The financial panic of 2007-8 should have been one of the great learning experiences of our collective lifetimes.
The first thing we can learn is that financial panics have a long heritage. Between Western Europe and the U.S. alone we have more than 200 years of examples to work with. And we can see that panics are always the result of a confluence of factors, which come together at just the right moment in history, build on one another and overwhelm those forces that maintain economic sanity.
In other words, no single factor is sufficient to create a panic; they all have to be present at the same time.
At its base the '07-08 panic was the bursting of a credit bubble. In this case, a huge amount of money was lent to an enormous number of borrowers who could not be expected, under any rational analysis, to pay it back out of cash flow. Most of these borrowers were residential homebuyers or homeowners, but some were buyers of commercial real estate and others were leveraged buyers of commercial enterprises.
So we know what happened, but why did it happen? If we recognize that the credit quality of many of the borrowers was so obviously low, we have to ask why so many lenders were willing to lend anyway, in volumes that could never be justified.
One explanation has been that so many loans were packaged, sold and resold that the eventual lenders lost sight of the quality of the underlying credits. But that explanation ignores the basic assumption that even the final lender — the buyer of that last in a string of collateralized debt obligations — should still require the same comfort that his money will be paid back. The fact that so many lenders abdicated their obvious responsibility to perform some due diligence should lead us to examine the factors behind this bubble.
One factor was what has become known as the agent-principal conundrum, or the divergence of incentives between the management (the agent) and the stockholders (the principal) of a company.
In financial services as a whole, and the credit arena in particular, the agent-principal conundrum takes on a life of its own. This is because finance businesses are all about risk: assessing it, taking it on, laying it off, getting paid for it, parsing it, modifying it. As we have seen across the finance business, creating assets (i.e., lending money) doesn't mean that you will be able to close them out (i.e., be repaid). So risk tremendously complicates the agent-principal conundrum in finance.
Financial firms booked large up-front profits for creating assets, while their traders, originators, salespeople and managers were richly rewarded out of those profits. The risks were never measured or used to offset the declared profits.
The agents walked away with handsome remuneration, while the principals either saw their valuations drastically reduced, or lost their investments entirely. We should additionally recognize that the agent-principal conundrum applies to the end buyers of credit assets as well as the creators, although here the principals were the institutional investors and the agents were the asset managers.
Another factor was the widespread belief that markets are essentially self-regulating. In other words, left to do business without much regulation, the markets would serve all constituencies equally well.
Actually, history has shown unequivocally that: (1) market insiders routinely have more and better information than market users, (2) market insiders routinely use their information advantage to generate profits at the expense of market users, and (3) market users that are categorized as professionals routinely have information disadvantages similar to those of nonprofessionals, albeit perhaps to a smaller extent.
If only the creators of complex credit securities understood the real risks, and if some of the structures served to obscure that very credit risk, it shouldn't surprise us that the purchasers remained largely ignorant of the credit quality of what they were buying. Nobody had a positive obligation to figure out the quality of the securities except for the rating agencies, and they had their own agent-principal conundrum. Specifically, the rating agencies were paid by the issuers, not the investors, to rate the securities.
But having agents paid on short-term profits without regard for long-term risk, and having a market where regulators expect investors to look after themselves under an information disadvantage isn't enough to create a bubble. It's enough to enable one, but any bubble needs an engine, a source of energy to get the values or transactions into the stratosphere. In the recent panic, the energy was supplied by an unusual source — the Federal Reserve. By following a 10-year policy of monetary stimulation, the Fed created an environment where lenders were flush with money — money that had to be lent.
So the lenders sitting on this credit pipeline bursting at the seams went looking for assets they could lend on; large assets where they can lend relatively large amounts at relatively high rates. Where can you readily find large loans at relatively high rates and in good numbers? Residential real estate, commercial real estate and leveraged buyouts.
Where did the credit bubble concentrate? Residential real estate, commercial real estate and leveraged buyouts.
Standing at the dawn of 2011, how can we apply what we have learned about bubbles and panics? The first lesson is not to let the engine over-rev or run too long.
But what about the enablers?
The problem is that all the enablers benefit someone. Every time we find a way to disassemble an enabler, someone points out that the very same function enables some other social benefit, or would be very expensive to implement.
We have to be able to detect when those claims are valid and when they are self-serving, and we have to be able to weigh the costs against the benefits of each change.
Unfortunately, the recent elections seem to have set us back in dealing with the enablers.
For example, Rep. Spencer Bachus, the incoming chairman of House Financial Services Committee, has said " … my view is that Washington and the regulators are there to serve the banks," and the incoming House overseer of the Federal Reserve has said, "The market is a great regulator, and we've lost understanding and confidence that the market is probably a much stricter regulator."
With that thinking in Washington, we can only watch and wait for the next bubble, and the next financial panic.
