The financial crisis – why students should still choose finance
For those people considering going to university this year at MSc level, this financial crisis will be the first they have experienced. Yet financial crises happen every ten or twenty years. What is different this time is the severity of the crisis ? the likes of which no trader in the City has ever seen before. This article first outlines the causes of the crisis and then asks whether students should steer clear of finance, accounting and economics as subject disciplines and potential careers, until the crisis has receded? I argue that the clear answer is ?no”.
Some would argue that the crisis results from the ‘sub-prime? mortgage problem in the US. In turn this could be argued to have been caused, in part, by US legislation introduced under President Clinton that made it very hard for US banks to refuse credit to individuals with low and insecure incomes. The outcome was a general pressure to try to find a way to provide mortgages to those who, under normal criteria, would not qualify. The factor which persuaded banks to lend to people, many of whom were unlikely to be able to pay back, was the long history of rising home prices in the US. This meant that even if people defaulted on the mortgage and their home had to be repossessed, it could be re-sold without the bank suffering loss. Reality started to bite when house prices stopped rising and suddenly the value of banks? assets (i.e. the loans they had made) fell below the amount they had advanced.
But why should this affect us in Europe? The answer lies in a very clever financial innovation. Traditionally mortgages are provided using money deposited in a region and then lend out to others in that same region. But increasingly the demand for resources to finance the huge growth in the mortgage market could only be met by tapping savings from China, Japan, the oil producing states and Continental Europe ? all countries with higher savings ratios than the US and the UK. The business models of some banks, such as Northern Rock, only worked if such global savings were tapped through the ?interbank markets?. The resulting mortgages were subsequently turned into securities and then ?tranched? which means divided up into different layers of risk including some which were rated as highly as US government debt. Banks and investors bought these securities because they gave a higher yield than government bonds yet, according to the rating agencies who evaluated them, had a similarly low risk. Of course the risk was not the same in practice as in theory and once property values collapsed, even the highest rated tranches collapsed in value. Indeed, it became almost impossible for those holding these securities ? banks and other investors ? to sell them simply because they were almost impossible to value. No one could tell how many borrowers would default or where house prices at auction would settle. This still remains a problem for governments everywhere who might like to buy the ?toxic assets? from the banks but cannot agree how much they are worth.
Not only have mortgage assets become a problem. Banks were also lending to private equity firms (firms that own companies such as the AA, Boots, Brakes Bros, New Look and United Biscuits.) providing what are known as ?leveraged loans? i.e. loans where the private equity companies did not have to put in much equity. Many of these loans are also now being marked down as some may not be repaid. That also hits the banks? profit and loss account and if bank profits for the year are negative, the loss has to be written off against the banks equity. If enough loans are written off, banks become bankrupt.
While this story is persuasive, it is not the whole story. What also needs to be understood is the change in business practice (some would say ethics) that made banks believe that these actions such as holding title deeds to homes and tranching could somehow eliminate risk. What is very surprising is that regulators do not seem to have been aware first, that banks had become so highly over-borrowed and second, in many cases had an equity cushion of only around 3% of their total loans. Thus a 3% loss in value of their loan book would make them bankrupt.
Even the previous Governor of the Bank of England who retired relatively recently said he was not aware, when he was Governor, that the banks were setting up so called Securitised Investment Vehicles (SIVs) as a way of increasing their gearing or leverage but keeping such vehicles off-balance sheet and thus not subject to the normal rules. What this adds up to is that the crisis, whatever you read in the press, does not have a single cause such as ?greedy bankers? but arose because of a very complex web of circumstances involving banks, ethics, politics, leadership, regulation and sociology. This surely makes for an amazingly rich and interesting area of study at university.
So what lessons are there for all of us ? potential students of finance, accounting and economics and for professors in these fields? Well first, the market collapse and worldwide recession is certainly not a reason for deciding no longer to make a career in finance. First, by the time of graduation, most of the layoffs will have happened. After such large layoffs, banks generally find they have over-reacted and then have to start hiring in large numbers. So that is good news for students. For professors, the markets are inherently interesting and this crisis is a particularly interesting time for finance, accounting and economics analysis. It is a real world test (something we often don?t get in our fields) of a lot of theories about how markets work.
For me and my colleagues at Henley Business School’s ICMA Centre ? the business school for financial markets, the crisis has generated data that will keep us going for years trying to analyse what really happened, why it happened and how it might be prevented in future. It is also going to provide a lot of work for the Bank for International Settlements which set the so-called Basle II rules for regulating banks worldwide, rules which are now seen to be flawed, for the SEC which has to explain why the Madoff Ponzi scheme was allowed to carry on for so long, for the Bank of England the FSA and the UK Treasury to work out whether the tripartite arrangements amongst them makes sense and for many European banks and regulators who thought they had immunity from this ?Anglo Saxon? crisis ? all things you can learn about on a good MSc finance degree.
So the conclusion is that we all need to learn from this crisis so that the next one, which will certainly happen in your working lifetime, will not be so severe and will be mitigated by actions learned from research on this one. And also, let’s not forget that a career in the financial markets is still one of the best and most exciting of all careers available to a graduate.