costing at least US$825 billion - that the Obama administration and Senate Democrats are considering.
Siegel said that policymakers should not worry about the impact on deficits; it is large, he added, but not dangerously so.
(Reproduced with permission from Knowledge@Wharton, http://knowledgeatwharton.com.cn. Trustees of the University of Pennsylvania. All rights reserved.)
Was it excessive greed on Wall Street? Was it mark-to-market accounting?
The answer is none of the above, says Jeremy Siegel, a professor of finance at Wharton.
While these factors contributed to the crisis, they do not represent its most significant cause.
Here is the real reason, 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."
Speaking in Philadelphia on January 20, Siegel, author of "Stocks for the Long Run and The Future for Investors," provided a detailed analysis of the factors that fueled the worldwide financial meltdown.
Explaining his theory further, Siegel pointed out that many troubled banks and insurers continued to prosper in almost every other aspect of their businesses right up to the 2008 meltdown.
The exception was the billions of dollars in mortgage-backed securities that they bought and held on to or insured even after US home prices went into a free-fall more than two years ago.
American International Group (AIG), the insurer that received an US$85 billion federal rescue package last September, is a prime example. Some 95 percent of its business units were profitable when the company collapsed.
"AIG has 125,000 employees," Siegel noted. "Basically, 80 of them tanked the firm. It was the New Products Division, which had an office in London and a small branch office in Connecticut (US state). They came up with the idea of insuring mortgage-backed assets, and nobody at the top decided it wasn't a good idea. So they bet the house - and the company went under."
Siegel said that in many important measures, the economy is not nearly as battered as it was during the early 1980s, when unemployment, inflation, and interest rates were all considerably higher than they are today.
Stocks - as evaluated by their price-to-earnings ratios - are undervalued to the point where they could draw enough investors to spark a recovery before the end of 2009.
"I'm actually an optimist," said Siegel. "I think by the second half of this year, things might turn around faster than people are now predicting."
While angry investors and taxpayers are anxiously looking to assign blame for the current state of the economy, it's important to know not only which factors led to the meltdown, but which ones did not.
He said that government programs encouraging home-buying by low- and middle-income families and short-selling of financial stocks - which was halted for a time last fall - have little to do with the crisis on Wall Street.
Instead, 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.
Their faulty reasoning was that the inability of homeowners to pay their mortgages - and the consequent foreclosures - would not pose a threat to their mortgage-backed securities.
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 said he and others have wondered why firms like Lehman Brothers, Bear Stearns and Morgan Stanley - which survived the much more severe Great Depression of the 1930s - collapsed during 2008.
One reason, he suggested, might be that, back then, these firms were organized as partnerships. In such an organizational structure, the partners would have to risk their own capital.
When the partnerships were reorganized as widely held public companies, however, they no longer had such constraints.
"Back when it was a partnership, you had your life invested in that company," said Siegel, noting that banks also began making higher-return but higher-risk investments in recent years as public ownership increased.
Keynesian plan
According to Siegel, monetary policy has failed to stimulate the US economy. The US faces a situation similar to what happened in Japan during the 1990s when interest rates of zero could not revive the country's moribund financial markets.
The only viable solution now open to American policy makers is Keynesian fiscal policy, a stimulus program that lowers taxes or increases government spending or both.
Indeed, this is exactly the type of program - costing at least US$825 billion - that the Obama administration and Senate Democrats are considering.
Siegel said that policymakers should not worry about the impact on deficits; it is large, he added, but not dangerously so.
(Reproduced with permission from Knowledge@Wharton, http://knowledgeatwharton.com.cn. Trustees of the University of Pennsylvania. All rights reserved.)
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