The 2007-2008 Economic Crisis

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Causes of the 2007-2008 Economic Crisis

The economic crisis of 2007-2008 had the most far-reaching financial repercussions for the U.S. economy since the Great Depression (Helleiner 2011). The significant increase in sub-prime mortgage defaults caused the bursting of a housing bubble. As a result of the growth in the number of defaults, the stability of financial institutions exposed to those mortgages was compromised. Following the collapse of several hedge funds in June 2007, panic broke out in numerous highly-liquid markets (Helleiner 2011). The US government-chartered institutions, Fannie Mae and Freddie Mae, were placed in a federal conservatorship program due to the significant losses experienced by them (Helleiner 2011). Moreover, authorities also had to prop up investment bank Bear Stearns in March 2008 (Helleiner 2011). The collapse of Lehman Brothers was an explicit signal that a market meltdown might ensue.

Securitization significantly contributed to the depth of the crisis (Lewis, 2015). This has to do with collateralized debt obligations (CDOs), and mortgage-backed securities (MBSs) issued by the U.S. institutions being purchased by foreign banks and hedge funds. Moreover, trading of credit risk was not restricted to mortgages but also included other asset-backed securities (Helleiner 2011, p. 70) such as car loans and credit cards, among others. Furthermore, credit risks that were sold and traded worldwide with the help of CDOs and MBSs were hedged via the credit default swap (CDS) and other derivatives (Helleiner 2011). The instrument was created in order to provide holders of bonds with insurance against defaults. However, a significant number of CDSs buyers were not holders of underlying bonds: their aim was to speculate on defaults of certain bonds.

Therefore, an enormous market for CDS contracts emerged. Its size exceeded $60 trillion at the beginning of the crisis (Helleiner 2011). The explosive growth of new types of securitization led to the increased confidence among market players because of the prevalent notion that new instruments were able to promote the stability of the financial system by distributing risks. However, mortgage lenders who were able to quickly sell mortgages started to overlook prudential concerns (Helleiner 2011, p. 70) in order to generate more fees from selling increasingly larger volumes of loans. MBSs and CDOs were bundled in such a way that it was difficult to determine their exact quality. Therefore, the rise in defaults led to dramatic consequences showing the lack of resilience of highly regulated individual financial institutions and other commercial actors. The diffusion of new financial instruments contributed to the intensification of panic over the inability to determine which institutions actually held these products and what their levels of exposure were (Helleiner 2011, p. 69).

The mortgage securitization was associated with the risks associated with over-relying on credit rating agencies, the ever-increasing significance of lightly-regulated firms, the opacity of OTC derivatives, the perils of crisis amplification across numerous markets and countries, and the concentration of risk in huge and interrelated companies (Helleiner 2011). It could be argued that these practices still exist today even though liquidity requirements have been changed, and capital ratios have been increased (Taylor & Baily 2014).

Tools for Forecasting Events and Predicting Crises

Role-Playing

Role-playing is a qualitative method of predicting events and forecasting crises in the business environment. This tool uses subjects who adopt the viewpoints of different groups in order to simulate interactions aimed at evoking reactions from decision-makers. Role-playing is used to test the alternative outcomes of a particular intervention (Armstrong, 1999). This tool is relevant for dealing with crises because unlike the method of the intention, which only helps to determine what actions can be taken by allowing subjects to adopt the perspective of decision-makers, role-playing helps participants to act out different scenarios. The advantage of this method is that it allows subjects to use their skills and knowledge during realistic interactions. However, group dynamics can negatively impact the process of role-playing. Evidence suggests that role-playing can be successfully used in the fields of the military, law, and business (Armstrong 2011).

Even though role-playing is more expensive than Delphi, which relies on independent expert opinions, it is more accurate. Moreover, situations that were brought about by the 2007-2008 crisis do not lend themselves to experimentation. Another argument for the use of role-playing for environmental forecasting has to do with the fact that the crisis was caused by unique factors such as defaulting mortgages and mispricing of the unregulated CDS market (Murphy n.d.). Therefore, analogies would not work as a method for predicting the outcome of interventions by relying on cases where similar interventions have been used. Role-playing, on the other hand, could have helped to predict the behaviour of actors such as government, financial institutions, local banks, credit rating agencies, renters, mortgage holders, and mortgage brokers among others.

