The most recent financial crisis was an all encompassing meltdown that affected the entire global economy. It is nearly impossible to quantify the distress this crisis put on the American economy and the world has yet to see the long term damage. After any disaster, people are eager to point fingers. This financial meltdown was no different, as critics were quick to blame anything and anyone from Wall Street to fair value accounting. It’s hard to pinpoint exactly what caused the most recent financial crisis, and even time may not tell.
Economists are still trying to figure out why the stock market crashed in 1929, and Ben Bernanke recently stated “to understand the Great Depression is the Holy Grail of macroeconomics. ” (Bernanke) Most of the discussion aimed at identifying causes of the crisis is focused on the financial structure of our economy. This has led to incongruent conclusions by many financial experts. It may be more important to direct attention to the social mechanisms that could have influenced not only this most recent crisis, but also the stock market crash of 1929 that threw the United States into the Great Depression.
While these two crises have their differences, at the very core we can find striking similarities. Both the state of the economy and pre-crisis attitudes and behaviors are similar in the two meltdowns that are separated by nearly a century. After seeing the devastation that these attitudes and behaviors caused in the 1920s, it can only be described as a social phenomenon that we allowed the recent financial crisis to occur. One of the most notable factors seen in behavioral and social mechanisms that led to the crises is greed.
Instead of choosing to learn from past mistakes, the economy and its willful participants, blinded by greed, happily succeeded in repeating the past. In addition, some mistakes may never be learned from if the government continues to bail out large public corporations. The repeat in financial catastrophes can be summarized with a quote by George Santayana that says, “A man’s memory may almost become the art of continually varying and misrepresenting his past, according to his interests in the present”. Consumer Confidence
Booming economies characterized by tremendous growth, optimism and prosperity characterized the time periods leading up to both the 1929 Stock Market Crash and the Global Financial Crisis. During the Roaring 20’s, the invention and widespread use of electricity and radios by average citizens was an indicator of economic growth. Gross National Production was growing at a steady rate and stock prices were ever rising. In post-war America, industries that had been expanded to accommodate war time production thrived and produced large amounts of capital (Taylor). This increase in capital led to an increase in investment in the stock market.
It became easier for middle class Americans to own stock. It seemed that times could only get better and a 1929 Business Week article predicted an upswing in the summer of 1930 (James). The 2000s boasted similar attributes with increased home ownership, an increase in spending, a decrease in unemployment and a rise in the value of real estate. Investor confidence was at an all time high. The number of homeowners soared to a percentage the nation had never seen, and investors were looking for ways to capitalize on the seemingly ever expanding real estate market. A Conflict of Interest
If there was any indication that the markets would fail during either time period, it didn’t show in the asset prices being traded. Stock prices rose from 1925 until the third quarter of 1929. Furthermore, credit rating agencies such as Moody’s and Standard and Poor’s downgraded less corporate bonds in 1929 and 1930 than before 1921, or after 1937 (James). The credit ratings issued by these agencies take into consideration the issuer’s creditworthiness. The large volume of high ratings gave investors no reason to believe that they had taken on more risk than was reasonable.
Similar good ratings were given to collateralized debt obligations (CDOs) that were sold to investors in the 2000s. These ratings were trusted by investors and fueled the sale of additional CDOs. Credit rating agencies have a fiduciary duty to the public to evaluate debt instruments without bias and with due diligence. A conflict of interest arises however because they earn their revenues from the issuers whose financial instruments they rate. The issuers have the ability to pick and choose their credit rating agencies, most likely based on their willingness to give a favorable credit rating.
In other words, it’s in the best interest of the credit rating agency to give favorable ratings in order to receive revenue. With an increase in bonds, and mortgages in 1929 and 2007 respectively, there was more profit to be made and credit rating agencies wanted their cut. Risky Credit Practices With increased capital and soaring investor confidence, both eras saw an increase in lending on credit. In 1929, “buying on margin” became very popular. Average investors wanted to get their share of the profits being made in the stock market and would find a stock broker to lend them money to increase their ownership.
Sometimes brokers would require 50% down payment by investors and riskier ones only required 25%. Investors would put up the margin capital and the broker would put up the remainder (Bierman). Brokers would then collect a fee on borrowed money. There was no regulation on margin buying, so setting margins was left to the broker’s discretion. As stock market prices rose, everyone was happy. Brokers didn’t mind lending out the money to investors regardless of their ability to pay it back, because if they couldn’t make their payments, they would just sell the stock which would probably have increased in value.
