CSR in the Czech Republic: Skoda Auto

The majority of companies in Czech Republic now consider CSR as an indispensable part of their business and Skoda Auto is just one of many examples (“Denik CSR pro manazery”). Skoda Auto is the largest car manufacturer in Czech Republic with a rich history dating back to 1859. Although the company is now a subsidiary of the Volkswagen Group many business functions including CSR are independent. Over the last decade, Skoda has expanded its product line to satisfy a wide range of customers with models ranging from subcompact to mid-size luxury cars (“SkodaAuto”). The company has positioned itself as a cheaper stylish alternative to brands like VW, Toyota, or Ford while delivering comparable quality and reliability.

About 70 percent of the company’s car sales come from Europe. Western Europe accounts for almost 44 percent of the total but Skoda has a growing position in India and China and is present on every continent except North America. In 2010, Skoda sold 762,600 vehicles generating revenue of € 8.7 billion. The company reported an operating profit of € 447 million and had thus a 5.1 percent operating profit margin–almost double compared to the Volkswagen Passenger Car division. Despite its global presence, Skoda Auto has a functional organizational structure that is then divided geographically further down the chain where necessary. Although Skoda is relatively small compared to its major competitors, it has an ambitious plan to respond to current trends with a zero-emission line of models. Management considers the major stakeholder’s as the key to the company success and has a CSR framework emphasizing the needs of employees, customers, and the environment (“SkodaAuto”). Skoda’s CSR is based on three main areas: economic, social, and environmental.

Regarding the economic are, Skoda is committed to reducing the negative impacts of its products on the environment. A proof of that is the recent series of GreenLine models that are more efficient and ecofriendly. Additionally, the company has an employee behavior codex outlining the CSR responsibilities of its workers (“SkodaAuto”).

In the social area of CSR Skoda is mainly involved in employee benefits, sponsoring, external relations, and education. The company offers for instance additional pension plans, no-interest real estate loans, or an annual social fund that made € 6 million available for culture, entertainment, and other employee activities. Regarding employee health, the company offers a personal health plan whose goal it is to motivate employees into leading a healthy life. Skoda is an equal opportunity employer and has only in the Czech Republic workers from 26 different countries. Skoda also has a quality improvement program that encourages employees to suggest improvements and has saved over €11 million in costs in 2009 in its Czech plants. Additionally, the company has a strict work injury policy and incidents have steadily declined over the past years (“SkodaAuto”).

Another part of social CSR is Skoda’s sponsoring which focuses mainly on sport, cultural, social, or humanitarian events that have the encourage good results, and demonstrate team spirit, persistency, and the will to succeed. Skoda also partners with various non-profit organizations supporting causes from cancer research to environmental protection. The company also works with the cities where it is located and helps its suppliers to implement concepts like TQM and ISO standards. The company places a high importance on education and spent about  €6 million.

Last, there is Skoda’s environmental commitment. The company is constantly improving its models to be more environmental efficient. Its compact Fabia model, for instance, achieves a gas mileage of 70 miles per gallon of diesel. This is achieved by using new technologies and the reduction in resistance through improved tires and better aerodynamics (“SkodaAuto”).

As mentioned earlier, many companies now regard CSR as an integral part of doing business. Nonetheless, especially in the online retail industry, it appears that almost no companies have CSR programs. An example is MALL.CZ which is an online retailer of home appliances. The only action CSR action is its quality certification but there is no concern about the environmental impact of the products it sells despite the fact that some of them require proper disposal (“Firemni informace”).

In conclusion, CSR in Czech Republic is well developed and its benefit is understood, but there are a few companies, especially in the online industry, that have to yet discover its benefits.

Sources:

“Denik CSR pro manazery.” CSR-online.cz. 15.Apr. 2011. http://www.csr-online.cz/Page.aspx?clanky

“Firemni informace.” Mall.cz. 15 Apr. 2011. http://www.mall.cz

“ŠkodaAuto: Zpráva o trvale udržitelném rozvoji 2009/2010.” Skoda-auto.cz. 15. Apr. 2011.

http://www.skoda-auto.cz/company/CZE/Documents/Pro_investory/Vyrocni_zpravy/

SkodaAuto_AnnualReport_2010_CZ.pdf

How to Solve the Foreclosure Crisis?

The past economic crisis, that many now hope to be over, was indisputably one of the biggest blows to the United States since the Great Depression. Like many recessions in the past, the current global financial meltdown was caused by an asset bubble and a subsequent price adjustment. Nonetheless, this was the first time in American history when rising foreclosure rates triggered a devaluation that forced the global economy into recession. The defaults and high foreclosure rates could be blamed on many factors including regulators, rating agencies, investors, mortgage brokers, or mortgagers itself. The wave of foreclosures triggered an unprecedented reaction of the United States and global capital markets that lead to the recent recession. If one looks into the future, he discovers that one of the main prerequisites for an economic recovery is the stabilization of the housing market which was the main cause of the crisis. Currently, the greatest challenge is to stabilize the whole real estate market by decreasing the foreclosure rate.

The direct reason for the global financial crisis was the devaluation of the underlying assets (homes) of mortgage backed securities (MBS) that were distributed throughout the world. The devaluation was caused by defaults on numerous sub-prime mortgages and foreclosure rates have been rising ever since the beginning of the crisis in 2007 (Figure 1 & 2). With rising default rates and more foreclosures, the MBS remain risky assets and investors currently lack trust to finance new mortgages. The situation in the financial industry can improve significantly only if the housing market becomes more predictable by hitting the bottom and thus regaining investors’ trust.

The housing market in the United States is cyclical going through booming bubbles and busts (Table 3). Low interest rates and an overall lack of sufficient regulation under Alan Greenspan around 2001 started the most recent housing bubble. This price inflation was, in comparison to previous housing bubbles, one of the biggest in past decades (Figure 3). Subsequently, the housing market experienced a very severe price adjustment. Even though some recent news reports might suggest that the worst wave of foreclosures might be already over[1], if the situation is carefully examined, one discovers that there are more foreclosures on their way if we assuming the absence of any future government intervention.

In November 2009, RealtyTrac estimated that there are over 400,000 real estate owned (lender owned) properties in the market that will eventually have to be foreclosed (Sharga). This delay in foreclosures is caused by the incapability of many banks to foreclose their properties in short time due to their incapability to process large numbers of filings. Alt-A and Option ARM loans are beginning to default on much higher rates than sub-prime loans which were always ahead in the number of foreclosures. These additional defaults are the results of a tough economic situation that followed the financial meltdown. RealtyTrac estimates that for every 6 to 10 lost jobs there is one new default and subsequent foreclosure (Sharga). Furthermore, the mortgage defaults lag behind the lost jobs–even if we suppose that the unemployment rate already peaked, there are more filings caused by lost jobs yet to come. Additionally, a declining unemployment rate does not guarantee that no more workers will lose their jobs–it just means that job creation is higher than job destruction. The jobs lost in the future will further increase the foreclosure rate which is supported by RealtyTrac’s predictions about foreclosure rates peaking in the third quarter of 2010 (Sharga).

Despite recent encouraging news about rising home sales, the housing market remains unstable. According to the senior vice president of RealtyTrac, Rick Sharga, the slight rise in home sales and home prices was caused by the temptingly low housing prices of foreclosed properties. Many investors that had no intentions to buy real estate were simply forced to buy by ridiculously cheap properties. Nonetheless, as the supply of cheap properties will continue to rise in the future, investors will most likely lose their confidence again and the housing prices will continue to plunge (Figure 3). This price adjustment is expected to last until the middle of 2010 and the US housing market could see significant appreciation in the third and fourth quarters of 2010 (Johnson).