Mispricing of CDSs was caused by the actions of mortgage bankers who were incentivized by loan origination commissions to just maximize the volume of issued mortgages because they were owned by other investors (Murphy n.d., p. 69). Moreover, statistical scoring procedures were provided with false or misleading inputs. Incentivized by the desire to sell more mortgages, lenders intentionally limited criteria for credit analysis based on the history of default rates (Murphy n.d.). Therefore, prior to the explosion in defaults, they were caught in the vicious cycle of borrowing that guaranteed them large profits. Role-playing could have been used to assess the actions of numerous players before the crisis. The behaviour of national government, local banks, financial institutions, credit rating agencies, borrowers, and economic advisors could have been modelled in order to predict the decisions of each party. Taking into consideration that decisions are difficult to predict, interaction stimulated by role-playing could have helped to forecast that lenders of original loans would have had inadequate incentives encouraging the creation of subprime mortgages. Moreover, the instrument could have helped to predict that heavy investment into various debt contracts by numerous financial institution will eventually result in their financial insolvency (Murphy n.d.).

Econometric Models

Econometric models involve analysis of information on causal relationships for making predictions (Johnson et al. 2013). This method is associated with the use of well-established theories, identifying key variables as well as specifying both forms and directions of relationships; therefore, it is useful for forecasting events that triggered the crisis of 2007-2008 (Hendry & Nielsen 2012). Whereas the extrapolations method presupposes that current trends will continue, econometric models only consider the constancy of the current relationships; therefore, they are more precise. Moreover, econometric models allow comparison of alternative approaches with one another in a relatively objective manner. Dynamic stochastic general equilibrium (DSGE) models and the New Area-Wide Model (NAWM) provide a fairly adequate interpretation of international factors contributing to the development of the crisis. These macro models can help test the internal consistency of a particular economic theory with the data (European CentralBank n.d., p. 9) thereby creating important clues for the interpretation of business cycle dynamics.

It should be noted that the financial crisis has revealed some weaknesses in both DSGE and traditional models, leading some experts to criticize their forecasting value (European CentralBank n.d.). Mainstream macroeconomic models have complex procedures, have a lack of data on casual variables and are expensive (Armstrong 1999). Moreover, unrealistic assumptions, lack of attention to financial frictions, and the role of the banking sector and to non-linear dynamics or interrelationships (European CentralBank n.d., p. 9) are some of the major disadvantages of this forecasting method. However, unlike extrapolation method that did not prove to be particularly accurate in the wake of the economic crisis because of its reliance on the past relationships between the causal factors, macroeconomic models are a fairly useful forecasting instrument that could be used to interpret economic developments in real-time.

How Organisations Can Survive a Crisis

Forecasting tools should be used in the initial stages of crisis management models. The crisis arc is a model for crisis management proposed by Hilburg (Crisis Management Model n.d.). To successfully handle a crisis, a manager has to recognize that every prevention and management strategy for coping with the uncertainties of the external environment consists of the following elements: crisis avoidance, crisis mitigation, and crisis recovery. Effective crises management strategy requires the careful evaluation of all vulnerabilities of an organization as a potential catalyst of a crisis (Crisis Management Model n.d.).

According to James, a typical crisis consists of the following phases: signal detection, preparation and prevention, damage containment, recovery and learning (cited in Wooten & James 2011). The first phase requires the detection of the early signals of a crisis. The second phase involves actions aimed at the aversion of a crisis. The third phase prevents a crisis from spreading to other departments of an organisation. The recovery phase entails the development of plans for renewing business operations. The final phase is associated with reflection and learning from a crisis (Wooten & James 2011). The first two phases of the model can be considered a part of a proactive approach to the process of crisis management; therefore, it is best suited to a crisis.

According to the crisis management model proposed by Gonzalez-Herrero and Pratt in 1996, there are three stages to crisis management: diagnosis of the crisis, planning, and adjusting to the changes (Crisis Management Model n.d.). The model presupposes regular monitoring of early indicators of a crisis through observation of employee performance and maximum levels of transparency. Therefore, it operates within the framework of structural functions systems theory by facilitating the proper flow of information across all hierarchies of an organization.

Five Phases of Crisis

Signal Detection

Signal detection is a phase in crisis management associated with analysing available information that is available at the moment of decision making. According to a recent study by the Institute of Crisis Management, only 30% of crises that occurred during the last decade were sudden, whereas the remaining 70 percent were characterized as smoldering (Penuel, Statler & Hagen, 2013, p. 629). Therefore, signal detection is a phase in a crisis cycle that has to be recognised in a timely fashion.