Brokers were earning their fees, and lending to more investors, while investors were seeing an increase in the value of their portfolios. An increase in value of a portfolio however does not lead to an increase in wealth. More importantly, the increase in value of a portfolio does not lead to an increase in liquidity. In fact, investors and brokers were dangerously ignoring the perils of illiquidity in their quest for profits. In the early 2000s, the Federal Reserve set the interest rate at 1% in lieu of the dot com bust to stabilize the economy and there was a large inflow of foreign capital.
Banks and investors alike were looking for a way to make a profit, and the real estate market seemed like a prime candidate. Similar to stock brokers in the 20th century, lenders were quick to grant mortgages to qualifying homeowners to make a profit upon sale of the mortgages to investment banks. Banks then grouped these mortgages into collateralized debt obligations and sold them to investors. Similar to the lack of regulation on margin levels, banks were allowed to measure their own risk and set their own capital requirements.
Because these new CDOs and financial instruments were so complex, they used Value at Risk to evaluate risk and set capital requirements on historical statistical data (Crotty). Eventually, qualifying homeowners were hard to find and sub-prime lending became the new practice. Sub-prime lending allowed un-creditworthy individuals to become homeowners. Similar to 1929 stock broker attitudes, the banks thought if these sub-prime borrowers couldn’t make their mortgage payments, they would just sell the houses and collect their money back.
After all, the housing market was booming and housing prices were always increasing. The Meltdown The assumption made by both stockbrokers and investment banks that these collateralized assets would increase in value forever was irrational. These “financial experts” were so blinded by greed and their ability to turn an easy profit that they didn’t contemplate the long term effects and consider that these new practices would not be sustainable. Taking money from the average investor and investing it in risky financial instruments or in unstable markets became the norm.
Increased leveraging had created financial monsters. Innovation in financial instruments and practices created volatility in the market that the economy hadn’t seen before. When the stock prices fell in 1929, investors’ payments due to their brokers far exceeded the value of their stock portfolio (Taylor). Ultimately, stock prices decreased below the margin and even after selling the stock, investors still had to pay more to make up for the original money loaned to them. Every investor that was underwater on their stock prices had to withdraw from their banks the money they owed.
Banks however, had also invested in the stock markets and even with a diverse portfolio, they substantial losses. The combination of huge losses by banks and investors and citizens trying to withdraw their money caused the financial system to be brought down to the brink of near destruction. In 2007, when real estate values plummeted, homeowners started to default on their mortgages, selling their houses back to the bank and leaving banks with basically worthless real estate. Even qualifying homeowners defaulted on their mortgages when the value of real estate dropped so low that their payments in total were worth more than their houses.
Banks were illiquid and unable to pay back the money they had borrowed to leverage these investments. Several of Wall Street’s biggest investment banks were about to fail (Jarvis). Government Intervention A huge indication of the severity of an economic crisis is the government’s response. The initial government reaction is typically modest, but as the crisis becomes increasingly more damaging and more difficult to ignore, the government’s response becomes much broader. Following the Great Depression, governmental intervention came in the form of widespread economic relief programs.
In contrast, today’s crisis was heavily concentrated in the banking sector and when some of the biggest bank’s neared bankruptcy, the government responded by pumping billions of dollars onto their balance sheets. For decades, critics have argued about whether governmental intervention benefits or exacerbates these crises. The phase of government programs following the Great Depression were intended to create jobs and economic activity. The effects of the Depression were so widespread that government stimulus packages could not be concentrated in a single industry or economic sector.
It would be incorrect to label these programs as government bailouts although the government did initially respond to the crisis by granting massive loans to railroad companies in the 1930s. In FDR’s Folly, Jim Powell presents a critical assessment of the risks of accepting governmental solutions to social problems and how these programs prolonged the Depression. The bailout of Lockheed Aircraft Corporation in 1971 paved the way for present day bailouts. It was the first bailout of a public corporation and following this event it seemed like no more than a few years passed by before the government was bailing out yet another public company.
Only two decades later, the grandfather of all government insurance payouts occurred during the Savings and Loans crisis. Barry Ritholtz scrutinizes the evolution of these corporate bailouts in his novel, Bailout Nation. He also evaluates the effects of the government bailouts on both corporate executives and individual investors. These bailouts led to a marketplace that he describes as being consumed by moral hazard—“the belief that you won’t bear the full consequences of your actions”.
