Corporations
The major Musculature of our modern free markets is corporations. They deserve attention. Corporations are collections of people doing business. Other types of business entities exist; sole proprietorship and partnerships, but corporations are surely the largest. (Some corporations are wealthier than some countries). They inspire joy in some people, fear in others.
Bodies in Two Parts:
Law professor Joel Bakan’s “The Corporation” explains that corporations date back to the 1690s in Britain.
From the start corporations were peculiarities, being bodies that are split into two parts. Directors and managers run the firms, but stockholders own them. And the stockholders are an ever shifting bunch, being owners today, sellers tomorrow.
Most stockholders have no interest in how the firm does business. They only look at the daily value of the stock. Since the only business of a corporation is to make profit, this is a recipe for corruption, because the stock's value can fluctuate on rumour and reputation, and a firm might grow wealthy on lies, or by overcharging, or by selling a dangerous product, or by not doing anything except issuing promises, and the stockholders are just as delighted. Stockholders don’t ask questions.
Second, the corporation has “a legal mandate to pursue, relentlessly and without exception its own self interest” and this “regardless of the harmful consequences it might cause others.” If along the way they have to pay some fines for damage they have done, this is calculated into business expenses. It’s all numbers. And since some corporations make massive profits, they don’t flinch at paying out very large sums to people and environments they have damaged very badly. And then return to do it again.
Corporations have been harshly attacked in several books by investigative reporters. For example, Mushier and Weissman’s Corporate Predators and Court’s Corporateering warn of the way corporations influence politics (by shifting massive capital around) as well as the way they take away our personal privacy and security. As a rule, they lack transparency. And they seem invulnerable surrounded as they are by walls of lawyers. Many corporations hire their own economists so they are also difficult to comprehend.
These books are a good and healthy part of the public’s reading. But these attacks have made no difference.
One book, however, written by a lawyer, may make a difference. It translates the stygian legalese and economics into common language. The book is no less frightening.
Anything that is an unfortunate by-product of making profit, such as stress, lives lost, disease, broken laws, pollution, immorality, ‘collateral damage,’ grief, disruption, riots, is called an ‘externality’ - because it is outside the crisp equation for calculation profit and loss. Most of what we know as morality and humanity are externalizes.
This breakage can have enormous effects on the world. Corporations are externalizing machines, bulldozing through to more profits, they routinely break stuff wherever they go and this single-mindedness has produced what we have today, colossus of indifference “of such power as to weaken government’s ability to control them,” so that “corporations now govern society perhaps more than governments do”.
Yes, there are some corporation CEOs who exercise morality and judgement. But they are not supported by Nobel Prize winning economist Milton Friedman, who believes the only moral duty of the corporation is to put profit over social and environmental goals (and business guru Peter Drucker thinks likewise). Bakan likens corporations to psychopaths (sociopaths). For his book he interviewed Dr. Robert Hare, a psychologist and expert on psychopathy, to get a list of personality traits that psychopaths exhibit (no empathy, asocial behaviours, manipulative ness, no conscience, and no remorse) and then tries those out on corporations. They fit. For instance corporations return repeatedly to make profits from things they know are lethal and that strew grief - cigarettes, cars that catch fire in crashes, drugs with devastating side effects - because the money is there. Enough money gives them a “psychopathic contempt for legal constraint.” Or any constraint. Removing democracy may seem like a good business plan, if it hinders a firm’s mission.
In corporate culture there is an emerging social order that is wide and dangerous, as dangerous as any fundamentalism, Bakan states. “For in a world where anything or anyone can be owned, manipulated, and exploited for profit, everything and everyone will eventually be.”
Every corporation’s Achilles heel is concealed in its original incorporation papers.
Soon after 9/11 Allen Greenspan, former Federal Reserve chairman started to lower down the interest rates periodically but very fast, the bank rate got it down to .05 percent per year. During the course of two years or so, the interest rate was down near or about one percent. Along with the interest rate, mortgage rates got down. The housing market was going toward the upper trend and soon got up to the roof. Several Mortgage Companies emerged besides the big Public companies and other private big and small companies that already exist. Several types of mortgages come forward besides the traditional mortgages that were common in the market. As the time goes on and the interest rates coming down, in tedium of that the housing market was going up. More sophisticated types of mortgages, major one – sub-prime mortgage along with the small and big sub-prime mortgage companies emerged. Nobody cared about the products that are good or bad; neither the buyers nor the sellers (mortgage companies, banks and other institutions) but the products were produced anyway. Many of the products never worked or never implemented, because of the complexity of the product and the collapsing of the market sooner than ever expected. Allen Greenspan keeps down the interest rates so low and for so long, that banks and financial institutions were making a huge amount of profits. There were cheap monies available to financial institutions and banks.
