[This article was originally written as an essay by my friend, teacher and guide on all things related to economics – Devanshi Madan. A quick guide on the financial crisis of 2009 along with a unique view on the principal-agency problem makes this a very interesting article for the average person. I have added a few lines, deleted a few and modified a few more before reproducing it here, all the matter published here has been the original work of the above mentioned author …]
Recessions and business cycles
Recessions are the outcomes of business cycle fluctuations. Business cycle fluctuations are naturally occurring crests (positive growth) and troughs (negative growth) in the revenues and growth of a business. These fluctuations in the business cycle have been well documented. A progression from a crest to a trough leads to a slowdown in economic growth and in extreme cases, as it was in 2008; cause a deep economic recession with global repercussions. Whereas slowdowns and recessions have been around as a naturally occurring economic phenomenon, the global recession of 2008-2009 was exacerbated by the fact that the fundamentals of the financial markets were thrown to the wind in the face of uncontrolled greed.
The global recession of 2009
The origins
It all started with the housing loan crisis, more commonly called the “sub prime mortgage” crisis. American banks and agencies started indiscriminately issuing housing loans to people who did not meet the required eligibility criteria to secure such loans. They slashed interest rates on these housing loans and the demand for these loans shot up. Banks ignored the “credit worthiness” of the applicant and gave loans which were backed by the house bought as the underlying security. These loans were offered at 3% the same rate as the inter bank rate!
The modus operendi of the lending banks and agencies was to lure people by showing much lower variable interest rates on housing loans for a certain period. However hidden behind this promise, as per the fine print, by the time the loan reached its maturity, the total amount repaid would have been the same as the total amount that would have had to been repaid in the case of a high interest fixed rate loan.
This process of ensuring that total cash flows were large and yet it looked to be small in the initial period was done by the process of “negative amortization”. As opposed to normal amortization in negative amortization the principle balance and hence the interest keeps increasing every month. With the lure of lower EMI’s in the initial years, the banks managed to play with peoples psyche and lead them to believe that they were actually getting a very cheap loan. This in turn led to a dramatic increase in the demand for housing.
After a certain amount of time the housing bubble burst, people were unable to pay back these loans and abandoned their houses. As a result, the supply of houses far outstripped the demand for houses, this drove the real restate prices down. The mortgaged houses were redeemed by the banks, albeit as non performing assets. The house prices were much lower than the loan value plus the cost of maintaining the houses would have had to be incurred.
In such a scenario, banks were collapsing due to the large number of non performing assets being added in the form of foreclosure of housing loans. In order to save the banks from collapsing, they were bought out or taken over by other banks and the Federal Reserve. The government intervened later with bail out packages running into billions of dollars to save the banks from bankruptcy.
What are the key lessons to be learnt in analyzing the cause for such a financial catastrophe?
In my opinion it is the misperception and the mismanagement of risk, the low level of interest rates and the indiscriminate de-regulation of financial systems leading to a skew in the market demand that is biased towards a price increase which is artificial and unsustainable.
Today’s world is highly interdependent. Instability in one institution will cause instability in many others. It’s the case of the “ripple effect”. It’s the human psychology around risk perceptions. Individual actions, such as the decision to forward loans to non credit worthy individuals, cannot be viewed in isolation. A global perspective is required in assessing the potential long term impacts over the short term gains that are achieved.
Too greedy in the present - future repercussions
The primary cause for the authorization of risky short term financial decisions would be the greed of the management to show phenomenal revenues and expected future profits. I would call it a managerial greed and callousness. CEOs and other senior managerial personnel rely on compensation received from the companies in the form of salary and other perks. They do not hold any significant stake in their companies. The banking and insurance companies are joint stock companies which have the system of collective ownership.
The “Principal Agency theory”, where the management top teams are just the managers but not the owners, comes into play here. They are the decision makers but they do not bear the burden of the losses incurred by the company. The risk is borne by them and the shareholders, who are collectively the “owners” of the company. The management team earns a percentage of the profits/sales of the Company. Incorrect and greedy decisions made on the part of the management for personal “short term” gain without paying any heed to the long term implications of such decisions, has lead to the financial meltdown in the “developed” countries. There needs to be a principle change in the laws that govern the structure of business institutions at an international level. There is a need to redefine the laws of management and ownership.
Given these observations, it is imperative to have a balance in the principal-agency relationship. Short term profits should not be the sole driver to determine the compensation of the top management team. Shareholders need to be more vigilant and governments need to introduce more stern rules with regard to the regulation of management compensations when linked with the performance of the company.