It is likely that under current conditions the present mortgage modification programs regarding, among others, Option ARM mortgages will not be able to prevent a new wave of foreclosures in 2010. Consequently, the foreclosures are not likely to slow down and stabilize before 2011. The foreclosure and default levels will remain above “normal” until 2012 and even in 2013 real estate owned property inventories will remain high (Sharga).

If no appropriate action is undertaken, the unstable housing market would threaten the recovery of the US economy by pushing it into a double dip recession as suggested by the worst case scenario of Global Insight’s predictions (Figure 4). Fixing the problems in the housing market should thus be one of the major objectives for 2010 along with redefining healthcare and the financial markets.

Fortunately, the US government together with the Fed initiated certain actions to mitigate the effects of the collapsing housing bubble. Examples are, for instance, the new homebuyer tax credit or the Fed’s plan to buy $ 1.25 trillion of mortgage-backed securities in 2010 (Spence). Additionally, the Department of Treasury took another step aimed on improving the housing market. The Treasury lifted the financial cap on its monetary support to keep Freddie Mac and Fannie Mea in operating conditions. This action’s goal most likely is to retain the overall confidence in the housing market as the government expects more foreclosures in the future (“Treasury Removes Cap for Fannie and Freddie Aid.“). This action will, however, solve only part of the problem: although it provides homebuyers with available mortgages it does not stop the rising foreclosure rates and has the potential to become excessively expensive for American taxpayers. Consequently, further government action is crucial to mitigate the impact of the upcoming foreclosures.

One of the easiest and most obvious ways to keep the foreclosure levels down is to target the unemployment rate and boost job creation. As already mentioned, there is an obvious relationship between the number of lost jobs and the number of foreclosed properties (Figure 2). If the US government successfully uses the stimulus money to boost job creation and decrease the unemployment rate, it will simultaneously decrease the number of new foreclosures.

Second, it is crucial to prevent as many foreclosures as possible. Foreclosures are, in fact, something the mortgagees (banks) try to avoid as much as the mortgagers (homeowners paying off the mortgage). Both sides lose in case of a foreclosure. The mortgager loses its home and the bank fails to recover its losses because of the deep discount which it has put on the price. Additionally, banks were used to deal only with a limited number of foreclosures in the past and their departments are not equipped to deal with the current huge amounts. Rick Sharga exemplified this situation in his presentation by describing the reason of a homeowner’s lawsuit in Florida. The homeowner sued his bank for not foreclosing on him because he was receiving mortgage invoices despite being declared insolvent. This was decreasing his credit score and inconvenienced him also in other ways. The bank, on the other hand, did not want to foreclose because it was already overwhelmed by other foreclosures and the gain of that action would be minimal (Sharga). This case illustrates the unfortunate situation of many banks and mortgagers when facing foreclosures.

If the bank is forced to foreclose, it usually tries to sell the property as soon as possible. The importance of time, together with the low demand for real estate during the current tough economic times, forces the bank to sell the properties at ridiculously low prices (Weatherly). On the other side, there are investors that take advantage of the deep discounts and buy these foreclosed properties. Investors can realize up to 50 percent of return on investment not including possible appreciation of the assets (Weatherly). These investors exploit the unfortunate situation of banks and evicted homeowners. I believe that the government should step in by creating a temporary agency that would buy the foreclosed properties from banks and rent them out possibly to people who just lost their homes. When the real estate prices recover the agency could sell the houses and realize a profit. This agency would provide the needed demand and capital for the housing market while solving most of the problems connected to foreclosures. Furthermore, the acquired real estate properties could be financed by government insured MBS that would be sold on the capital markets. This would trigger much needed involvement of American and global investors in the US housing market and enable a very fast rebound in the housing prices.

Additionally, this new agency could also acquire the houses of people who owe more on their homes than they are worth. By doing this the agency would help the banks avoiding foreclosures and getting a relatively fair price while significantly decreasing the immediate average cost of living. The average cost of owning a housing unit was about $ 927 a month in 2007 while the cost of renting was only $ 755. Thus, many households could save on average $ 172 per month on their living expenses by switching from paying their mortgage that they would probably lose anyways to renting their home (“American Housing Survey,” 26). The new government agency, if financed through MBS, would not place any further burden on the American taxpayer while significantly improving the situation in the housing market.

Nonetheless, targeting the unemployment rate and establishing a new government agency has also certain disadvantages that should not be overlooked. The effort to decrease unemployment is by definition connected either with increased government spending or decreased government savings. In both cases, decreasing the unemployment rate will increase the government budget deficit. On the other hand, minimizing the unemployment rate is in the economic interest of the United States and the money spent in the present will be paid off by the benefits of the economic growth in the future. However, one has to keep in mind that all government actions pertaining to unemployment should be only temporary since they could disrupt the economic equilibrium in the future as was the case before this current crisis[2].

The temporary government agency would place a minimal burden on taxpayers if funded by MBS. However, there would be a certain amount of risk involved connected to possible vacancies and other risks connected with renting out real estate properties. These risks could be effectively mitigated through reasonable financial planning putting a sufficient amount of the agencies income aside for unexpected expenses. Similarly to the measures aimed at decreasing unemployment, the government agency would have to be strictly temporary. This means that the agency would have to have a set timeframe in which it should accomplish its goal and be discontinued hence forth.

Although the current situation in the housing market is somewhat better and far clearer than a year ago, the foreclosure rates are nowhere near to be decreasing (Figure 1). The US government made many steps to improve the situation but additional action is still needed. These additional efforts could be realized through policies decreasing unemployment and by creating a temporary government agency to buy, lease, and subsequently sell foreclosed properties. These actions would have the potential to quickly eliminate the foreclosure crisis, stabilize the housing market, and significantly contribute to a strong economic recovery in 2010.

Please download the following version for figures and graphs: How to Solve the Foreclosure Crisis

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[1] USA Today: “Good news: Foreclosures down 10%; state-by-state chart.” (Armour)

[2] Alan Greenspan‘s policy of slashing the interest rates significantly contributed to a swift recovery in 2001; nonetheless, it created the foundation for the current crisis.

FRIEDMAN’S KEY TO PROSPERITY

I first learned about Korea in 9^th grade history class in my hometown, Prague, when our teacher told us about the Korean War and the fight of the capitalist and communist powers over the country. The Korean nation was cut in half through a simple line along the 38^th parallel. At that time I thought that that was all I needed to know about this country. Last year, however, I was proven wrong when I was selected for a summer study program at the University of Ulsan. Through this intense learning experience, I discovered far more about Korea than I have ever dreamed of: roughly half a century ago, South Korea was comparable to the poorest African countries with a per capita GDP just above $ 100,[1] but when I was there in 2009, it was a highly industrialized nation with all the comforts of the Western world.

In stark contrast, North Korea, more industrialized than its Southern neighbor in the 1950s, experienced a decreasing life expectancy since 1995[2] and barely got rid of famines in the past decade. One Friday night, sitting in a bar in Ulsan, I learned from my Korean host that his grandparents are still in North Korea–that is, if they are still alive, since he has not heard from them in over a decade. At that point I realized that South Koreans and North Koreans are the same people: just Koreans. How is it then possible, that during 40 years, one part of a country became the 14^thlargest economy in the world,[3] while the other part barely survives? The answer may well be hidden in Milton Friedman’s 1970 statement:

“There is one and only one social responsibility of business–to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud.”[4]

This statement is indisputably one of the focal points of today’s debates about the responsibilities of businesses and the morality of profit and can answer fundamental questions about the prosperity of countries. This essay will examine Friedman’s idea in a simplified idealistic world model trying to answer the question about the two Koreas as well as revealing new paradigms.

