Why Another Financial Crisis Is Inevitable

Remember Jaws? In 1975, the small town of Amity was on the eve of the Fourth of July weekend, a time of celebration of the founding of this marvelous country. But just before the celebration was about to begin, a vicious shark attack occurs. Concerned about losing the money from the holiday tourist trade, the mayor and townsfolk ignore the warnings to keep people out of the water. But then after another shark attack, and yet another, the town’s leadership finally grasps the peril, but not before more disasters occurred.

Jaws, writes John Whitehead, wasn’t just a simple story about sharks. Instead, it was a social commentary about how a love of money can blind us to averting preventable disasters.

Fast forward to the financial meltdown of 2008 and what do we see? America again was celebrating. The economy was booming. Everyone seemed to be getting wealthier, even though the warning signs were everywhere: too much borrowing, foolish investments, greedy banks, regulators asleep at the wheel, politicians eager to promote home-ownership for those who couldn’t afford it, and distinguished analysts openly predicting this could only end badly. And then, when Lehman Bros fell, the financial system froze and world economy almost collapsed. Why?

The root cause wasn’t just the reckless lending and the excessive risk taking. The problem at the core was a lack of transparency. After Lehman’s collapse, no one could understand any particular bank’s risks from derivative trading and so no bank wanted to lend to or trade with any other bank. Because all the big banks’ had been involved to an unknown degree in risky derivative trading, no one could tell whether any particular financial institution might suddenly implode.

Since then, massive efforts have been made to clean up the banks, and put in place regulations aimed at restoring trust and confidence in the financial system. But the result in terms of dealing with the basic problem, according to a terrific article by Frank Partnoy and Jesse Eisinger in The Atlantic entitled “What’s Inside America’s Banks?” is failure.
Another global financial crisis is on the way

Financial reform didn’t work. Banks today are bigger and more opaque than ever, and they continue to trade in derivatives in many of the same ways they did before the crash, but on a larger scale and with precisely the same unknown risks.

Ignoring warning signs has inevitable consequences. We ignored them before and we saw what happened. We can say this with virtual certainty: if we continue as now and ignore them again, the great white shark of a global financial meltdown will gobble up the meager economic recovery and make 2008 look like a hiccup.

We can’t say when this will happen. We can’t say which bank or which particular instrument will trigger the debacle. What we can say with virtual certainty is that if we continue as now is that it will happen. Because the scale of the trading is larger, and because the depleted government treasures are not well placed for another huge bailout, the impact will be worse than 2008.
Today’s financial scandals are mere sideshows

Thus the biggest risk we face is not the stories of repeated wrongdoing by the banks that are still making headlines, such as:

  • Trading gone awry: JPMorgan’s [JPM] loss of $6 billion from trading activities of which CEO Jamie Dimon was blissfully unaware.
  • Price fixing at LIBOR. “Many of the biggest banks now stand accused of manipulating the world’s most popular benchmark interest rate, the London Interbank Offered Rate (LIBOR).
  • Foreclosure abuses. Just this week, big banks agreed two settlements totaling $20.15 billion for foreclosure abuses.
  • Money laundering: Accusations of illegal, clandestine bank activities are also proliferating. Large global banks have been accused by U.S. government officials of helping Mexican drug dealers launder money (HSBC), and of funneling cash to Iran (Standard Chartered).
  • Tax evasion: Two Swiss banks were involved in Switzerland-based. In 2009, UBS [UBS] helped 20,000 U.S. taxpayers with assets of about $20 billion hide their identities from the IRS. Now, the oldest Swiss bank, Wegelin & Co. has been indicted on criminal charges for helping U.S. taxpayers avoid taxes on at least $1.2 billion for a nearly ten years.
  • Misleading clients with worthless securities: Only after the financial crisis of 2008 did people learn that banks routinely misled clients, sold them securities known to be garbage, and even, in some cases, secretly bet against them to profit from their ignorance.
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