The government intervening and saving bankrupt corporations proves that excessive risk taking is rewarded and provides more incentive to investors who choose to take on extreme risk. Free market theories, including the efficient market hypothesis, argue that the markets should be left to function alone and then crises and bailouts would be minimized (Crotty). Critics of EMH and other free market theories assert that the theories are founded on unrealistic assumptions. Regardless of which argument one chooses, this is one history lesson that cannot be learned from because many public corporations have not been left to fail.
Auditor’s Role in the Crises Auditors are an easy target when looking for whom to blame after any individual corporate failure or after an entire industry wide breakdown, such as the aftermath of the credit crisis. They work closely with the management of large public corporations and theoretically should gain an objective assessment of management’s practices. The profession is regulated by the Securities and Exchange Commission, a governmental entity, and is overseen by the Board of Directors of large public companies, comprised mostly of industry specialists and financial experts.
It is the accounting company’s assurance that the financial statements are fairly presented that gives confidence to prospective investors. The predominating issue surrounding the accounting profession’s role in today’s crisis is concentrated around fair value accounting rules. Fair value accounting, or mark-to-market accounting, requires valuing assets at current market prices. Critics argue that recently, mark-to-market accounting has caused excessive write-downs on bank’s balance sheets, which has intensified the severity of the financial crisis.
Fair value accounting has been described as creating a risk contagion effect. This means that the consequences of asset write-downs spread among multiple firms because of the complex structure of the financial debt instruments being used. One study investigated the risk contagion effect and concluded that it is worse when a higher percentage of the bank’s total assets and liabilities are valued using fair value (Kahn). Contrastingly, during the Savings & Loans crisis, all assets were valued at historical cost. From a lender’s perspective, the value of a loan is inversely related to interest rates.
When interest rates rose dramatically in the 1970s, the market value of the loans decreased but the historical value remained unchanged, and no losses were reported unless the loans were sold. This accounting treatment was unsuitable in the long run, however, because the losses on loan values ultimately translated into operating losses (Clikeman). A lesson can be learned by comparing the different crises. In both, the accounting methods were blamed, but historical cost accounting and mark-to-market accounting both produced unfavorable outcomes.
That is because it is not the accounting methods used, but rather the unseen economic factors, such as soaring interest rates or the risky lending practices to unsuitable borrowers, that exacerbated the crises. It is strongly debated whether or not accounting practices increased the severity of the crises, specifically through asset valuation on large corporation’s balance sheets. A phenomenon that is not as widely discussed is whether there are social mechanisms surrounding the accounting profession that lead to investors accepting greater risks.
Independent auditor’s attest to the financial statements based on accounting standards developed by the FASB. The scope of an audit engagement is to conduct the audit in accordance with GAAP and to identify any material misstatements in the financial statements. When auditors must use personal judgment during an engagement, it is still ultimately dictated by GAAP. The average investor may incorrectly assume that because a large public accounting firm’s signature appears on the statements, that the statements are perfect.
Auditors do their job by performing due diligence, but investors should still be more invested in understanding where their money is going and how much risk they are assuming. A clean audit opinion or a signature from a Big 4 firm could perhaps lead investors to believe that they are shielded from more risks or uncertainties than they actually are. Summary As explored above, there are several people that could be blamed for the most recent financial crisis. Investment banks, credit rating agencies, and investors all are viable candidates.
One thing all three have in common is that they were all taking on great amounts of risk to turn a profit. America was built on the foundations of hard work and ambition but there is a fine line between ambition and outright greed. It is clear that the invisible hand ideology has been disproven by both the Stock Market Crash of 1929 and the recent global financial crisis. In our society, individualism is rewarded. People strive to succeed for their own benefit. These individuals that are driven to succeed are the backbone of our country and what allow us to be an economic superpower.
It is impossible to learn from mistakes in the past when one is blinded by greed. With economic fluctuations and market players always finding a way to make a short-term profit, crises follow a similar cyclical pattern. We are likely to see another stock market crash or financial crisis in the future, in fact, it’s almost certain. Ultimately the underlying factor in each of these crises is greed, and these instances of financial turmoil are almost inevitable unless you can altogether eliminate greed in the marketplace.
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