Sub prime crisis not caused by greed? 4

Professors Aumann and Yunus have two entirely different approaches to business: Professor Aumann believes that the sole purpose of business is to make money – and that individuals won’t work for others – he doesn’t believe that the sub-prime crisis in the USA, which lead to a global financial crisis results from greed. Professor Yunus takes a different approach – he believes that man is not here simply for the sole purpose of making money, at the expense of others. Read this report and give your views on the approach you believe we should adopt in South Africa.

Not greed – that’s the conclusion proposed by 2005 Nobel Prize winner and renowned author Professor Robert Aumann – in a presentation to the UCT Graduate School of Business this week.
The well-publicised failure of certain banks and financial institutions within the USA, which have had international repercussions, was directly caused by the “sub-prime” crisis. The term used to describe those borrowers who fall below the usual security standard to borrow; essentially, these borrowers don’t have sufficient security to justify the amount lent to them.
Banks identified that there was an increased risk in lending to medium to high risk home-owners, but thought that by bundling these loans and effectively “insuring” themselves against loss –also taking into account that they could repossess the house if the borrower defaulted, it was sufficient to justify the risk being taken.
In addition, Lending Officers were incentivised to lend. In some cases more than 100% of the value of the property was advanced.
Easy borrowing encouraged construction companies to build, causing a glut of houses and subsequent falls in house prices, to such as extent, that borrowers who hadn’t defaulted weren’t inclined to repay funds in excess of the current value of their property. They simply said – take the house back.
Compounding the impact of the overleveraging, additional underlying causes were identified: “entanglement” – the spreading of the banking risk to the insuring institutions – so that not just banks failed, but the organisations who had become involved in the bundled risk arrangements. Subsequent to the bank failures, it has been identified that the over-borrowing was up to 35 times the assets of the banking institutions.
Bank Managers were incentivised by stock options – stock that they could choose to purchase at a future date. When share prices fell, they simply didn’t exercise their stock options, they didn’t effectively lose income, they might not have gained, but they didn’t lose anything.
As share prices fell, investors lost confidence and sold off their stocks, exacerbating the fall, and more bankers failed to exercise their options.
Professor Aumann does not recommend government regulation – other than to prevent “entanglement” – to avoid the failure of one institution being able to damage others. He believes that governments should not abandon the market economy as these failures do not represent a failure of the capitalist system – the market economy is superior to the alternative that is socialism. He quotes particularly China as making progress through the adoption of a market economy.
He does not think that executive pay should be reduced – merely restructured – and proposes continuation of incentives, just structured differently.
He does not believe what happened resulted from greed as the purpose of business is to make money – to make profits – and to take risks.
Finally, although economic forecasts are notoriously unreliable he suggests that we are recovering from the financial crisis.
Compare Professor Aumann’s approach with that of Prof Muhammad Yunus – the founder of the Grameen Bank in India.
Professor Yunus rejects the view that the only purpose of business is to make money to profit at the expense of others and to push others into poverty. Poverty he argues is not created by poor people, poverty is created by the system and the policies adopted; poor people cannot be blamed for poverty, they are the victims.
He argues that access to credit is a basic human right and rejects the system that has existed to date, namely that financial institutions have effectively excluded 2/3 of the world’s population. Financial institutions need to be re-organised as inclusive institutions.
His experience tells him that it is the poor who really pay back – it is the rich who default on payments. He firmly believes that the poor are as creative and as resourceful as anyone, it is the denial of opportunity that causes them to remain in poverty.
He has a view of a new world order and believes that it is possible, that it is not a pipe dream. If we can meet our Millennium Development Goals to halve world poverty, then it is logically possible to continue to remove poverty completely. However, once removed, he proposes that mechanisms would need to be put in place to prevent poverty re-developing.
The question then seem to be: which approach is more appropriate in South Africa today?
Prepared for Portal Publishing
By sylvia hammond
4 August 2009

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4 thoughts on “Sub prime crisis not caused by greed?

  • Sylvia F. Hammond Post author

    Hi Miro
    I like your analysis – I think the questions then are:
    How do we create a society where the value of an individual is on things other than how much money they have? And what should we value?

  • Miro Bagrov

    I think people want to blame the system because they do not want to blame themselves and their society.

    Actually society (thats us) at the moment is based on the American model, and is comparable to the same of ancient Persia & Babylonia…
    All being based on the fundamental principle that success is measured by how much money you have.
    Needless to say feelings of inadequacy arise because the human mind sometimes can’t understand why others can have and they can’t… So there greed arises…

    There are people who read this post that know exactly what i say because I am speaking of them.

    So infact greed was present in the financial industry for as long man has walked the earth…

    The things that caused the crisis is:
    – Willing Incompetence

    1) Bad Investment
    – The funds were firstly borrowed to bad debtors. They were not properly assesed.

    2) Bad Financing
    – The money that was borrowed to bank’s clients – had to come from somewhere, so someone made a bad investment by giving the money to the bank which they gave to the people who couldnt pay it back.

    A mere change in 1% in a bank’s Liabilities can cause millions of losses, cosidering we are dealing with very large numbers.
    All it takes is a simultaneous decrease in Assets to create an irreversable disaster.

  • Chris Reay

    Warren Buffet saw this coming in 2006 and warned that the penchant for derivatives would lead to the plethora of toxic investments. Note that the profits for the bankers were “made” on the relay of transactions of the same product up the line to the point where the value could simply not relate to the original “bundled”, and originally imbalanced, investment product. Someone coined the phrase that the world had got into a conspiracy of optimism where the reality of the limits to growth in any cycle were ignored by the human behavior called the gambling instinct.
    My vote is for the intoxication caused by a belief that we had a system that would enable asset growth forever. But those that perpetrated the process initially knew to not be left holding the parcel when the music stopped, and so were aware of the fundamental flaws that otherwise mesmerised the masses. It was a bubble and bubbles are in effect an overshoot of a system that does not have critical damping, in this case a form of regulation that will now be put in place which simply will try to check that liabilities are secured with real value.