Much as been said about the 2008 Financial Crisis we are still going through; unfortunately, populism has come into force to point the wrong people and the wrong pratices: here is a list of errors commonly spread in the press.
1) Hedge Funds are in part responsible for the crisis due to massive speculation: FALSE
Because Hedge Funds' management are opaque, because they are located in Tax Havens, because the bonuses of their top managers are way above that of Goldman Sach's heads, they are regularly criticized by politicians, who perceived them as a threat to the financial stabilization ; in 1998, one of the biggest Hedge Fund that ever existed, LTCM ("Long Term Capital Management"), was about to collapse because of the Russian Crisis. It was saved thanks to William McDonough, president of the New-York Federal Reserve back at the time, who convinced American and European major banks to contribute to a 3,625 billion dollars bailout; in fact, with over 4,5 billion dollars equity and 124 billion dollars debt, its collapse would have been a disaster for the Global Financial System. It happened that the management of the Fund was a failure, so the Hedge Fund Industry in general brought many suspicion with the current crisis; however, things are quite different now. Let's recall why:
Were Hedge Funds responsible for the Oil Soar in 2008? NO
When oil soared till mid-2008, many said hedge funds were speculating on a continuous rise with a 200 $ target for the barrel. But the rise of oil was led by simple supply & demand criteria, and the Hedge Funds had nothing to do with it. The Graph below shows the part of non-commercial positions in long-term forward contracts in percentage of total contracts, ie speculative positions; as one can see, those speculative parts didn't play a key role..
Did Hedge Funds managed ot make profits with the Subprime Crisis? NO
The graph below shows the evolution of Hedge Fund indices recently, for each strategy used (Equity Market Neutral, Convertible Arbitrage, Event Driven, Macro & Equity Hedge); it proves that Hedge Funds suffered the crisis (because of spreads widenings and liquidity contraction).
2) The Financial Crisis was a consequence of Excessive Traders' Bonuses: FALSE
One common argument you may heard is that traders' desire to get big bonuses led them to take too many risks which ended up in the crisis; this is completely false. Actually, a good trader is an efficient risk-manager, and not a speculator. A trader who exceeds his risk-budget will always be fired, since banks are fully aware of the risk a massive position can turn out to be a losing one; to those who would object by speaking of Jérôme Kerviel, I would suggest to wait for the end of his trial... Up to 2008, many traders got bonuses without jeopardizing their banks or the financial system....
3) Too much Risk led to the Subprime Crisis: FALSE
First, what happened to subprime mortgages?..
This is a touchy part that deserves a clear explanation; when American banks started to lend money to individuals who didn't meet underwriting guidelines, they didn't keep these loans in their balance sheet, using a sophisticated financial technique called securitization: described simply, a bank create a pool of the mortgages embedded in its balance sheet and produce a financial security (called ABS, "asset-backed security") which is in turn sold to investors, and freely negotiated on capital markets. The graph below illustrates the way securitization works:
How could those mortgages impact the entire World?
Once those mortgages were packaged in MBS (for "Mortgage-Backed Securities"), they were traded on capital markets, either directly or through tranches of CDO (for "collateralized-debt obligations"); those products were supposed to offer a very interesting risk-reward profile, so many investors and banks buy those products throughout the World, and consequently regional banks in Germany, Scandinavia turned out to have subprime mortgages in their balance sheets; they were exposed to the US Real Estate market.
Source: Credit Suisse
As a conclusion, what can be infered about Risk?
The conclusion is that banks' balance sheets and assets are so much intertwined that flaws in securities built on American Mortgages impacted banks in the entire World; an interesting thing to underline is that bankers faced fierce criticism for creating sophisticated derivatives products, but no one ever thought of asking to treasurers in smaller banks and financial institutions why they bought those complicated products. As a matter of fact, the issue with the subprime crisis was that no one was fully aware of where lied the risks, no that there was too much risk.... the difference is important.
4) Complex derivatives products led to the Financial Crisis: PARTLY FALSE
Glorious speculator Warren Buffet once expressed a curious opinion on derivatives products that he called. "weapons of mass destruction" In fact, derivative products were first created 30 years ago; here is a summary of the financial crises that occured since 1980, excluding the October 1987 Krach that wasn't followed by an economic crisis:
Latin American Crisis
Foreign Debt of Latin American Crisis exceeded their earning powers
US Savings & Loans Crisis
Tax regulation and imprudent real estate lending
Inflation of Real Estate and stock prices
Asian Government decisions to let their currencies float
Russia inability to reimburse its debt
Foreign Investors withdrew their investments from Argentina
And as one can see, every financial crisis that occured during the past thirty years had nothing to do with structured products and/or derivatives; the subprime crisis of 2007-2008 had one simple reason: the end of the rise of the Real Estate Market in the US, that is shown on the graph below:
Since the mortgages lent to American borrowers were based on the value of their houses, and not on their own wealth, things started deteriorating when the Real Estate market stopped rising. Obviously, US bankers that recommanded those mortgages were not absolutely honest...
However, concerning the crisis we are going through as well as for those above, the very first reason for their appearance was each time a macroeconomic reason and not for some dangerous behaviors on trading floors..
The mortgages-derivatives products described above obviously played a role in the spreading of the crisis since every bank was exposed to them; that why those derivatives were part of what brought the crisis.
But to be completely precise, it must be said: - that the trigger of the crisis was a macroeconomic event and nothing else - that mis-management of the risks linked to mortgage-derivative products is to be underlined, not all the derivatives themselves...
5) Rating Agencies Are to Blamed for the Subprime Crisis: TRUE
Some pointed at the Rating Agencies (Moody's, S&P, Fitch) for they role in the crisis; but not enough, to my mind... and even if more regulation is being discussed at the time, one could wander if strong decisions will be taken in the end. A Rating Agency assesses the credit worthiness of a firm which issues bonds; this credit worthiness is symbolized by letters, from AAA (the company has very little chance of defaulting) to C or D (the company has defaulted or is close to default); surprisingly, and though many banks fiercly compete with each others to get customers, rating agencies almost form a monopoly: only three major rating agencies exist, two of them acting as leaders on the market (Fitch is a little less active).
Conflicts of Interest
The way they work carries some conflict of interest; the firm who want to have its debt ranked has to pay the agency, which in turn must be as objective as possible when assessing the firm...
When Rating Structured Products
The Rating Agencies not only rated debts issued by companies, but also the famous Asset Backed Securities, Mortgage Backed Securtities and CDOs discussed above; many of those products got a very good grade, mostly AAA, though it appeared that the risks embedded in those products were largely undervalued.
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