The sub prime crisis came about in large part because of financial instruments such as securitization and derivatives where banks would pool their various loans into sellable assets, thus off-loading risky loans onto others. (For banks, millions can be made in money-earning loans, but they are tied up for decades. So they were turned into securities. The security buyer gets regular payments from all those mortgages; the banker off loads the risk. Securitization was seen as perhaps the greatest financial innovation in the 20th century.)
As BBC’s former economic editor and presenter, Evan Davies noted in a documentary called (January 14, 2008), rating agencies were paid to rate these products (risking a conflict of interest) and invariably got good ratings, encouraging people to take them up.
Starting in Wall Street, others followed quickly. With soaring profits, all wanted in, even if it went beyond their area of expertise. For example,
Banks borrowed even more money to lend out so they could create more securitization. Some banks didn’t need to rely on savers as much then, as long as they could borrow from other banks and sell those loans on as securities; bad loans would be the problem of whoever bought the securities.
They had access money in hand and wanted to give back and lend them at higher rates. They wanted to lend more money and did not look at bad credit or the buyer capability to pay back; level of income of the person in question etc. As we discussed above other big financial institutions and big bank get involved, bought them, repackaged them and sold out all over the world to all major and big banks and institutions. Speculator had bought the houses to resell and make profit, they never intended to occupy. Some people made profits by buying and selling back with no money invested (no down payments) just contracts of sub-prime mortgages. When it expanded all over the places and there was over supply than the actual demand and need. There were no buyers and only sellers. People were unable to pay their mortgages on their second home, which they were intending to sell back. Then the bubble burst. Home prices coming down very fast, there were no buyers. Many people, who were first time buyers, were caught up in this scenario. On top of that recession had already begun. People lost their jobs and were not able to pay their mortgages, which end up with the foreclosures. Many people lost life savings, their houses and so on. Not only individual lost money but also the companies, domestics and foreign as we talked before that foreign companies and banks were involved in this mess too.
Some investment banks like Lehman Brothers got into mortgages, buying them in order to securitize them and then resell them on.
Some banks loaned even more to have an excuse to securitize those loans. Running out of whom to loan to, banks turned to the poor; the sub prime, the riskier loans. Rising house prices led lenders to think it wasn’t too risky; bad loans meant repossessing high-valued property. Sub prime and “self-certified” loans (sometimes dubbed “liar’s loans”) became popular, especially in the US.
Some banks evens started to securities from others. Collateralized Debt Obligations, or CDOs, (even more complex forms of securitization) spread the risk but were very complicated and often hid the bad loans. While things were good, no-one wanted bad news, such people would likely lose their job; anyone trying to slow down would have seen a decline in their market share compared to others, for example.
High street banks got into a form of investment banking, buying, selling and trading risk. Investment banks, not content with buying, selling and trading risk, got into home loans, mortgages, etc without the right controls and management.
Many banks were taking on huge risks increasing their exposure to problems. Perhaps it was ironic, as Evan Davies observed, that a financial instrument to reduce risk and help lend more—securities—would backfire so much.
When people did eventually start to see problems, confidence fell quickly. Lending slowed, in some cases ceased for a while and even now, there is a crisis of confidence. Some investment banks were sitting on the riskiest loans that other investors did not want. Assets were plummeting in value so lenders wanted to take their money back. But some investment banks had little in deposits; no secure retail funding, so some collapsed quickly and dramatically.
The problem was so large; banks even with large capital reserves ran out, so they had to turn to governments for bail out. New capital was injected into banks to, in effect, them to lose more money without going bust. That still wasn’t enough and confidence was not restored. (Some think it may take years for confidence to return.)
Shrinking banks suck money out of the economy as they try to build their capital and are nervous about loaning. Meanwhile businesses and individuals that rely on credit find it harder to get. A spiral of problems result.
Banks had somehow taken what seemed to be a magic bullet of securitization and fired it on themselves.
Derivatives and Securitization was an attempt at managing risk. There have been a number of attempts to mitigate risk, or insure against problems. While these are legitimate things to do, the instruments that allowed this to happen helped cause the current problems, too. And caused more risk by trying to manage risk.
