Sunday, March 28, 2010

The 5 acts of the financial crisis - review of The Power of Yes

Ever wanted answers to some of the many questions in your head on the current financial crisis? Want to know how the story started? David Hare's play, The Power of Yes, at the National Theatre in London kept me on the edge of my seat feverishly taking notes in the dark, and hanging onto every word said in the 1hr45min stage play. If you have the chance, see it. For someone like me, who's not had much to do with finance but would like to understand, this is investment 101, with interesting, non-monotone lecturers. (Actually, I did take Investment 101 in an MBA module during my master of management in operations research program at the Sauder School of Business in Vancouver, Canada, and the prof was quite fun.)

The story informatively reveals to the audience the complexity of the crisis' origin, however, mainly pointing fingers at the bankers, the governments and the mathematical models which claim to predict the future. Altogether they upset the balance of greed and fear, which the financial market and capitalism survive on. The story tells of the current (2007-present) financial crisis in 5 acts: SLUMP.

  1. Sub-prime
  2. Liquidation
  3. Unravelling
  4. Meltdown
  5. Pumping

1. Sub-prime loans (this is the longest part as much history is involved)
Hare starts the storytelling with a mathematical formula (which perked me up right away) - the Black-Scholes formula for option pricing. Wikipedia says, "Trillions of dollars of options trades are executed each year using this model and derivations thereof". That's why Hare went straight to it, and throughout the play referred to the model and its derivations as to "claim to predict the future". Also mentioned was the Monte-Carlo model of the probability of defaulting.

Perhaps I'm biased, as this is operations research in finance, but I would disagree with Hare's statement about the models claiming to predict the future. All models are an approximation to the real world, but aren't the real world, so they always have inherent flaws and limitations. Understanding the limitations is the key to applying the results from the models in the real world, otherwise it is foolish and risky. If you read through the Wikipedia article on the Black-Scholes formula, you will see that it also tries to make this point across to the readers. Assumptions such as a 'rational market and behaviour' and 'normality' goes out of the window when in a financial crisis like the stock market crash, and the model becomes defunct.

Having set the theoretical stage and outlined one 'villain', Hare goes on to illustrating the roles of the second 'villain' - the governments, in particular, the British and the US governments. In 1997, the British government made the Bank of England an independent entity, and gave the regulatory and monetary policy setting responsibility of the financial system to a new body, FSA (Financial Services Authority), so that the banks could concentrate on running the bank business and managing its products. However, Hare argues that this division of responsibility meant no one was responsible for the overall financial system. The FSA was more of a neighbourhood watchdog than a police of the system. Also, the financial sector grew to 9% of UK's economy paying the government 27% of the taxes it collected. It was a big cash cow, and no government wanted to limit its growth. In fact, the Bush administration wanted every American to own his/her home, which only encourages borrowing.

Then the third 'villain' is revealed, the banker. The banker is greedy, and is driven to be so by targets and "regular incremental growth". The banker encouraged the people to buy homes when they couldn't afford it, and pressured the credit rating agencies to give good credits so the people can get loans. The division of responsibility meant no one was ensuring the credit ratings were reliable when the banks pushed to make more money by lending it out to every living and breathing person, but who can't actually afford it. Sub-prime loans.

2. Liquidation
("The conversion of assets into cash. Just as a company may liquidate an entire subsidiary by selling it to another firm, so too may an investor liquidate by selling a particular type of security.")

Why were the bankers pushing for more loans? Because homes = assets, and assets = more leverage to lend out for the banks. In fact, The Royal Bank of Scotland (RBS) was lending out at 30-to-1 leverage ratio (i.e. you lend out £30 based on £1 of asset).

The game of slicing and dicing of assets into packages and then trading it with other financial institutions (i.e. selling / liquidating debts) meant that soon enough no one knew what was in those packages, but some of them were sub-prime loans, which was toxic debt. The concept of toxic debt is well explained here: "The easiest way to describe toxic debt is to see it as two separate issues. One, large amounts of loans were improperly given higher credit ratings (implying lower risk of default). The second is that the value of the homes securing these loans has dropped".

3. Unravelling
Credit = Trust. Toxic loans ==> bad credit ==> no trust.

On August 9, 2008, banks lost trust, and stopped lending money. One quote from the play says, "Banks don't go bankrupt for any other reason... but that they ran out of money". This brought the financial system to a halt. Capitalism was having a cardiac arrest. Let's just say the media didn't help and drove fear steady into the mass.

4. Meltdown
Subsequently, the cardiac arrest brought down Lehman Brothers in the US first, and in the UK, Northern Rock went down as the nation's first casualty. The fall of Lehman Brothers triggered a world-wide panic and collapse of 'trust' in the financial system. People in the UK were queueing for their money from the banks. The Brits love to queue for things: a quote from the play, "When the Brits see a queue, they join it". In the US, the big financial institutions went one after the other into troubles.

5. Pumping
The US government had to bail them out by spending hundreds of billions of dollars. And if they didn't do so, the other sectors would be dragged down by the fall of the financial sector as well. Then other governments followed suit as this is a global financial crisis, and now governments are wasting and pumping money into the economy to try to rescue it.

This wraps up the 1hr45min play with no intermission. I think the title, the power of yes, is referring to the 3 'villains' of the story saying yes to lending recklessly, and therefore creating debt-laden societies. What's your interpretation? I hope I've done the play justice. I thoroughly enjoyed it, and learned lots from it that is helping me shape my understanding of the financial crisis. I wonder why my alma mater didn't include any financial applications of operations research in the programme. Is it because it is so easily misunderstood by newcomers? Then wouldn't that be a reason for teaching it more broadly?

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