The Current Financial Crisis

Lecture 8 was Contemporary International Business Issues: The Credit Crunch of 2008.

In September 2008, a global financial crisis was initiated by the bankruptcy of U.S investment bank Lehman Brothers, and the collapse of the world’s largest insurance company AIG. (BBC, 2008) The recession left 30 million people unemployed and cost the world trillions of dollars. (Pollin, 2011)

Weissman (2008) suggests that much if the blame can be put on dynamics of unregulated global financial and other markets. Since the 1980s the rise of the financial sector has led to a series of increasingly severe financial crises. Each crisis has caused more damage, while the industry has made more and more money.

After the Great Depression in America, the financial industry was tightly regulated. Most regular banks were local businesses, prohibited from speculating with depositors’ savings. Investment banks, which handled stock and bond trading, were small, private partnerships. (Thomas, 2012)

In the 1980s the investment banks went public, allowing them to get a huge amount of shareholders money. (Shleifer & Vishny, 1987) People on Wall Street started getting rich.

Also during the 80s, economists and financial lobbyists supported a 30 year period of financial deregulation. Savings-and-loan companies were deregulated allowing risky investments, using depositors’ money. Hundreds of saving-and-loan companies failed, costing taxpayers $124 billion, and cost many people their life savings. Thousands of executives went to jail for looting their companies. (Donahue, 2009)

By the late 1990s the financial sector had merged into a few enormous firms, each of them so large that their failure could threaten the whole system.

According to Willem Buiter, (2010) Chief Economist, Citigroup the firms merged together to create big banks because banks like monopoly power and lobbying power and also because they know that when they’re too big, and fail, they will be bailed.

Since deregulation began, the world's biggest financial firms were caught laundering money, defrauding customers, and cooking their books. (Rozek, 2011)

On April 22^nd, 2008, in the UK, Royal Bank of Scotland announced a write-down of £5.9bn on the value of its investments between April and June - the largest write-off yet for a British bank. (BBC, 2009)

On September 7^th, 2008, the takeover of Fannie Mae and Freddie Mac was announced, two giant mortgage lenders on the brink of collapse. (BBC, 2009) Two days later, Lehman Brothers announced record losses of 3.2 billion dollars. The stability of the global financial system was in jeopardy and under British law, Lehman's London office had to be closed immediately. Lehman's failure also caused a collapse in the commercial paper market, which many companies depend on to pay for operating expenses, such as payroll. When AIG was bailed out, the owners of its credit default swaps, the most prominent of which was Goldman Sachs, were paid 61 billion dollars the next day. (New York Times, 2009)

The AIG bailout cost taxpayers over 150 billion dollars. On October 4^th, 2008, President Bush signed a 700-billion-dollar bailout bill. World stock markets continued to fall, within fears that a global recession was happening. By December of 2008, General Motors and Chrysler faced bankruptcy. (Zywicki, 2011) Millions of people lost their jobs while the top executives at Lehman Brothers made over a billion dollars between 2000 and 2007; and lost nothing when the firm went bankrupt. The CEO of Merrill Lynch, received $90 million in 2006 and 2007 alone. After driving his firm into the ground, he resigned; and collected 161 million dollars in compensation. (Wernke & Mock, 2009) In the U.S., the banks are now bigger, more powerful, and more concentrated than ever before.

Ever since the fall of Lehman Brothers in 2008, it has been a popular view that banker bonuses are at least partly to blame for the financial crisis. (Tonks, 2012)

Rajan (2005) focused on incentive structures that generated huge cash bonuses based on short term profits, but which imposed no penalties for later loses. Rajan argued that these incentives encouraged bankers to take risks that might eventually destroy their own firms or even the entire financial system.

Families responded to the recession in two ways: by working longer hours, and by going into debt. For the first time in history, average Americans have less education and are less prosperous than their parents. When the financial crisis struck just before the 2008 election, Barack Obama pointed to Wall Street greed and regulatory failures as examples of the need for change in America. (Brighenti, 2011)

The Obama administration made no attempt to recover any of the compensation given to financial executives during the bubble. In 2009, as unemployment hit its highest level in 17 years, Morgan Stanley paid its employees over 14 billion dollars; and Goldman Sachs paid out over 16 billion. In 2010, bonuses were even higher. (The Guardian, 2011) For decades, the financial system was stable and safe, but then something changed. The financial industry turned its back on society, corrupted the political system, and forced the world economy into crisis.

At enormous cost, we have avoided disaster, and are recovering. But the men and institutions that caused the crisis are still in power; and that needs to change. They will tell us that we need them, and that what they do is too complicated for us to understand. They will tell us it won't happen again. They will spend billions fighting reform.

Risk vs. Return

Lecture 3 discusses international stock exchanges & stock market efficiency and whether risk and return is correlated.

One of the most essential theories in finance is that risk and return are interconnected. Is it true? The more you risk, the more return you get back?

The principle behind risk vs. return is that potential return rises with an increase in risk. Low levels of uncertainty (low risk) are associated with low potential returns, whereas high levels of uncertainty (high risk) are associated with high potential returns. According to the risk-return trade off, invested money can render higher profits only if it is subject to the possibility of being lost.

Risk measures the probability of financial loss. Investors often compare risk, as measured by standard deviation of returns, to historical or expected return when making investment decisions. Typically, investors demand higher returns for investments they consider more risky. (Svetlozar & Rachev, 2011)

Investors believe the higher the risk of loss, the great the potential return. Contrariwise, the lower the risk of loss, the lower the potential return.

Conversely, Paris E. M. Murray, an American-born stockbroker in the Philippines argues that academics would have us believe that if we seek to generate high returns, we must expose ourselves to high risk. In other words, invested money can render higher profits only if it is subject to the possibility of being lost. Hence the refrain: “The higher the risk, the higher the return.” - This belief is false (E.M Murray, Invest Philippines, 2011)

Murray also debates that it is not the level of risk that determines the amount of return but it is actually controlled risk that keeps the risk of loss low and will generate higher returns. This is backed up by Seth Klarman’s assertion, “the less risk, the more return. They’re two sides of the exact same coin”.

“Academics say; the riskier it is the more return. But we say the less risky it is, the more return. So we’re really talking at complete odds with each other.” (Klarman, 2011)

From yet another point of view, a Wall Street trader, Nassim Taleb, made a statement that a lot of people take risks because they don’t know the odds. He suggests that they do not know what the true risk actually is which is why they take the risk in the first place. (Taleb, 2003)

Risk refers to the chance that some unfavourable event will occur.  Investment risk is related to the probability of actually earning less than the expected return; thus, the greater the chance of low or negative returns, the riskier the investment. (Ehrhardt, 2001)

A simple example of risk return trade-off is if you put your money into government bonds it is almost guaranteed that you will get your money back, unless the government goes bankrupt or is taken over, which is not very likely. So they do not pay a great deal of interest. On the other hand, the stock market is more risky, companies can go bankrupt more easily. Bad news can drop the price or good news can raise it drastically, so there is the potential to make a lot more money, but with a higher rate of risk. There is also the potential to lose a lot more money.