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Why the Financial Crisis Happened

In one of our first news articles on 8 March 2002, we commented on the trend for excessive lending for house purchase. In many articles over the years since we have commented on the rise in prices of houses well above increases in incomes and consumer prices indexes. Our closing line in the March 2002 article was '...consumers have been extending mortgages through home-equity loans and rock bottom interest rates. This has helped consumers maintain spending despite recessionary trends. This cannot go on forever as eventually spending and income have to come into balance'. The Reserve Bank gave similar warnings but these produced no public policy response.

Western developed world politicians and economists love to say 'the marketplace' will sort things out - don't interfere. They argued that the debt to buy inflated houses was matched by the increased household wealth from the stock market. This myth is now busted. The markets have not efficiently allocated capital. Having 8 times wages locked in Australian houses rather than the historical rational average of 4.5 times, means we have over $2.5 Trillion unproductive assets locked in houses (13 million households, average wages $60,000, 3.5 times extra).

Why was no action taken to avert this crisis? Here are some of our conclusions:

* The big bang in banking in late 1990's allowed banks to do lending, derivatives and insurance under one roof and the regulators relied on the banks' risk models rather than objectively looking at risk and capital themselves.

* Executive options and remuneration let the senior ranks of banking build personal wealth disproportionate to their skills and capital at stake in their businesses

* The financial regulators were conflicted by remuneration envy and regulated with a light touch. They swanned around financial conferences seeking leads for a job shift to the private sector with 5 times their goverment remuneration.

* Politicians basked in low interest rates and house price rises as a badge of honour for re-election - they even added fuel to the fire first home grants and sub-prime mortgage encouragement.

Posted Monday, 26 January 2009


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