“Greed is good,” insisted Gordon Gekko in the 1987 film Wall Street. Most of us disagree. Recent events in the mortgage lending industry prove us right.
The “subprime loan crisis” has been making headlines since it began in August. It refers to the fact that a relatively high percentage of mortgages offered to people with significant probability of default have gone sour.
The moniker is a bit misleading, though. The crisis we are witnessing starts from risky loan deals but will extend to all varieties of credit and risk: consumer loans, credit cards, businesses, and so on. It is just about to heat up, but the roots of this crisis were laid years ago.
It’s a credit crisis, but credit per se is not the problem. The problem lies in how credit was traded from one hand to another on an unprecedented scale. This was done through financial innovations called derivatives.
Derivatives are contracts that allow companies to trade risks that derive from some other underlying assets. For example, a currency futures contract lets you to lock into a specific foreign exchange rate. It’s a sensible move if you trade abroad and do not wish to carry the risk of a sudden change in exchange rates.
Recent decades brought much trickier – and riskier – derivatives, such as “over-the-counter credit default swaps (CDS).” Sound complex? It is.
Credit derivatives permit lenders to transfer their credit risks (mortgage defaults) to third parties, such as hedge funds. Thus, banks can do more business. In the 1990s and 2000s, credit derivatives became a massive global gamble.
If used properly, derivatives are useful and ethically unobjectionable. They enable efficient risk allocation that benefits all parties concerned. But their abuse is a nightmare. They become a house of cards, built on greed.
Derivatives could, for instance, be used to circumvent regulations that protect investors and the public. These stakeholders lack the time or ability to track the risks taken by companies, which is why financial institutions cannot freely invest in risky asset classes. But through derivatives, many institutions made complex speculative bets without regulators catching on.
If it works, it pays off. Companies make abnormal profits and managers take huge bonuses. If it doesn’t work, someone else will usually pay the bill, such as investors and bank depositors.
Then there’s the Fed, always keen to save bankers by printing more money. The losers are the unsuspecting working and middle classes, whose savings are eroded by inflation. What to do?
One thing we need is better rules. True, we have lots of regulations in financial markets. Some are so complex that most professionals can’t follow them. Often they are equally unhelpful.
Derivatives are a case in point. After Enron, we got the Sarbanes-Oxley Act, which costs fortunes to U.S.-listed companies. Despite this new layer of regulation, abuses are rampant: massive off-balance sheet items, shadowy over-the-counter deals, unrealistic marking-to-model pricing, murky offshore special purpose entities (SPEs). Risk-hiding has become widespread, often with the explicit or tacit approval of regulators.
We need simpler rules, ones that tackle the real issues. But more than rules, we need personal conversion.
Remember Enron? “They broke the law,” people say. Well, yes. They also abused financial derivatives, SPEs, and a range of other tricks to hide their excessive risks. But what really destroyed Enron, and made it so dangerous, was its corporate culture. It was infected with institutionalized greed.
The current situation is Enron writ large. We have more derivatives, more leverage, and bigger losses. Wall Street is hardly superior when it comes to generosity and detachment from worldly goods.
The Apostle Paul identified the issue 2,000 years ago: "The love of money is the root of all evils" (1 Timothy 6:10). He concurred with Jesus, who said, "You cannot serve God and mammon" (Matthew 6:24).
The goods of this world are good. But we have to pursue them in the right order, guided by love of God and neighbor. It applies to personal life, and it applies to finance. Wisdom shuns greed. Prudence depends on the moral virtues, as Aristotle taught. Greed is like pride: It blinds.
The year 2008 will be a tough one. We may witness the largest financial crisis in history. We need to study the past to see how we got here. But more than that, we must think about the future.
In order to make finance safe for our children, we need better laws and regulations. This is hard to accomplish, however, and it’s never enough. Unless people – at least most people – are willing to do what is right because it is right, our laws will be objects of mockery and abuse.
First we need a change of heart. Perhaps we’ll then get the laws right, too.