The Financial Crises: A Ripple Effect of Incentivised Disorder

R I s k M a n a g e M e n T: the current financial crisis, lessons learned and future implications
The Financial Crises: a Ripple effect of Incentivised Disorder
by Paul Conlin
The current financial crisis is the result of the interplay of oping economies (first Japan, then Korea/Singapore/Hong
changing circumstances, since the 1970s, on Main Street, Kong and finally China/India) adopted protectionist/capi-
Wall Street and internationally.
talist strategies similar to what the United States adopted
On Main Street, savings and lending used to occur lo- in the 1800s. But unlike the American consumer, the con-
cally. There’s the classic scene from “It’s a Wonderful Life” sumer of these export-led economies never switched from
where the depositors of a local S&L demand their savings a savings- to a consumption-based lifestyle. Even in now-
back from the bank manager, played by Jimmy Stewart. He developed Japan, consumers save a substantial portion of
says, correctly, that he can’t give them their money back their income. So the large surpluses in the world continue
because he doesn’t have it—it’s invested in the homes of to recycle back into the United States, including dispropor-
their neighbors. In the world portrayed by the movie, lend- tionately (thanks to the implied, and after Sept. 8, 2008, the
ing standards were monitored by local lending officers in official, government backing of Fannie Mae and Freddie
the communities—lending never got too loose, since the Mac) into American housing.
S&Ls would have to eat the losses; or too tight, since no The world of the local S&Ls, the partner-owned invest-
loans would happen. And when blow-ups did occur, as in ment bank and Bretton Woods isn’t coming back. So what
Texas in the 1980s oil glut, they tended to be contained lo- does that leave us to do next? Part of me is persuaded by the
cally. But the S&L crisis of the 1980s destroyed the local second law of thermodynamics, which says that existence
savings institutions and ushered in the era of interstate fi- gets progressively more and more disordered with the pas-
nancial conglomerates that borrow funds, short term, from sage of time, since any work done to address the current
the worldwide credit markets.
crisis expends more energy and causes more disorder than
On Wall Street, the investment banks were partnerships. it fixes.
When the Wall Street firms underwrote a deal or traded se- On the other hand, we need to at least try something.
curities, it was the personal wealth of the partners on the The lending of money by $500-per-year Chinese factory
line, so solvency was highly incented. During the 1970s, workers to Americans to buy $250,000 houses strikes me as
the partnership ownership structure constrained growth of the best place to start. A home mortgage should not be able
the Wall Street firms and caused capital shortages. Don- to be securitized. If this makes it more difficult for Ameri-
aldson Lufkin Jenrette filed for public ownership in 1969, cans to borrow for homes, so be it—the true economic costs
and the stock market boom of 1982–2000 caused most of (and risks) of such loans must be reflected in mortgage rates,
the others to follow. With shareholders putting a premium and the ripple effect must be felt in home prices. There is an
on earnings growth and return on equity, the Wall Street insurance precedent for this—a primary insurer can trans-
firms increased leverage and risk. They had no margin of fer risk to a reinsurer, but always remains on the hook if the
error for the wave of credit defaults, which were to begin in reinsurer defaults. A mortgage loan must be a permanent
2007.
arrangement between the lender and borrower—if this is
Finally, internationally, the lapse of the Bretton Woods not acceptable to either, no problem: no deal. Legislation
monetary system in 1973 and free float of currencies al- and regulation codifying such a (seemingly, by comparison
lowed the United States, the highest currency on the food to current rules) draconian regime must be enacted while
chain, to sustain massive budget and trade deficits. Devel- the consequences of the alternative are fresh.
Paul M. Conlin, FSA, is an actuary at Aetna in Hartford, Conn. He can be reached at conlinp@aetna.com.
20

---