The majority of today’s societies are democracies. This means, at least in theory, that everybody has the equal right to influence politics through their vote. In modern countries the political system creates and enforces a legal framework, provides education and healthcare, and helps the needy. In short, the public sector creates and sustains a comfortable environment for people to live in and is ultimately accountable to them. This system also unites the interests of individuals and transforms them in a “greater good” beneficial to everybody. The private sector is the counter pole to the government and consists of individuals who have the freedom to make choices in their lives. Free societies can be characterized by people choosing where to work, live, or what to buy; a free market economy is essential to the fulfillment of these freedoms.

In order to maximize the benefits in the long run, the public and private sectors need to be in an equilibrium state that can support itself. Extremes at both sides are disastrous, with communism being just one example. The greatest challenge for developed countries in the 21^st century is to find a sustainable equilibrium between the government and the private sector; the current political tension in the United States is a great example of this challenge.

Crisis situations, like the recent global economic crisis, always trigger a debate about who was responsible–either the government or the people. This discussion is usually followed by a corresponding correction of power.  A big debate about who is to blame for the past economic downturn is currently underway in the United States. Some point at the government’s lack of regulation, whereas others blame corporate greed. To understand this issue better it is advisable to study human nature first.

People are ultimately selfish beings, and everything they do satisfies either a materialistic or spiritual need. Negative human qualities including greed occur naturally, but they are channeled by individual morals. As morals are very subjective and not enforceable, there is a need for a stronger set of rules: laws and punishments established by government.

Societies sometimes evolve so quickly that the government either does not recognize the need to respond or lacks the sufficient time. This is what happened in the United States: the shadow banking industry with its mass securitization of mortgages was the new child of the evolution process. The government failed to recognize this new reality, which allowed for the creation of an asset bubble triggering the global meltdown through its deflation. In fact, all crises caused from within, like the Great Depression or its recent modern follower, can be all blamed on the lack of government action.

Consequently, the government carries a far greater responsibility than what is generally accepted, which will help to comprehend the morality and responsibilities connected to profit, markets, and businesses in general. As Milton Friedman emphasized, businesses cannot be judged on their morality because they are not human beings.[5] One can extend this idea towards markets and profits.

Markets are essentially abstract concepts that nonetheless have real effects on the exchange of goods and services. The morality of markets is thus connected to the morality of people who utilize this concept. The same applies to profit, which is merely a motivational tool for businesses. Questioning the morality of profit translates into questioning the morality of people who established this system and those who take advantage of it. This notion suggests that the moral responsibility of basically everything lies solely within the people themselves. As there is no generally accepted set of morals in the world, it is difficult, if not impossible, to objectively judge the morality of individuals and doing so would be highly discriminatory. This, of course, does not imply that the concept of morality does not have its important role in society, but it rather suggests that morality alone cannot be the only system of rules to guide human behavior.

This is where the government has to step in by providing a system of universal laws. The function of the government overtakes and supersedes morals by establishing what is right or wrong through a democratic process. In extreme cases like war or crisis situations, people are likely to break both sets of rules. Nonetheless, morals are likely to be broken first as they do not have any direct punishment, which reduces morals to a useful set of rules that, unfortunately, cannot always be relied on.

This logic supports Friedman’s idea that businesses should be subject only to the legal system and focus only on its main reason of existence–provide people with goods or services and make a profit off of it. Opposing this idea is the fact that in a perfect market in an equilibrium state there is no room for profit. The only means to create profits is to knock the market out of its equilibrium, which can be done by change in the form of innovation or diversification. The hunt for profits thus becomes a major contributor to advancement. Profits help to increase the total wealth of a nation and the standard of living along with it. The concept of profit provides many advantages for people and societies as a whole, but its morality lies within the effectiveness of the legal framework.

Friedman also argues that companies are responsible only to the shareholders or owners. The owner is essentially an investor whose goal is to get the highest possible return on investment usually represented by dividends. Nonetheless, some people believe that businesses should be accountable to other interest groups than just investors. John Mackey,[6] for instance, argues that companies should respect the needs of these groups even though they are not defined by law. This implies that Mackey relies on morality to guide managers or owners to make the right decisions. This becomes a truly difficult task as there is no unified business morale. By redistributing profits to third parties, companies impose a tax on consumers, employees, or owners and, in fact, duplicate the role of governments or charitable organizations. Additionally, it would be unwise to believe that companies are qualified to make decisions regarding the redistribution of wealth. The most qualified entity deciding on how to tax and who to support should ultimately be the electorate through the means of the government. This same concept can be applied to environmental regulations because companies do not have the expertise to make decisions about environmental issues and should leave this decision to the government. I do not imply that governments always do the right thing; however, I believe that the “ideal” governments should be solely responsible for the “greater good.” In democratic countries, a clear line should thus be drawn between the moral responsibilities of individuals mediated through charities or governments and businesses.

Psychology teaches us that all human action satisfies a need or a want. In economic terms, needs and wants are both part of a notion known as demand and differ in importance or elasticity–the relationship of the change in quantity and the change of price. According to Adam Smith’s The Wealth of the Nations,[7] all these needs and wants, no matter if perceived as good or bad, have a positive effect on the economy. In a free market economy, the selfishness of people (comprehended as a motivator) increases the wealth of a society.

The power of the free markets to convert a vice onto a virtue can be applied to the relationship between profit and greed.  An excessive amount of demand can be described as greed.  Being one of the Seven Deadly Sins, greed is considered an undesirable human quality. On the other hand, being greedy is one of the rights people should be granted in a free society. Keeping profits for themselves is then only a matter of personal values and morals. If we assume that by paying taxes people repay their debt to society for all the luxuries they enjoy through a working social system, nobody should be obliged to give back more than required by law, but anybody can freely choose what to do with their own wealth. From this point of view, greed can even become a motivator increasing the efficiency of businesses, maximizing the production, and creating innovation.

Up to this point, all concepts were discussed in the context of one country with a working government. In the global environment, there are vast differences between countries in terms of culture and morals, economic and legal systems, and the overall stage of development. While about 1.2 billion people[8] truly live in the 21^st century, other world regions are hundreds of years behind dealing with issues that are mere historical facts for the Western countries. In less advanced societies, wealth is spread very unequally:

“Even in good times wages were low, hours long and working conditions hazardous. Little of the wealth which the growth of the nation had generated went to its workers. The situation was worse for women and children, who made up a high percentage of the work force in some industries and often received but a fraction of the wages a man could earn. Periodic economic crises swept the nation, further eroding industrial wages and producing high levels of unemployment. “[9]

This passage is a historical description of the situation in the United States during the industrial revolution in the 19th century. All developed countries went through the problems that third world countries experience today including famines, revolutions, lack of human rights, and military conflicts. In general, differences between poor and rich countries are only matters of economic and social development in time.

Many developing countries are the target of international critique for not respecting human rights. Nonetheless, as demonstrated by the history of the United States, rapid progress and economic development take their toll on the society. Whether this human suffering can be evaded or not remains a question. However, protectionists of human rights should be careful with their critique because the hardship might, in fact, be a necessary step in the development of a society.

