Sure, the financial crisis seems quite abstract. Let me make it more concrete: You will have an extremely hard time finding a job after graduation as a result of the recession. Not only that, but statistics show you will probably earn less money throughout your entire career as a result of it beginning during this time. Does it sounds applicable to you?
How about a little cherry on top? If we do nothing to change the current financial system, another meltdown has a high probability of striking in the next five years. This means all junior employees who finally settled into a new job and life are probably most at risk of being laid off.
These are up for debate and the weight of each cause also is debatable. That being said, the most visible cause of the financial crisis was a housing market bubble that finally burst in fall 2008. Money was too cheap and many potential homeowners and speculators took advantage of this for a limited amount of time.
However, the blame does not lie fully with the investors. Banks took on investments they shouldn’t have by investing in intentionally overcomplicated derivatives and hedge-funds. Their decisions to lend were as ill-informed and foolish as the mortgage holders. There were even a significant amount of loan officers who took advantage of customers’ ignorance. They were able to intentionally convince people to sign loans they could not pay; either because of the financial capabilities of the customer or because of the nature of the loan itself.
Another vastly important cause of the crisis, while not as visible or simple to understand, is actually much more important. That is the growth of and lack of regulation of complex financial instruments such as derivatives. Derivatives are best summarized as an investment on an investment. They are extremely varied and can be investments in mortgages, currency values, interest rates or even soybean prices. The problem is these financial tools became more and more complicated and were regulated less and less. Just like the mortgages, these derivatives were used dangerously and foolishly and when the mortgage bubble burst, the weaknesses of derivatives became apparent. These investments gained their value from the growing housing market. When the entire mortgage system took a hit, the damage spread throughout the whole financial system because of the way in which derivatives can spread out risk through multiple investors. Unfortunately in a crisis like this, the spread-out risk merely means everyone is hurt badly.
Deregulation was most to blame. Companies were allowed to grow into titanic creatures. Financial instruments were deemed safe and too complicated to regulate. Lastly, in 1999 Bill Clinton signed into law a bill that repealed the Glass Steagal Act — a law that kept investment banks and commercial banks separate.
This meant banks can essentially gamble with your money on the financial markets. They can use your life savings for dangerous, high yield, unwise investment decisions. If you had wanted to make those dangerous investments, you wouldn’t have put your money in a commercial bank. That kind of behavior is both devious and dangerous.
In the current financial and political discourse, there are three different proposals on how to fix the risks of the financial system.
The one the bankers prefer is to leave thing the way they are. This of course means that job of your will be secure for another few years until yet another crisis ripples through the economy. That’s why I said we will probably have another crash in the next few years.
Sen. Chris Dodd D-Conn., has written a bill which seeks to restructure the Federal Reserve by giving less power to bankers and more to Washington. The issue there is, who do you trust more? The bankers who deceived you or the government that failed to regulate those bankers’ actions? Dodd’s bill also increases regulation on proprietary or “prop” trading.
Prop trading is when a bank takes your deposit money and trades it for other investments for bank profit. This may sound like what banks do already, but prop trading is different in that your money isn’t used to make loans. Instead your money is used the way an investment bank would use it. The bank uses your money to buy bonds, gamble in the stock market, buy complicated and dangerous derivatives, etc.
The plan by Paul Volcker, Economic Recovery Advisory Board chairman, while being the most radical, is the one that has the best chance of fixing the system. It addresses two major issues that contributed to the crisis and potential dangers of future crises.
First, Volcker’s plan takes a much harder line on prop trading. While Dodd’s plan places more regulation on prop trading, Volcker’s proposal attempts to put a complete stop to this activity. The advantages of this are simple, regulation of complex financial instruments is not always effective and bankers can get around regulation. So why allow banks to make these unnecessary investments in the first place?
The second is the “too-big-to-fail” mentality of certain financial institutions. If an institution is big enough, then its failure will inevitably lead to a depression. No governmental leader can admit to allowing a depression to happen, so they bail them out. With hundreds of billions of dollar of taxpayer money. Volcker’s plan gives the government power to break up these institutions into smaller, less dangerous pieces.
The troubles of the last financial crisis are far from over. We have still not recovered. It is important that we take action to prevent future crises before the wounds heal and we forget how bad this recession truly was.
Remember, bankers don’t get fired during financial meltdowns. You do.
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localsooner 2 years, 1 month ago
I'm not sure I understand your thesis. That the financial crisis is a mess? That some people are to blame?
If your point is that we should completely get rid of derivative financial instruments, you completely misunderstand how they can be used to offset risk.
For example, oil companies set budgets based on oil prices. If oil prices tank, these companies can be up a creek.
