The Credit Crisis: a Lethal Cocktail of Scale, Oligopolistic Markets and Rewards

The credit crisis has led to unprecedented far-reaching intervention in the financial sector of the economy by the Dutch government. The government has bought out the shares of Fortis and ABN AMRO banks from Fortis Holding. Minister of Finance Wouter Bos has created a generic rescue fund of €200 billion. In addition, at a European level an interbank credit guarantee system has been set up until the end of 2009, to which the Netherlands is contributing €200 billion. It is interesting to see that the American government followed the European example two days later with a similar explanation for its bailout plan of $700 billion, which had previously been approved by Congress. Usually it is the other way around. Looking at these figures, the credit crisis can be characterized by the concept of ‘scale’.

Firstly, we have the scale of the supply of capital. One of the main reasons for the historically low interest rates of recent years is not only the coordinated interest rate policies of the central banks, but also the nearly unlimited scale of available capital. The high oil price led to significant value transfer to oil-producing countries, which subsequently had the problem of investing this money profitably. In addition to this enforced type of saving, pension funds in the Western world also had large sums of money to invest from pension contributions. The financial sector has the knowledge, and financial incentive in the form of fees, to invest capital on this scale. The credit crisis shows that even extremely low return products such as subprime mortgages can be turned into attractive investments by adding leverage. Two birds were killed with one stone when these financial products were placed in special purpose vehicles. The market could be increased substantially because banks didn’t need to keep their own capital on the balance sheet and a steady flow of fees could be booked. The parties involved have never acknowledged that in the United States this created a housing market situation akin to a pyramid scheme.

Secondly, it’s not only the financial markets that are substantial, the players on these markets are larger than life as well. What is more, the most important players can be counted on the fingers of one hand. Bear Sterns, Lehmann Brothers, Merril Lynch, Morgan Stanley and Goldman Sachs are the famous, and now also infamous, investment banks that kept this market going. The other players either followed these five or they were buyers. It is the same in the credit derivative market. AIG was the largest and most important credit insurer. No wonder the American government couldn’t abandon this insurer to its fate. It is well known that in oligopolistic markets the companies involved make surplus profit. However, an equally important fact is that they exercise market power or market influence. The companies involved undoubtedly made surplus profit, but they did not adequately acknowledge the market influence they exercised and the associated dependency. This dependency was revealed when the US housing market collapsed. This collapse annihilated profitability because no new securitization transactions could be entered into, the existing vehicles got into financial trouble, as did the investment banks because they were dependent on short-term credit to finance long-term obligations.

Thirdly, the extensive use of variable reward schemes by the companies involved played a role as well. A strong focus on bonuses makes employees concentrate on the short term and on scale. The higher the turnover, the bigger the bonuses. It is hard to stop playing this game. Show me a CEO who would stop such a game when the company is presenting handsome profits and the commercial department doesn’t want to stop but go even further. This bonus game was played on the two most important markets in the credit crisis: the housing market, where mortgage sellers received bonuses for mortgages sold, and the CDO market, where investment bank employees received bonuses based on the fees they’d earned.

All in all it’s obvious we are creating our own recession. Institutions are urgently looking for returns which investment banks offer by developing products that meet that requirement. The scale of the available funds means that too many bills are being drawn on the underlying markets, currently the housing market in the US, which results in a sort of pyramid scheme. Because they are oligopolistic markets, the problems are rapidly becoming systemic instead of staying limited to the companies themselves. The government has no option but to intervene or to provide support.

It is not easy to find solutions for this problem. It is unlikely that the amount of available investment assets will decrease in the short term, or that the markets will become less oligopolistic. However, the role of leverage will be drastically reduced in the near future, which will limit the effects on such a large scale. This is a good thing. New regulations, which will undoubtedly be introduced soon, will have to focus on the systemic effects of scale, oligopolistic markets and reward schemes. The regulations could focus on aspects such as stricter requirements for the capital position of banks, requirements for off-balance vehicles and requirements regarding risk spreading. Finally, reward schemes should focus less on the short term. If bonuses were reduced, the importance of the development of normal salaries would increase. In addition, bonuses shouldn’t be paid out in the year that they have been earned but kept ‘at risk’ for another year.