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Moderation, Knowledge and Modesty Moderation, Knowledge and Modesty

November 2008November 2008

Professor Asher TishlerFaculty of Management

Tel Aviv University

November 2008

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The financial crisis: The financial crisis:

The problemThe problem

The causes The causes

Future actions Future actions

Comments about IsraelComments about Israel

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The financial crisis in the world

Began as a crisis in the subprime market.

Today, it is a liquidity crisis (trust crisis).

Today, the crisis is global. It is not just a problem for the USA.

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Initially, the financial crisis due to the subInitially, the financial crisis due to the sub--prime problem prime problem (mainly in the USA)(mainly in the USA)

Initially, a drop of $2 trillion in the value of housesInitially, a drop of $2 trillion in the value of houses

There is a problem of liquidity in the various banking There is a problem of liquidity in the various banking institutionsinstitutions

The drop in the value of houses is due to excess building, The drop in the value of houses is due to excess building, unbridled granting of mortgages (a mortgage higher than unbridled granting of mortgages (a mortgage higher than the value of the house, too long a period of grace for the value of the house, too long a period of grace for overdue mortgage payments, and so on)overdue mortgage payments, and so on)

The existence of overly sophisticated financial assets that The existence of overly sophisticated financial assets that hide the extent of the problem (securitization of mortgages, hide the extent of the problem (securitization of mortgages, ‘‘new assetsnew assets’’, and more) and prevent a simple solution, and more) and prevent a simple solution

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The response of the US government: purchase of troubled The response of the US government: purchase of troubled assets from financial institutionsassets from financial institutions

What and how to buy? (buy bonds using the right What and how to buy? (buy bonds using the right techniques)techniques)

The government needs to help where there is a problem of The government needs to help where there is a problem of liquidity. It should not rescue badly managed financial liquidity. It should not rescue badly managed financial institutions (with weak customers, inefficient management, institutions (with weak customers, inefficient management, too high risk, etc)too high risk, etc)

How much to pay? (today the market price is low due to How much to pay? (today the market price is low due to liquidity problems)liquidity problems)

Banks (financial institutions) that are badly managed should Banks (financial institutions) that are badly managed should be allowed to go under. The receivership process should be allowed to go under. The receivership process should be fair (selling assets to other institutions)be fair (selling assets to other institutions)

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Reasons for the financial crisis

The bubble in the real estate market.

Too many overly complex financial assets (throughout the world).

Financial systems with regulation that isdefective or completely absent.

Defective regulation systems in other markets.

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Signs of problems in financial marketsSigns of problems in financial markets

Exist for a long time Exist for a long time

Are reflected in many real marketsAre reflected in many real markets

Are reflected mainly in the Are reflected mainly in the ‘‘alternative investmentsalternative investments’’ markets markets

We did not We did not ‘‘connectconnect’’ all the signsall the signs

Governments (economists) did not understand the problemsGovernments (economists) did not understand the problems

No government response No government response

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Degree of globalization and connections among countries increases

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Commodity prices increase due to actions in real and financial markets

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Debt increase in many western countries

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Large savings in emerging countries caused a flood of capital to rich ones (especially the USA). This, in turn, caused the financial boom by pushing long term interest rates down.

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Banks hold a lot of ‘short term’liabilities (and ‘long term’ assets).It is difficult for governments to offer guarantees for depositors.

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The modern financial system was meant to supplement (in reality it bypasses) the ‘old’banking system.

Its development over the last 30 years may be attributed to four main factors:

DeregulationDeregulation

Technological innovationTechnological innovation

Growing international mobility of capitalGrowing international mobility of capital

Globalization in real marketsGlobalization in real markets

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Securitization: Banks collected together bank loans, particularly mortgages, and sold the package to various financial institutions.

Other banks, particularly investment banks, collected these assets and repackaged them according to various risk types (and additional categories), added a bit of leverage, and sold the package on. This process was repeated several times.

Technological developments, including the appropriate algorithms, made possible the creation of several types of derivatives, the trade in which ballooned significantly (credit-default swaps, for instance). At the end of 2007 the total number of contracts was 600 trillion (12 times the world’s GDP!!!)

The development of the financial markets over the The development of the financial markets over the last 30 yearslast 30 years

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The financial innovations created enormous profits for the The financial innovations created enormous profits for the players in the market and the market makers.players in the market and the market makers.

Some of the financial innovations were designed to Some of the financial innovations were designed to circumvent the prevailing regulations.circumvent the prevailing regulations.

For example: A large part of the subFor example: A large part of the sub--prime loans were prime loans were created when Fannie Mae and Freddie Mac began to created when Fannie Mae and Freddie Mac began to purchase subpurchase sub--prime mortgages in 2004 to enable and even prime mortgages in 2004 to enable and even to broaden the availability of affordable housing (as to broaden the availability of affordable housing (as demanded by the politiciansdemanded by the politicians).).A developed capital market certainly gives rise to growth. It A developed capital market certainly gives rise to growth. It is clear today that it is no easy matter to regulate a is clear today that it is no easy matter to regulate a developed capital market, however much wisdom is applied developed capital market, however much wisdom is applied to the issue.to the issue.

