Since the 1929 Great Depression , the worst debacle the world has encountered is the financial crisis.

Leading to millions of jobs lost and massive amounts of money in market value evaporated, the financial
crisis did not suddenly appear out of nowhere, but was the result of “a long period of rapid credit
growth, low risk premia, abundant liquidity, and the development of real estate bubbles. “ (Economic
Crisis: Cause, Consequence, and responses - István P. Székely). An early warning was the savings and
loan disaster (1986-1995) in which 1,043 banks failed with a cost to U.S. taxpayers of about $124 billion;
it was ignored. A few years later, in several colossal corporate scandals - Enron, Tyco International,
Adelphia, WorldCom, and many others - companies used dubious accounting practices or outright
accounting fraud to deceive the public and enrich executives.

The dot-com bubble of 1995 to 2001 was a different kind of crisis, fueled by irrational spending on
Internet stocks without considering traditional business models. Investors did not seem to care about
earnings per share or other more traditional measures. Moreover, there were too many companies
trying to create online businesses. This bubble was not based on fraud as much as overvaluation of
stocks (especially the IPOs) and excessive speculation. The recent housing bubble, on the other hand,
which was very much part of the current financial meltdown, was fueled to a large degree by the ready
availability of deceitful mortgages. What was apparent from the dot-com bubble was that prices cannot
go up forever – a lesson not learned by the mortgage industry.

In 1998, Long-Term Capital Management (LTCM), borrowed over $125 billon, but had equity of just $5
billion. The financial crisis started by LTCM at that time demonstrated how the entre financial system
could be put at risk by a single fund. The Federal Reserve Bank crafted a $3.5 billion rescue package in
1998 to protect the financial markets from a total collapse because of the actions of the hedge fund.
LTCM’s sophisticated mathematical models were developed by two Nobel laureats - Myron Scholes and
Robert C. Merton - who were both members of the board of the hedge fund.

The Pursuit of Self-Interest

One pillar of mainstream economics is based on the famous saying of Adam Smith in his classic work,
The Wealth of Nations : “It is not from the benevolence of the butcher, the brewer or the baker that we
expect our dinner, but from their regard to their own interest.” Smith demonstrated how self-interest
and the “invisible hand” of the marketplace allocate scarce resources efficiently.

Today, students are taught that “economic man” (homo economicus) acts with perfect rationality and is
interested only in maximizing self interest, resulting in an economic system (capitalism) that is both
efficient and productive. For the corporation, self-interest has become synonymous with unconstrained
maximization of profits and maximizations of shareholder wealth.

In his first book, The Theory of Moral Sentiments, Adam Smith made it clear that he believed that
economic growth depended on morality. In 1937, at his second inaugural address, President Franklin D.
Roosevelt stated: “We have always known that heedless self interest was bad morals; we know now that
it’s bad economics.” Lawrence H. Summers, in a 2003 speech to the Chicago Economic Club said: “For it
is the irony of the market system that while its very success depends on harnessing the power of self-
interest, its very sustainability depends upon people’s willingness to engage in acts that are not self-
interested.” The financial meltdown of 2007 shows quite clearly what happens when everyone s solely
concerned with self-interest.

Closely tied to the pursuit of self-interest is the belief that free markets do not need regulations. Even
our so-called watchmen and gatekeepers – corporate directors, investment bankers, regulators, mutual
funds, accountants, auditors, and so on – have fallen into the self-interest trap and disregarded the
needs of the public.

Free Markets and the Role of Regulation

The federal government did not do a good job monitoring Wall Street. Arthur Levitt, former chairman of
the Securities and Exchange Commission (SEC), said: “As an overheated market needed a strong referee
to rein in dangerously risky behavior, the commission too often remained on the sidelines.” Not only
was there a relaxation of enforcement, there was also a reduction n SEC staff. Senator Charles E.
Schumer, as well as other members of the Congress, believed the rules had to be changed to encourage
free markets and deregulation f the United States were to remain competitive.

