Aug. 5, 2008

Poor Governance, Not Easy Money, is the Cause of Current & Many Other Crises

Former Fed chairman Alan Greenspan, as well as current chairman Ben Bernanke, have been blamed for following an easy money policy that was supposed to have engendered and aggravated the current financial market crisis. But these accusations are almost certainly misplaced.
While money was probably eased excessively at one point, that is not the reason why many CDOs went sour and why mortgaged backed securities lost value plunging many banks and financial companies into a relentless decline, with not a few actually falling under.
The main reason is poor governance. This was also the reason behind the S&L crisis during the eighties, the collapse of Enron in the fall of 2001, and dozens of other disasters.
Many academics have tried to design various warning indicators. But warning indicators are no substitute for good governance. Poor governance will lead to disaster sooner or later. When there is a conflict of interest and the person making important decisions looks after his personal interest ahead of the interest of the corporation, the corporation suffers. When there is a conflict of interest and the corporation making important decisions looks after its self interest ahead of the social responsibility entrusted to it, society suffers. Thus an auditor is supposed to do its job on behalf of society, but his fees are paid by the firm audited by him, there is a strong temptation for him to compromise his professionalism. There is now a report from Reuters saying that Freddie Mac Chief Executive Richard Syron refused to heed warnings about risky loans that were issued as early as 2004. Buying the questionable loans and other choices initially paid off for Syron, who “collected more than $38 million in compensation since 2003, the NY Times said.” Earlier on, some commentators had pointed to the conflict of interest besetting rating agencies, whose ratings may well have been contaminated by financial incentives.
One must ask why loans were made to people without the ability to repay the loans. Why were financial institutions allowed to lend to home buyers without the ability to come up with a reasonable down-payment? The fact is: if lenders had lent only 70% of the market value of homes, all the mortgaged backed securities would still have been able to maintain their market values. Bear Stearns would still have been a viable company. We need to relearn the same lesson we thought we had learnt before: we need good corporate governance and common sense risk management.

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