As globalization opens doors to new markets, businesses are presented with a chance to choose other government systems to operate in. As many developing countries do not have a legal framework comparable to Western nations, it might seem that they are easy prey for international corporations. Nonetheless, in cases where a democratic government allows for a free market environment, the entry of another player into the market will usually be beneficial to the total wealth of the system through increasing competition, reducing margins, and spurring innovation. Issues regarding human rights or the environment are then the responsibility of the local government. Critics of international “exploitation” usually point at the debated notion of unequal exchange[10] which examines international trade from a developed country’s perspective. Nonetheless, it is important to assess international trade relative to the situation in the developing country: no matter how harsh the situation is to the common people, the conditions and compensation provided by foreign companies have to be more attractive than other opportunities or there would be nobody working for such a company. As an example, strict child labor laws might be successful in keeping children from work, but they also might rob a family of an essential portion of their income making bare survival difficult. Furthermore, chances are that children would be working as hard in the household or on fields anyways if there was no other employment possibility. A comment of a Shanghai worker about the life in the city illustrates the idea of beneficial progress: “Yes, life is hard, and our work is hard, but it’s a million times better than life in the countryside.”[11] Eventually, as more and more companies try to “exploit” the advantages of third world countries they have to raise wages to attract employees. Higher wages in turn help lift the country from poverty.

The vision of profit also motivates local entrepreneurs that are so essential to economic growth. As domestic entrepreneurship is the key to a growing economy, it is important to realize the limited role third parties (e.g. foreign governments and other donors) can play. When dealing with donations, it is important to differentiate between crisis intervention and counseling.[12] Much of the foreign aid can be regarded as simple crisis intervention: foreign specialists come into a poverty stricken country, bring supplies and expertise, and demand certain responses and results. This approach, although necessary in some situations, is not sustainable in the long run. It teaches people that there will always be some form of outside help instead of encouraging them to make a difference by themselves. Change, in order to be successful, always has to come from within making every country responsible for its own destiny.

In Milton Friedman’s ideology, profit is a universal motivator that ultimately serves the greater good of society. This concept is based on a democratic political system where the public is able to influence the laws protecting human rights or the environment.  The situation becomes more complicated in non-democratic countries or restricted markets. These conditions allow for monopolies which lead to true exploitation. Although one should not rely on morals due to their subjective nature, in the described situation, business morals are the only rules left.  As my argument supporting the role of profit was based on the presence of a free market system in a democratic government, every business created under these conditions should have a “moral” responsibility to operate only in free democratic countries. Businesses violating this essential rule are basically denying the whole concept their very existence is based on and are deterring examples of hypocrisy.

Profit, understood as an abstract concept, cannot be judged on its morality as well as markets or businesses. The moral responsibility lies within the system that enables these concepts to become real. In democracies, the moral responsibility is transferred to the people. Even outside the boundaries of countries, profits should remain the main motivators, the creation of rules should remain with governments, and international organizations should not try to impose new rules on sovereign democratic governments. A need for moral business behavior arises only in non-democratic and restricted economies. Otherwise, the drive of individuals for profit creates growth in the economy and helps to advance the society as defined by Adam Smith already in the 18^th century:

“By pursuing his own interest [an individual] frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good.”[13]

As suggested by this essay, the two Koreas’ crucial difference is that the South embraced a democratic free market economy while the North became a communist dictatorship. In other words, profit was the main motivator for South Koreans, while North Koreans were motivated by brainwashing propaganda–profit was the right and moral choice. The attitude of North Korea is, in fact, immoral: keeping a country at the same stage of development, letting its people die in famines, when the concept of profit has been proven beneficial is truly immoral.

Thinking about the 9^th grade history class, and my life until now, I realize that having the opportunity to live in a modern country is invaluable. However, my life experiences, including my trip to South Korea, taught me that there is a concept leading to prosperity of countries and the notion of profit is at the heart of it. To truly make the world a better place for everybody, it should be a moral duty of everybody to support, propagate, and spread this concept throughout the world, and especially in the poorest countries like North Korea.

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[1] “GDP Per Capita, South Korea,“ Nationmaster.com, 18 Feb. 2010, http://www.nationmaster.com/time.php?stat=eco_gdp_percap-economy-gdp-per-capita&country=ks-korea-south.

[2] Sung Pyo Jun, “Social Characteristics of Korea,” Lecture at University of Ulsan, South Korea, 30 Jun. 2009.

[3] “Korea, South.“ CIA World Factbook. 18 Feb. 2010 https://www.cia.gov/library/publications/the-world-factbook/geos/ks.html.

[4] Milton Friedman, “The Social Responsibility of Business is to Increase its Profits,“ The New York Times Magazine, September 13, 1970.

[5] Milton Friedman, “The Social Responsibility of Business is to Increase its Profits,“ The New York Times Magazine, September 13, 1970.

[6] John Mackey (CEO of Whole Foods Market), “Rethinking the Social Responsibility of Business,“ Reason Magazine, October 2005, http://reason.com/archives/2005/10/01/rethinking-the-social-responsi/singlepage.

[7] Adam Smith, “An Inquiry into the Nature and Causes of the Wealth of Nations“, (London: Methuen and Co., Ltd., ed. Edwin Cannan, 1904), Fifth Edition, http://www.econlib.org/library/Smith/smWN.html.

[8] “2008 World Population Data Sheet,“ PRB, 18 Feb. 2010, http://www.prb.org/Publications/Datasheets/2008/2008wpds.aspx.

[9] “The Struggles of Labor,“ Countristudies.us, 18 Feb. 2010, http://countrystudies.us/united-states/history-82.htm.

[10] John Brolin, The Bias of the World: Theories of Unequal Exchange in History, (Sweden: Lund University), extensive draft version: http://www.kallebrolin.com/Local%20Images%20Folder/portfoliostills/0TheBiasoftheWorld.pdf.

[11] Rob Gifford, “China Road,“ (New York: Random House, 2008), 22.

[12] From the notion of crisis intervention versus counceling trap in Andreas Widmer’s essay „A Mind for the Poor,“ In the River They Swim, (West Conshohocken, Pensylvania: Templeton Press, 2009).

[13] Adam Smith, “An Inquiry into the Nature and Causes of the Wealth of Nations“, (London: Methuen and Co., Ltd., ed. Edwin Cannan, 1904), Fifth Edition, IV.2.1, http://www.econlib.org/library/Smith/smWN13.html#f38.

The US Energy Consumption and its Future Transformation

Today’s modern societies are highly dependent on energy resources. With rising consumption and limited resources, energy is becoming an issue all over the world. According to the EIA, the United States accounts almost for 22 percent of the world’s total energy consumption, making it the number one energy consumer (“International Energy Annual”).  Because 33 percent of the US energy consumption has to be imported (mostly in the form of oil), and with 85 percent the import coming from fossil fuels, it is necessary for the US to transform its current state in order to lessen its dependence on nonrenewable sources as well as the world’s oil producers  (“Annual Energy Review”). This issue, as well as being a question of prudent energy, is a matter of national security, which makes it even more important.

In order to reduce the current energy consumption, one has to first understand why the Unites States became the world’s biggest energy consumer.  As a liberal capitalist country, the United States has promoted low taxes throughout the past. This was and still is reflected in the energy prices–gasoline prices in particular.  If one compares gas prices in the US and the EU, the United States seems to be a paradise for motorists. Although the actual gas prices are almost the same before taxes, taxes on gas in the EU are much more substantial, making US gas relatively cheap (“International Energy Price Information,” Figure 1). This same trend can be observed among electricity prices, which are almost half of the EU and G7 average (“Quarterly energy prices: tables,” Figure 2). As already mentioned, it is not greater efficiency but extremely low taxes that allow the US energy prices to be low. Thus, throughout the past, the low energy prices promoted higher consumption among Americans. Although this approach contributed to the American economic boom, it relied on low and stable global energy costs. With most of the current energy resources being limited in their quantity, the prices are bound to go up in the future. The future energy cost increase will affect the whole world, but the biggest consequences will be felt by the countries with the highest consumption, namely the United States.