The problems began at a 2004 meeting between the SEC and five major investment banks, which
wanted an exemption from a regulation that limited the amount of debt they could have on their
balance sheets. This would enable them to invest in mortgage-backed securities and credit default
swaps (CDS). The SEC agreed to loosen the capital rules and also decided to allow the investment banks
to monitor their own riskness by using computer models to analzye the riskiness of various securities,
that is, switch to a volunatry regulatoy program. The firms did act on the new requirements and took on
huge amounts of debt. The leverage ratio at Bear Stearns (a global investment bank and securities
trading and brokerage, until its collapse and fire sale to JPMorgan Chase in 2008) rose to 33:1; this made
the firm’s business very risky since it held only $1 of equity for every $33 of debt.

The Fed could have put a stop to highly risky and fraudulent mortgages by using power under a 1994 law
(Home Owner Equity Protection Act) to prevent fraudulent lending practices. It was obvious that the
mortgage industry was out of control and was allowing individuals with very little money to borrow huge
sums of money. Washington Mutual, for example, approved almost every mortgage request. Loan
officers were encouraged to approve mortgages with virtually no checking of income. The term NINJA
loan was used to describe mortgage loans made to people with “No Income, No Job or Assets.” Fed
Chairman Alan Greenspan could also have used the monetary powers of the Fed to raise interest rates
and end the housing bubble. Various stated did try to do something about predatory lending but were
blocked by the federal government. Freddie Mac (Federal Home Loan Mortgage Corporation) and
Fannie Mae (Federal National Mortgage Association) purchased $400 billon of the most risky subprime
mortgages, In September 2008, the federal government had to take over both Fannie and Freddie.
Alan Greenspan (Chairman of the Federal Reserve of the United States from 1987 to 2006) has admitted
that he allowed the markets for derivatives 1 and CDS2 to go out of control. Warren E. Buffett (an
American investor, industrialist and philanthropist) has called derivatives “financial weapons of mass
destruction”. Greenspan, on the other hand, felt that “derivatives have been n extraordinarily useful
vehicle to transfer risk from those who shouldn’t be taking it to those who are willing and capable of
doing so.” Greenspan finally admitted at a congressional hearing in October 2008 that he had relied too
much on the “self-correcting power of free markets.”

CDS were originally developed to insure bond investors against default risk but they took on a life of
their own and were used for speculation purposes. A CDS encourages speculation since the owner of
CDS does not actually have to own the underlying security. This is equivalent to buying fire insurance on
someone else’s house. The markets for derivatives and CDS became unregulated thanks to the
Commodity Futures Modernization Act of 2000. This law was pushed by the financial industry in the
name of free markets and deregulation. It also made it virtually impossible for states to use their own
laws to prevent Wall Street from doing anything about these financial instruments.

Conflicts of Interest

I believe that we could have avoided the global financial crisis if executives had been truly ethical. A
large number of people knew that the mortgages they were dealing with were toxic. It does not take a
great financial expert to see that mortgages with no down payments given to people with no income
were extremely foolhardy. The rationale that they believed that housing prices would continue to keep
going up is credible – and, indeed, it is not even a legitimate justification for this behavior. Conflict of
interest – for example, make an obscene amount of money in bonuses by encouraging toxic mortgages
or make considerably less money in salary by giving mortgages only to people who can afford them – is
difficult for most people. The bankers failed the test. They encountered mortgage brokers to do
everything possible to get people to take out mortgages.

1
In finance, a derivative is a financial instrument (or, more simply, an agreement between two parties) that has a
value, based on the expected future price movements of the asset to which it is linked—called the underlying asset
such as a share or a currency
2
A credit default swap (CDS) is a swap contract and agreement in which the protection buyer of the CDS makes a
series of payments (often referred to as the CDS "fee" or "spread") to the protection seller and, in exchange,
receives a payoff if a credit instrument (typically a bond or loan) experiences a credit event