Growth is not the only goal!Growth is not the only goal!

Development of the Financial Markets (2)Development of the Financial Markets (2)

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Solutions

Understand the problems

Do not blame ‘greedy Wall Street’ and managers of financial institutions (there are few, if any, ‘action items’ here)

Generally, managers acted rationally

The markets moved into ‘inferior equilibrium’ due to defective or altogether missing regulation

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Solutions

Short run (now) – solve the liquidity (lack of trust) problem

Inject capital to banks, boost the economy (mostly in infrastructure), pay attention to the poor, weak and old (they will be hurt)

Long run – set better regulation in financial and real markets (governments should not replace the private sector)

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Is it possible to regulate the market better?

It’s difficult. Individual players will always be one step ahead of the regulators (preferably, they should be only one step ahead and not more).

The tension between nationality and international regulation

In general (the economists’ answer): Politicians should be prevented from introducing distortions into the capital market.

Set simple regulation and simple rules

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Changes that will take place following the Changes that will take place following the crisiscrisis

All the important financial markets in the West (derivatives, All the important financial markets in the West (derivatives, mutual funds, securitization, etc) will be subject to stronger mutual funds, securitization, etc) will be subject to stronger (hopefully better) regulation. The minimum capital (hopefully better) regulation. The minimum capital regulation will be stronger and more conservative, leading regulation will be stronger and more conservative, leading to much smaller leverage than at present.to much smaller leverage than at present.

There will be more government intervention in real There will be more government intervention in real markets, particularly, but not only, through regulation.markets, particularly, but not only, through regulation.

The regulation array itself will change substantially and will The regulation array itself will change substantially and will be arranged in an orderly fashion (it will be clear who be arranged in an orderly fashion (it will be clear who regulates what and the relations between the various regulates what and the relations between the various regulators will be plainly set out).regulators will be plainly set out).

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Changes that will take place following the Changes that will take place following the crisis (continued)crisis (continued)

Emerging markets will have more of a say in what goes on Emerging markets will have more of a say in what goes on in the financial markets.in the financial markets.

Generally speaking, inconsistent and unwiseGenerally speaking, inconsistent and unwise government government activity in financial and real markets (defective regulation, activity in financial and real markets (defective regulation, inappropriate subsidies, poorly executed ideological inappropriate subsidies, poorly executed ideological reforms, etc) contributed substantially to the current crisis. reforms, etc) contributed substantially to the current crisis. Governments will now be more conservative and certainly Governments will now be more conservative and certainly wiser (less wiser (less ‘‘ideologyideology’’ and more knowledge).and more knowledge).

The comparative advantage of countries with high levels The comparative advantage of countries with high levels of human capital will increase.of human capital will increase.

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Why is Israel in “good” shape?

There is no real estate bubble.There is no real estate bubble.

We lagged behind in adopting the overly complex We lagged behind in adopting the overly complex assets.assets.

The banks are fairly well regulated (the alternative The banks are fairly well regulated (the alternative capital market less so). capital market less so).

A problem: Defective regulation in most of the A problem: Defective regulation in most of the other markets.other markets.

The economy is in good shape (five years of The economy is in good shape (five years of healthy growth, low unemployment, an export healthy growth, low unemployment, an export surplus.surplus.

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A strong, growing and successful private sector

Infrastructure planning and operations by a weak public sector: defense, education, higher education, the legal system

Defective regulation of oligopolistic markets: water, electricity, the ports, telecommunications

A government sector with many planning and operations problems

IsraelIsrael

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Why does the public sector have so many problems?

The public sector is burdened by many difficult tasks (security, welfare, …)

The public sector has no strategy and lacks planning integration

The pay in the public sector is low, it has a large number of unskilled employees and a small number of skilled employees

It suffers from a lack of awareness of the need for long-term planning (in a rapidly changing world!)

There is a lack of professional knowledge and experience (managerial and other), particularly at the center, amongst the integrators (MOF, PM)

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Policy required in Israel (we are somewhat lucky in the current crisis)

In the short run In the short run –– concentrate on the crisisconcentrate on the crisis

In the long run In the long run –– there is a need for longthere is a need for long--term term planning in a number of focal areasplanning in a number of focal areas

Need for a serious level of professional knowledge, Need for a serious level of professional knowledge, permanently in placepermanently in place

Need for professional personnel with the ability to Need for professional personnel with the ability to manage complex systemsmanage complex systems

Need for knowledge and professional personnel to Need for knowledge and professional personnel to regulate rapidly changing marketsregulate rapidly changing markets

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Moderation Moderation (no extreme capitalism or socialism)(no extreme capitalism or socialism)

Acquire more knowledge Acquire more knowledge

Be more modest Be more modest

Policy in IsraelPolicy in Israel