It is obvious that the restructuring of the United States’ energy supply towards total independence is a very complex and extenuated process. There are two different approaches towards the current energy issue: the first approach, conservation, is based on cutting consumption as a means for decreasing independence whereas the second approach, innovation, focuses on the replacement of current energy sources by other alternatives not depending on fossil fuels or imports. The best solution is logically a combination of both approaches reflecting the current environmental, technical, and economical situation. Currently, it is very important to start an extensive initiative as soon as possible: the earlier the transformation begins, the less painful it is going to be. Additionally, other world countries (especially the EU) have a big head start in green technologies and energy conservation, making the need for action in the US even more prominent–Germany, for instance, has 14 percent (“Big boost for renewable energies”) of renewable energy compared to the US’ 6 percent (“Annual Energy Review”).

The total US energy consumption is 101.6 Quadrillion Btu (British thermal unit). Fossil fuels account for about 85 percent of the total consumption, whereas nuclear and renewable energy share only 15 percent (Figure 3). As more than 30 percent of the fossil fuels are being imported (mostly in the form of oil), the US energy sector is highly dependent on imports (“Annual Energy Review”). This fact significantly increases the volatility of the energy supply:  the fluctuating price of oil forces the US costs to go up or down depending solely on the supply and demand of oil. Thus, the US is very volatile in an unstable global environment where rising oil prices can lead to an economic downturn. Furthermore, 85 percent of the US energy supply has a life span of only a few hundred years. Nuclear energy resources, on the other hand, can last for thousands of years if unconventional resources and new technologies are taken into account (Price). Renewable energy sources have an endless life span, making them the perfect energy source for the distant future.

According to the EIA, the US energy consumption can be divided into four sectors:

1. Residential – encompasses single-family, multifamily, and mobile home households
2. Commercial – consists of all activities that are service related (other than transportation whose principal activities are not residential or industrial businesses)
3. Industrial – encompasses establishments engaged in manufacturing, agriculture, forestry, fishing, construction, and mining
4. Transportation – consists of passenger travel and freight movement

The energy consumption distribution is depicted in Figure 4. All four sectors have great possibilities to reduce energy consumption; however, to discover the best possible ways to minimize the dependency on fossil fuels, the types of energy resources used in each sector have to be examined first. The energy consumed by the four sectors can be divided into primary energy and secondary energy. Primary energy means that a resource is directly converted and used as the needed energy. Secondary energy, such as electric power, is on the other hand converted to a different form which is then used at the needed place. Primary energy can further be divided into fossil fuels and renewable energy resources.

The residential sector highly relies on secondary energy in the form of electric power, which constitutes 69 percent of the residential total. Fossil fuels constitute 28 percent (with natural gas claiming 24 percent) of the total leaving only 3 percent for renewable resources ( “Annual Energy Review,” Figure 5). As most of the people live in single-family homes, about 64 percent, they consume the biggest share of energy in the residential sector. A study done by the Center for Sustainable Systems at the University of Michigan showed that single family home sizes increased 62 percent between the years 1970 and 2005. This, even if new more efficient materials and technologies are considered, directly translated into higher energy consumption. Much energy can be saved through conservation. This encompasses more efficient insulation materials, maximizing day-lighting, or make use of passive cooling. Innovative technologies can also strongly contribute to the residential energy use reduction. Examples are passive heating methods, the use of natural gas instead of electricity (which reduces the primary energy consumption by 75 percent), or using wastewater heat exchangers. According to the study done by Michigan University houses in the US consume about 1.3 GJ per square meter annually as compared to comparable more efficient houses in Sweden which use only around 0.5 GJ of energy (“Residential Buildings”). Thus, it is possible to save 30 to 40 percent of energy in the residential sector during the next few decades by using current technologies and resources.

The situation is very similar in the commercial sector: the majority of the energy consumption belongs to electricity with almost 79 percent, fossil fuels claim about 20 percent, and renewable energy contributes with less than 1 percent to the total commercial energy consumption (“Annual Energy Review,” Figure 6). Almost 50 percent of the total energy consumption in commercial buildings goes towards lighting and temperature regulation. This energy consumption can be easily reduced by use of passive solar heating and lighting, low emissivity windows, structural insulating panels, and energy efficient landscaping. Studies have shown that new innovative commercial buildings can consume up to 55 percent less energy than conventional buildings (“Commercial Buildings”). This again can lead to a 30 to 40 percent energy saving in the commercial sector in the future time horizon of few decades.

With 60 percent being fossil fuels and 6 percent being renewable fuels, primary energy is used the most in the industrial sector. Electric power then claims the remaining 34 percent of the energy consumption (“Annual Energy Review,” Figure 7). As almost 30 percent of energy consumption comes from petroleum products, the industrial sector is dependent on international oil. A focus on reducing the consumption of oil in the industrial sector thus also contributes to increased national security. A study conducted by national energy labs concluded that about 22 percent of energy could be saved by the year 2020 (“North Carolina State Energy Plan,” 59).

The transportation sector utilizes mostly fossil fuels in the form of oil with 98 percent. Accordingly, 2 percent then remain for biofuels as a renewable resource (“Annual Energy Review,” Figure 8). Within that sector, the biggest energy consumption comes from fuel costs of cars and light trucks, which represent 58 percent of total transportation consumption (“Personal Transportation”). Given the US’ big share of personal highway transportation in the energy consumption, Germany’s per capita transportation energy consumption is three times lower than in the US (“Member Countries and Countries Beyond the OECD”). This sector thus provides a big opportunity for energy savings. According to MSNBC, cars and light trucks in the US had on average a mpg of slightly above 20 as compared to 40 mpg in Europe (Jones). Thus, renewing the vehicle park with higher gas mileage cars could mean a reduction in energy consumption of more than 25 percent in the future. Nonetheless, there are other alternatives to conventional gas such as biofuels, electric cars or hydrogen cars. Biofuels currently look like the best substitute for gas since they would not require significant changes in car technologies and the distribution networks. Biofuels, together with electric cars and hydrogen cars, do not yet offer enough efficiency to be implemented in large amounts as the overall economic costs are still high. With advancement in science and technology, the processes of creating biofuels can be made more efficient in the future. Large investments into research of new fuel resources and methods of conversion of fuel are currently necessary but will be offset by the savings in the future. Another way to decrease transportation energy consumption is public transportation, which allows for much greater efficiency than individual transportation. Promotion of public transportation with a campaign aimed at making people more energy efficient can have a great impact on the total energy consumption. This campaign should promote –apart from using alternative modes of transportation to the car– living closer to the place of work, telecommuting or home office possibilities, and combining errands or carpooling. It is indeed possible for the US to become independent from foreign oil but this independency will require sacrifices from the whole population.

Electric power as secondary energy is represented in three of the four sectors. It is responsible for 40 percent of the total US energy consumption. Electricity is converted from the following resources: fossil fuels, nuclear energy, and renewable energy.  The fossil fuels have a share of 70 percent, nuclear energy 21 percent and renewable resources only 9 percent (“Annual Energy Review,” Figure 9, 10). In order to reduce the dependency on fossil fuels, it is necessary to implement new technologies of manufacturing electricity. These alternative resources that can decrease the oil, gas, and coal dependency are nuclear and renewable resource. With further advancement in science and technology, these resources have a huge potential in their power generating capabilities.