So they buy oil futures, which are derivatives, and the value of the derivative moves in the opposite direction of oil prices, so if they don't make as much money due to a drop in oil prices, this will be partially offset by the increased value of the derivative. This would be called an "effective hedge." These are good things.
Not all fancy, difficult to understand concepts are bad. However, if we're going to prevent this situation from happening again, a far more nuanced approach is more appropriate than a blanket ban on derivatives.
impatient_with_ignorance 2 years, 1 month ago
A great article... thanks for tackling such a complex, difficult yet crucially important topic. I think the remedy proposed by Volcker and endorsed by five former Secretaries of the Treasury is essentially to impose stringent regulations of CREDIT derivatives, rather than prohibit their regulation as we did in 1999.
@chris robertson: encouraging more market participants to "smooth out the risks" was precisely the argument made to support the aggressive marketing of increasingly complex CDOs in 2002-2007. So you're saying that worked out so well, we should do MORE of it? How does broader participation "smooth out" risks if the risks are so complex that investors cant't understand them, and the "risk models" developed by the Quants are so badly flawed they fail completely (as they just did in 2008).
Eagles101 2 years, 1 month ago
Great example of a [journalism major's] understanding of the 2008 recession and the U.S economy as a whole. First, derivatives are complex formulas used to diversify financial firms investments in order to reduce systematic risk (the unavoidable risk associated with investing).
To speak to your pessimistic 'theory' on our future jobs. Yes, with YOUR attitude YOU WILL get fired (recession or no recession). If however, you work hard and show potential to your employer, you will not get fired b/c you are a 'junior employee'..
JOHN BEST- You are terribly confused. Stop watching the Colbert report.
Chris_Robertson 2 years, 1 month ago
This is like saying we should get rid of internet stocks because of the tech bubble or banning tulips because of Dutch Tulip Mania in the 1600's. If anything we need to broaden the scope of financial markets to encourage more participants. In other words, we need to democratize markets to smooth out the risks.
dan131m 2 years, 1 month ago
For once in my life, I'd like to see an article about financial derivatives that doesn't describe them as "too complex" without any support for this statement. Allow me to describe a couple popular types of options:
(1) Put options: A put option on a stock ensures you against the price of the stock falling below a certain price. For instance, if I sell you a $5 put option on a stock, it means that if the value of the stock falls below $5, you can still get $5 back from me per share.
(2) Collateralized debt obligations (CDOs): A bunch of people get in line to make a joint investment. The interest from the investment goes to the people in the front of the line first; once they're paid off, it goes to the next people in line, and so forth. The further back in the line you are, the more risk you take; you are compensated for taking on this extra risk with large discounts.
Neither of these derivative instruments seems all that difficult to understand. Of course someone will point out that these aren't precise legal definitions of these securities, but it's not as though the technicalities here are any more complicated than for non-derivative securities, like stocks or bonds.
(Admittedly, credit default swaps are a little harder to describe to a layman, but this is primarily because they make use of some tried-and-true financial machinery borrowed from commodities futures contracts that would take a little while to explain.)
Perhaps, though, the argument is that the mathematics required to model the newer instruments are simply too complicated to understand. Indeed, several people have tried to blame the Gaussian Copula model for the crash, but I don't buy it. Yes, the copula model doesn't work the same way as, say, the sorts of models used in, say, meteorology -- it doesn't predict the future, the way a naive analysis suggests it might. However, there's another extremely well-known model with exactly the same benefits and disadvantages, namely the Black-Scholes model for equity options. The industry has been using Black-Scholes for decades, and nobody using it makes those sorts of mistakes.
impatient_with_ignorance 2 years, 1 month ago
John's article is an excellent attempt to bring attention to the causes of the financial meltdown of 2008. That the S&P 500 lost 58 percent of its value from peak-to-trough and in a very short time, makes it the worst financial crisis since 1933. None of John's critics in the posts above offer any explanation for the financial meltdown, nor any interest in identifying its causes. The idea that credit derivatives require stringent government regulation and enforced transparency, and the limitations on proprietary trading are proposals from Paul Volcker and have been endorsed by FIVE former secretaries of the treasury. That's not the Colbert report, nor are these people who could be called "confused." To say that CDOs are not complex and were understood by many who bought them is contradicted by a flood of books and articles from inside players and economists. I would suggest Richard Bookstabber's A DEMON OF OUR OWN DESIGN. And to assert that the Black-Scholes model actually works and avoids mistakes is contradicted by these recent books: THE QUANTS, THE BIG SHORT, ECONNED or the article by Haug and Taleb, "Why We Have Never Used the Black-Scholes-Merton Option Pricing Formula."