In essence, what had happened was that banks, hedge funds and others had become over-confident as they all thought they had figured out how to take on risk and make money more effectively? As they initially made more money taking more risks, they reinforced their own view that they had it figured out. They thought they had spread all their risks effectively and yet when it really went wrong, it all went wrong.
Many hedge fund managers and bankers fool themselves into thinking they are safe and on high ground. It was a result of a system heavily grounded in bad theories, bad statistics, misunderstanding of probability and, ultimately the greed.
What allowed this to happen? They were looking for ways to manage, or insure against, risk actually led to the rise of instruments that accelerated problems:
Derivatives, financial futures, credit default swaps, and related instruments came out of the turmoil from the 1970s. The oil shock, the double-digit inflation in the US and a drop of 50% in the US stock market made businesses look harder for ways to manage risk and insure themselves more effectively.
The finance industry flourished as more people started looking into how to insure against the downsides when investing in something. To find out how to price this insurance, economists came up with options, a derivative that gives you the right to buy something in the future at a price agreed now. Mathematical and economic geniuses believed they had come up with a formula of how to price an option.
This was a hit; once options could be priced, it became easier to trade. A whole new market in risk was born. Combined with the growth of telecoms and computing, the derivatives market exploded making buying and selling of risk on the open market possible in ways never seen before.
As people became successful quickly, they used derivatives not to reduce their risk, but to take on risk to make more money. Greed started to kick in. Businesses started to go into areas that were not necessarily part of their underlying business.
In effect, people were making more bets — speculating. Or gambling.
Hedge funds, credit default swaps, can be legitimate instruments when trying to insure against whether someone will default or not, but the problem came about when the market became more speculative in nature.
Some institutions were paying for risk on margin so you didn’t have to lay down the actual full values in advance, allowing people to make big profits (and big losses) with little capital. As Nick Leeson (of the famous Barings Bank collapse) explained in the same documentary, each loss resulted in more betting and more risk taking hoping to recoup the earlier losses, much like gambling. Derivatives caused the destruction of that bank.
Hedge funds have received a lot of criticism for betting on things going badly. In the recent crisis they were criticized for shorting on banks, driving down their prices. Some countries temporarily banned shorting on banks. In some regards, hedge funds may have been signalling an underlying weakness with banks, which were encouraging borrowing beyond people’s means. On the other hand the more it continued the more they could profit.
The market for credit default swaps market (a derivative on insurance on when a business defaults), for example, was enormous, exceeding the entire world economic output of $50 trillion by summer 2008. It was also poorly regulated. The world’s largest insurance and financial services company, AIG alone had credit default swaps of around $400 billion at that time. A lot of exposure with little regulation. Furthermore, many of AIGs credit default swaps were on mortgages, which of course went downhill, and so did AIG.
The trade in these swaps created a whole web of interlinked dependencies; a chain only as strong as the weakest link. Any problem, such as risk or actual significant loss could spread quickly. Hence the eventual bailout (now some $150bn) of AIG by the US government to prevent them failing
Derivatives didn’t cause this financial meltdown but they did accelerate it once the sub prime mortgage collapsed, because of the interlinked investments. Derivatives revolutionized the financial markets and will likely be here to stay because there is such a demand for insurance and mitigating risk. The challenge now, Davis summarized, is to reign in the wilder excesses of derivatives to avoid those incredibly expensive disasters and prevent more AIGs happening.
This will be very hard to do. Despite the benefits of a market system, as all have admitted for many years, it is far from perfect. Amongst other things, experts such as economists and psychologists say that markets suffer from a few human frailties, such as confirmation bias (always looking for facts that support your view, rather than just facts) and superiority bias (the belief that one is better than the others, or better than the average and can make good decisions all the time). Trying to reign in these facets of human nature seems like a tall order and in the meanwhile the costs are skyrocketing.
The extent of the problems has been so severe that some of the world’s largest financial institutions have collapsed. Others have been bought out by their competition at low prices and in other cases, the governments of the wealthiest nations in the world have resorted to extensive bail-out and rescue packages for the remaining large banks and financial institutions. The scale of the crisis: trillions in taxpayer bailouts.
The total amounts that governments have spent on bailouts have skyrocketed. From a world credit loss of $2.8 trillion in October 2009, $14.5 trillion, or 33%, of the value of the world’s companies has been wiped out by this crisis. The UK and other European countries have also spent some $2 trillion on rescued and bailout packages.
No comments:
Post a Comment