Renewable electricity energy resources in the United States compared to the EU countries have a relatively low percentage chart. Given the geographic features of America and its potential, the US could already be much further in the development of renewable energy share. Although hydroelectric power is the current leader in the renewable electricity generation sector with almost 70 percent of total production, there is no more useful potential in the power of water in the US. Solar and wind energy, on the other hand, have great potential for expansion. Wind, currently generating only 0.8 percent of the total electricity allows for about two times lower electricity costs than coal (“Wind Energy”). According to the US Department of Efficiency and Renewable Energy, it is possible to reach a share of 20 percent generated by wind power by 2030 (“20% Wind Energy by 2030”).

Solar power, which currently comprises a negligible part of electricity production, has great future potential. With the advance of technology, the prices of photovoltaic cells are constantly decreasing. According to EDN, the price of a kW/h of solar electricity could fall in 2010 to only 13 cents (Mutschler). With the current average electricity price in California of 12.6 cents per kW/h PV, cells would become economically competitive (“Electricity”). A study shows that PV cells covering 0.4 percent of US land could generate a sufficient amount of electricity for the whole nation (“Photovoltaic Energy”). This study reveals the potential of solar energy and should encourage investors to explore the possibilities in this sector. According to the Scientific American, solar power has the potential to be supplying 69 percent of the total electricity around 2050 (Zweibel). However, there are no specific government plans to take advantage of this large possibility and issues like inconsistencies in the PV energy supply are the main barriers to a great expansions.

As many of the alternative energy expansion plans need a considerable amount of investment, it should be the government’s responsibility to promote research and development of the alternative energy projects. Even though the direct costs of some alternatives might be higher than their benefits in the present, it is necessary to examine their benefits in the long run. However, the government should also keep a proper cost/benefit ratio in mind regarding the amount of money they invest into research and the potential gains of said research. It is also essential to involve the whole nation in the process of restructuring the energy supply. A lot of change can already be achieved by individuals investing in their homes, businesses or efficient transportation.

If the United States takes advantage of the current possibilities of innovation and conservation in the energy production and consumption sectors, the total energy consumption of the nation can be reduced at least by 20 percent in 2020 as compared to the current level. The structure of the energy supply has a potential of reducing fossil fuel dependency in the electricity generation sector by 20 to 30 percent by 2030.

Please look at original document for graphs and works cited: US Energy Consumption

The U.S. Credit Crisis

The U.S. Credit Crisis

The U.S. economy is currently in a crisis, possibly the largest one since the Great Depression. Signs of this situation can be seen everywhere and almost no one in the economy will remain unaffected. The current crisis was primarily caused by the mortgage business which promised big profits in exchange for high risk. However, the system failed to recognize the real risk involved which was subsequently transferred into the financial market where it became the problem of investors who now pay for the faulty risk assessment in the transaction chain.

The American mortgage industry has been around for more than a century and has helped people to fulfill their dream of home-ownership since. But how could such a business with years of experience backed by favorable statistical data go bad? The answer can be summed up into a single word: subprime. Nonetheless, this poses another question: How did subprime come into being?

Fannie and Freddie

Although the mortgage business was already present in the early 1900’s, it did not really take off until Fannie Mae or the Federal National Mortgage Association was called into existence in the 1930s. It bought FHA (Federal Housing Administration) insured loans and sold them in the financial market (“The history of Home Mortgages”). This not only created the secondary mortgage market, but most importantly assured a steady flow of capital towards mortgage companies and finally lenders with homeowner dreams. Furthermore, Fannie Mea introduced central guidelines and rules for issuing loans and was the tool of the federal government to look over the mortgage industry. On the other side, investors were also happy with the government backed securities Fannie Mae sold in the financial market.

The end of the Second World War brought–apart from victory for the allies–a big part of the workforce back to the States. These veterans needed housing and the Veteran Administration decided to help those American war heroes. In 1944, the VA was granted the right to back mortgages made by private lenders to veterans. This step of the federal government massively expanded the mortgage industry and helped to spur the United States’ economic growth. However, the demand for loans was still outweighing the supply, therefore the U.S. Congress chartered in the year 1970 the Federal Home Loan Mortgage Corporation also known as Freddie Mac (“The history of Home Mortgages”). Thus, in the 1970s, a big portion of the flow of capital towards mortgages was controlled by government-sponsored organizations. The federal government had, therefore a strong influence on the mortgage business giving the rules and guidelines. Nonetheless, Fannie Mae and Freddie Mac, even though created by the government, did not have any guaranties from the government to help them out in tough times, but it was generally assumed that the U.S. government would not let them fall (“Fed Chief Warns of a Risk to Taxpayers”).

The S&L Crisis

Not all mortgage companies were dependent on the capital flow from Fannie and Freddie. There were savings and loans associations, also known as thrifts, who were lending deposited money as mortgages. S&Ls were a major player in the mortgage industry since its origin accounting for 53 percent of the whole business in 1975. Even though S&Ls received preferential treatment by the FED, Various laws passed by the Congress kept them strongly regulated. Deregulation came in the year 1980 in the form of the Depository Institutions Deregulation and Monetary Control Act (“DIDMCA”). Thrifts were given rights that banks enjoyed but lacked the regulation enforced upon banks. Furthermore, the limited savings account rate was eliminated giving banks the possibility to raise rates. Unfortunately, S&Ls were originating mostly long term fixed rate mortgages and thus they could offer only a limited amount of return on their savings accounts even though current rates changed. While there was a big demand for capital, banks raised the interest rates; for S&Ls to keep up they had to raise their rates too which created an asset-liability mismatch. This mismatch together with decreased regulations, lack of experience and supervision in the newly formed industry lead to the savings and loan crises of the 1980’s and 1990’s. The resulted was a dramatic decrease of the number of federally insured S&Ls by about 50 percent and a request for financial assistance of more than 1600 banks to the Federal Deposit Insurance Corporation (FDIC). Consequently, the costs of the savings and loan crisis were estimated at $150 billion for the American taxpayer after government stepped in (Muolo 54).

Surprisingly, there were also entities profiting from this crisis, namely the competition of S&Ls; those were nonbanks funded by Freddie, Fannie or other loans from large banks called warehouse loans. Angelo Mozilo’s Countrywide was a good example. By that time, the two government chartered organizations were allowed to purchase “A” quality loans which gave a significant boost to nonbanks in gaining market share. Nonetheless, there still was no sign of subprime, however its “predecessor” second liens or “second deeds of trust” were well around since the 1960s (Muolo 30).

Second Liens–Subprime Roots

Second liens were small mortgages built on top of the first mortgage. They were considered more risky and therefore had a higher interest rate. With a higher rate there also came higher profit. Benefitial, a company that started the second lien business, made huge profits in the mid 1970s. This made the nondepository second lien companies very attractive for investors –mainly big banks–that opened their warehouse lines of credit to companies like Benefitial or The Money Store. By the end of the 1970s, Benefitial was issuing nonconforming mortgages to less than “A” paper standard borrowers. Although the term subprime was not yet around, these mortgages were basically what we call today subprime mortgages. When the S&L crisis surged in the late 1980s, investors lured by the big profits Benefitial or The Money Store were making turned their attention to nonbanks. Finally, the news of the big profit reached Wall Street where investors were eager to get a piece of the future subprime mortgage pie. This involvement of the Street opened huge warehouse lines of credit to nonbanks. Wall Street firms like Bear Stearns, Lehman Brothers, Merrill Lynch and several others non-prime mortgages into MBS (mortgage-backed securities) turning huge profits (Muolo 35).

The Hunt After “Nonconforming” Mortgages

Meanwhile, mortgage companies found out that it is much more profitable to employ loan brokers instead of having branches. A loan broker is in short a person out on the street trying to sell mortgages and bringing them to the local office. If the loan gets approved, the broker gets percentage points from the deal; the higher the interest rate, the more money the broker gets. This system gives the mortgage broker an incentive to close even very inconvenient deals with his customers. However, this “always closing” attitude was promoted by the mortgage firms because the more high-rate deals they closed the more profit they got.

Moreover, with big profits new competition arose and mortgage companies started looking for new ways to close more deals. Thus, they introduced new mortgage products to the market. Those new products were for instance: adjustable rate mortgages, graduated payment mortgages, or negative amortization mortgages. Some of them, like the negative amortization mortgages, allowed for low initial payments gradually rising throughout the period. Furthermore, the requirements posed on the borrower significantly loosened through time. Mortgage companies required less proof of the borrowers’ solvency to pay the loan back. An example of that are stated income loans in which lenders just write down their salary and it was assumed to be valid.

This pressure was created by the hard competition on the loan brokers to act unethically and close deals that are unfavorable for the lender and also for the company. However, since the broker’s deals were not identified as bad instantly, and the mortgage companies usually approved them while seeing the big profits, there was no direct quality control. Furthermore, since the main goal was quantity, it is obvious that quality was left behind. After 2000, big players like Countrywide and Ameriquest joined the ongoing subprime party with the aim to dominate (Muolo 120). This further boosted the volume of subprime mortgages.

Inflating the Housing Bubble

The easy accessibility of mortgage loans created artificially high demand for housing, which consequently raised the prices and created the housing bubble. In some regions like California for instance, the value of houses was growing by 25 percent annually (Muolo 184). This in turn created equity and thus even if the loan went bad the mortgage company would still end up fairly well off. This was, at least, the very attractive theory.

Most of the mortgage companies went public to raise additional capital to enhance their business. The firms could do it either through a traditional C corporation structure or a real estate investment trust also known as REIT. The main difference was that REIT was based on paying out dividends. In fact 90 percent of the company’s earnings went to the shareholders of a REIT company (Muolo 131). In exchange for this profit giveaway, REITs enjoyed a huge tax break from the federal government. This structure attracts–due to its dividends–a lot of investors, being consequently able to raise a large amount of money by going public. However, the company could not create a pool of capital to serve as a buffer for bad times, and in order to maintain profits it had to expand constantly. REITs were working well when the industry was healthy, but in case of a downturn, they would be the first to go.

Another important thing to impact the mortgage industry was the drastic cut of the federal funds rate. The cuts were mainly a result of 9/11 and the accounting scandals in Fannie Mae and Freddie Mac. The federal funds rate stopped at its historical minimum of 1 percent in 2002. This cut logically influenced the loan funds market including the mortgage industry. Consequently, lower mortgage rates made housing even more available and the industry just boomed. In 2003, when “A” paper rates fell to 5 percent loan originators set a new record of $3.9 trillion of which 10 percent were subprime (Muolo 259). The next year, although the total amount of mortgages fell to $2.8 trillion subprime increased to $608 billion or 21 percent. Finally, in 2006, the second best year, lenders originated $ 3.2 trillion in new loans of which $ 665 billion (21 percent) were subprime. However, another $ 650 billion were stated-income loans, payment option ARMs, and double mortgages (secondary and primary mortgages together), which also belonged to the riskier category (Muolo 185). Therefore, in 2006, roughly 40 percent of the originated mortgages were high risk.

The Hungry Wall Street

The rise in the volume of house loans issued obviously demanded an increase in warehouse lines of credits. The Street however, was hungry for all those mortgages issued and supplied the necessary capital. This huge change in the mortgage industry left Fannie Mae and Freddie Mac behind licking their wounds from their accounting scandals. By issuing MBS and their derivatives in huge amounts the Street begun to dominate most of the capital flow to its liking.  Regardless of the enormous profits, for every dollar spent on mortgages, Wall Street firms got an unidentified amount of risk. This lack of comprehending the risk involved was due to the fact that there was really no statistical data about the subprime industry because it has only been around for few years and was still unsettled because its enormous growth. To fully understand the whole processes behind a mortgage loan, one has to examine the complete chain of transferring capital and risk.

The Mortgage Chain

In the front lines there are mortgage brokers looking for customers usually with the help of real estate agents. Once a broker finds a client, he gathers information about the home the mortgage is going to be on and credit information of the borrower. Then he negotiates the mortgage conditions to suit the customer’s demands. The mortgage broker is paid by closed deal, which gives him the incentive to always be closing. As already mentioned, the higher the interest rate is, the higher the commission. Consequently, loan brokers do whatever they can to sell mortgages, which includes overstating home values or unethical selling practices where they talk the customer into getting loans with higher rates. These faulty mortgages were supposed to be sorted out by the mortgage company’s approval department. But because every mortgage, especially of the subprime kind, translated into income almost immediately (for the reason of using gain-on-sale accounting), which in turn meant higher bonuses for the employees, many bad mortgage loans were in fact accepted and passed on to Wall Street.

The big players on the Street send the mortgages to be evaluated by rating agencies such as Standard & Poor’s, Fitch, and Moody’s (Muolo 217). However, subprime mortgages pooled into bonds were not exactly the rating agencies’ cup of tea since there was no sufficient statistical data or experience. Furthermore, there was enormous pressure from Wall Street firms on the rating agencies: First, in order to make things easier, firms like Bear Stearns or Merrill Lynch demanded to rate only a fraction of the whole lump of mortgages. Second, if a rating agency gave a bad grade to a bond or CDO (collateralized debt obligation) it risked losing its customer to the competition that was possibly somewhat more easygoing (Muolo 228); for example, if the CDO did not meet the standard Wall Street firms used insurance companies to enhance the rating. Thus, subprime junk mortgages could become part of AA or AAA rated bonds throughout the whole process.

Many investors also from overseas were attracted by the good ratings and returns on many CDOs. Nonetheless, they did not have a clue into what exactly they were investing. Thus, investments were mainly based on trust in the big Wall Street entities like Solomon Brothers, Merrill Lynch, Bear Sterns or Citigroup. In the whole process, from issuing mortgages to selling them in bonds at Wall Street, there was a huge risk transfer. As the home prices continued to rise, and profits kept flowing in, nobody really wanted to see the risk involved.

If the market fails to recognize the risk involved, government entities like the Fed or the SEC (Security Exchange Commission) should step in. According the Federal Reserve System’s Mission it should “maintain the stability of the financial system and containing systemic risk that may arise in financial markets” which also includes controlling asset bubbles (“Mission”). However, no major steps were taken. Similarly, the SEC did not assure the transparency in the MBS (mortgage backed securities) market.  Moreover, this apathetic attitude of the government entities might have been caused by lobbying of various mortgage companies to further leave the rules loose. Thus the government failed to recognize and fight a looming crisis and has to deal now with the consequences.

Closing the Candy Store

The big boom in the mortgage industry started to come to an end in 2007. Risky loans began to go bad. By October 2007, Countrywide, the biggest lender in the US, had a 24 percent delinquency rate of its subprime servicing portfolio (Muolo 253). Similar reports could be seen throughout the whole industry. The delinquencies did not just stay in the subprime sector. “A” paper late payments have risen by 30 percent in the last year. The number of foreclosures rose taking the home prices down. The most important process the whole mortgage industry relied on–home value appreciation–drastically failed leading many mortgage firms to bankruptcy.

The disaster wave caused by late payments and foreclosures continued towards Wall Street.  Two hedge funds managed by Bear Sterns and focusing mainly on CDOs collapsed in the summer of 2007 with millions of investor assets gone. Consequently, Bear reported a $850 million loss for the fourth quarter and had to write down assets of almost $2 billion in its books. Simultaneously, at the end of 2007, other Street firms found themselves writing down billions of dollars of subprime CDOs: Citigroup $11 billion with a potential of $45 billion, United bank of Switzerland $10 billion, Merrill Lynch $8.5 billion, with others following. By spring 2008, the write downs made by investment banking firms, banks, and thrifts totaled $200 billion (Muolo 260).

Back at the other end of the chain, mortgage companies had huge lay-offs, and together with the downturn in the construction industry about 420,000 jobs disappeared. This rise in unemployment again triggered late payments and foreclosures even for “A” paper loans. Home prices were falling by 10 to 20 percent in some metropolitan areas. Signs of an upcoming crisis forced the Fed into action: by March 2008 it has cut short-term overnight rates to 2.25 percent in order to create more liquidity in the funds markets (Muolo 286).

The Crisis Begins to Unfold Itself

The Fed was now worried about the collapse of the U.S. mortgage market which by March 2008 securitized more than $1 trillion in subprime loans during the previous 30 months (Muolo 287). Thus the central bank assisted in the sale of Bear Stearns (which had $30 billion in problem assets mostly coming from CDOs, ABSs, and mortgage derivatives) to JPMorgan Chase.  Seeing one of the most prominent names on Wall Street vanish is an undisputable sign of a financial crisis.

By spring 2008, 10,000 loan brokerage firms had closed with another 10,000 in danger of failing by the end of 2008. As companies like Countrywide or Ameriquest were gone almost 40 percent of the mortgage industry disappeared (Muolo 301).  The crisis worsened throughout summer of 2008 with the collapse of the largest mortgage lender IndyMac (“IndyMac Bank seized”). The end of the summer brought another series of catastrophic news: on September 8, Fannie Mae and Freddie Mac were seized by the government to guarantee their future existence (“Government Seizes Fannie Mae, Freddie Mac”). The series of bad news continued in mid-September when Lehman Brothers filed for bankruptcy, Merrill Lynch was acquisitioned by Bank of America, and AIG asked the Fed for a loan. The Fed then issued a  $85 billion rescue package to help AIG (“Financial Giants Falling: Lehman, Merrill Lynch, AIG”). Furthermore, on September 25, Washington Mutual, the largest U.S. savings and loan association, was closed and subsequently sold to JPMorgan Chase. All this unfavorable news had obviously a devastating effect not only on the stock markets in the U.S. but also throughout the whole world. In September, the Dow Jones Industrial Average sunk below the 11,000 mark while it was a year ago breaking records with an overall high at more than 14,000.

The Bailout Plan

The size of the crisis was now enormous and the Fed had to take radical action. On September 28, Congressional leaders and the White house agreed on a $700 billion bailout plan to rescue the plunging economy and stop the financial crisis. Although this solution would help the current situation, it would also increase the 2008 budget deficit which will in turn add to the U.S. government debt, which would be forced to pass the $10 trillion mark. Consequently, the huge tax burden of the bailout was the reason that on Monday the 29th, Congress did not pass the plan and sent the stock markets into a nosedive, resulting in the Dow losing 777 points: the biggest day point loss ever. This translates to over $1 trillion worth of assets erased from the market over the course of six and a half hours. Consequently, investors hold on to their assets, further decreasing the overall liquidity in the economy. Confirming this fear was the Tuesday’s Bank-To-Bank lending rates increase to 4.05 percent (“Bank-To-Bank Lending Rates On The Rise”). However, The Dow recovered the same day almost half its losses because of the rise in confidence about the passing of the bailout bill. Thus, the plan was modified by the Senate to be passed over on Friday, October 3 to the House of Representatives. The new legislation, among the promised $700 billion, encompasses tax cuts or raising the FDIC insurance limit to $250,000 to ensure more votes in the House (“Senate passes $700B rescue; House votes lured”).

Although the U.S. government bailout will be a huge burden on taxpayers, it has become a necessity to get the financial markets moving. This is especially important since many entities in the American economy rely on the lending which is a factor influencing consumer spending–the motor of the U.S. economy. On the other hand, the money will be used to save financial institutions that already proved themselves unworthy by getting themselves into the crisis. Additionally, the people whose houses are being foreclosed on will not see a penny from the deal and will be left to battle their financial problems on their own. The bailout is thus definitely not a solution to the whole crises, but just a small step to make things right again. Furthermore the depth of the crisis is yet to be discovered because of unknown amounts of MBS derivatives and the number of mortgages that will go bad.

The Japanese Way

About four years ago, Japan was experiencing a credit crisis similar to the current situation in the U.S. The four islands east of China experienced a property market boom which lead to a lot of mortgage loans. As the housing bubble imploded, decreasing the real estate prices and driving developers bankrupt, many investors found their money lost.  Consequently, a lot of major Japanese banks went on the edge of bankruptcy and it was assumed that the crisis could become a global threat. Fortunately, the Japanese government stepped in and bailed out the financial institutions with $100 billion (“Japan offers solution to financial crisis”). As of 2006, most of the banks were back in the green numbers and even the Bank of Japan made a profit on the whole deal. Thus, the Japanese bailout was a success.

The Japanese case, although somewhat similar to the U.S. crisis, cannot be applied to the American economy. First, the magnitude of the crisis is far bigger in America, and second, the Japanese economy is better off in terms of the trade balance with one of the biggest exports in the world. Thus it had another source of capital which is missing in the American economy. Another difference is that the 2008 credit crisis is already global for the reason that investors from around the world trusted Wall Street with their assets. The global nature of the crisis suggests a global solution. Unfortunately, there are currently too many barriers (like the lack of an authoritative international institution) to make the global cooperation work. Therefore, the bailout is not really a good solution; nonetheless, at this point of time, it is the only rational thing to do.

Other Approaches

It is imperative to understand the fundamental reason behind the crisis in order to overcome it. Greed for money caused people disregard the risks taken. Thus, investors from all around the world bet their assets on the U.S. housing market. As the housing prices went up, their assets were safe, but with the burst of the housing bubble, the investment disappeared in thin air. Therefore, the key to a successful solution of the crisis is to get the housing prices up again. This is easily done by increasing demand for housing.

As mentioned earlier, the global nature of the credit crisis is a fact that has to be taken seriously. It is logical that the U.S. needs to solve the crisis on a global level. Thus, in order to increase demand for housing, the U.S. should promote immigration not only of people but also companies that could profit from the American economy. Although, this would probably mean harder times for the average American, it would bring investment back into the U.S. economy, simultaneously spurring production. Furthermore, this policy would not continue to increase the financial burden of taxpayers and could–on the other hand–possibly even increase the total taxes by increasing production.

Future Changes

It is obvious that this crisis pinpointed some fundamental shortcomings in the current legislation. In the future, it will be necessary to change the rules of the financial market in order to avoid the repetition of a similar situation. Strict rules need to be applied to the loanable funds industry and the controlling mechanisms must be improved. Thanks to modern technologies, implementation of controlling methods should not be a big issue. Furthermore, the principles of transparency and accountability will have to be strictly enforced. This means that investors should know exactly where their assets are going and that managers will be held responsible for the companies’ failures (in contrast to collecting multi-million bonuses while their company goes up in flames). The current crisis is acting as yet another lesson about how the economy functions and gives people the opportunity to fix the system so that it will be safer and more efficient for future generations.

Works Cited

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