Prevention and Preparedness

The second phase of James crisis management model is prevention and preparedness. This phase is associated with systematic planning to prepare the organization to deal with a crisis, explicating critical personnel, resources, and actions to be allocated during the crisis situation (Penuel, Statler & Hagen, 2013, p. 630). According to an article that explores the management of the 2007-2008 crisis, coordination issues between different financial institutions of Europe were conducted through a combination of ad hoc and existing instruments (Pisani-Ferry & Sapir 2011). Therefore, the managers of those institutions were not focused on all modes of preparation and coping measures during the second phase of crisis management. Arguably, this phase can be divided into two different sets of activities, as in the PPRR model, in order to better prepare for a crisis before it presents itself.

Damage Containment

The damage containment phase involves mitigation of a crisis, aimed at preventing it from further escalation, resulting in severe damage to an organisation. Systematic interventions in the source of a crisis (Penuel, Statler & Hagen, 2013, p. 630) are an essential element of this phase that helps to minimise the impact of a crisis and prevent it from spiralling out of control. Proper contingency planning, which should be a part of the previous phase of crisis management and should include communications strategy, can help to protect an organisations reputation, assets, and infrastructure when a crisis is unfolding (Penuel, Statler & Hagen, 2013).

Recovery

The fourth phase of crisis management involves fixing the damage caused by the crisis (Penuel, Statler & Hagen, 2013, p. 630). During this stage, organisations ensure their business continuity and resume their linkages with all groups of stakeholders. Just like the previous phase, recovery is highly dependent on contingency planning and preparedness. A properly constructed communications strategy is also essential to an organisations survival during the recovery of critical structures and procedures.

Learning

The final stage of James model is associated with the development of crisis management-specific organizational learning (Penuel, Statler & Hagen, 2013, p. 632) that should include experience gained during the dissemination of a crisis both within an organization and for its constituents. The obtained knowledge can help to modify the practices and policies of an organization in order to make it more resilient to future shocks.

Leadership Lessons for Senior Management

Successful leaders should be able to correctly identify stages in a crisis life cycle and apply a complex set of skills, abilities, and competencies for planning, responding to and learning from crisis events while under public scrutiny (Wooten & James 2011, p. 2). The conceptual model by James could significantly enhance the capacity of leaders to lead an organization through the various crisis phases and into a successful recovery (Wooten & James 2011, p. 2). Examining a crisis with the help of James framework helps to develop a structure for framing the process by filtering knowledge and by providing a roadmap for decision making (Wooten & James 2011, p. 4).

The shock caused by the crisis had a spill-over effect that fundamentally changed the correlations between international stock markets. The economy was not responsible for the crisis but rather a chain of poor managerial decisions, such as the take-over of Merryll Lynch and allowing the failure of Lehman Brothers (Hausman & Johnston 2014, p. 2720). Therefore, the senior management of both financial and political institutions of the country have to carefully consider the underlying factors that led to the crash of the markets in order to derive important lessons from its consequences.

Interdependence among global markets is one of the reasons why mistakes originating in the US credit and housing markets produced such devastating effects on the global economy. In order not to repeat similar mistakes in the future, it is necessary not only to create better oversight of financial institutions and tightening mortgage markets (Hausman & Johnston 2014, p. 2720) but also to introduce changes to formal governance structures and composition of their teams. An important leadership lesson that can be taken away from the crisis of 2007-2008 is that every crisis is a deviant event that requires people who are able to act in nonconventional ways, recognise the unknowable and move beyond their initial emotional reactions.

Nobody would deny that revising organizational structures and implementing changes are some of the greatest challenges that leaders can face. These actions are associated with a tremendous amount of strategic planning and assessment that could help inadequately reacting to the important idiosyncrasies of a problem and to choose the right direction to take. Nonetheless, effective leaders have to find structures and processes that mobilise members of their organization and challenge thinking while retaining productive power-resistance relations. It should be noted that productive dissent can engender communicative practices that play a facilitative role, resulting in organizational change based on transformation of knowledge (Thomas, Sargent, & Hardy 2011, p. 25).

Effective leaders should possess the perspective, mentality, confidence, and authority necessary for implementing radical structural changes. Moreover, they have to espouse certain attitudes so that they can engage in implementation activities as well as have in-depth knowledge of the tasks that should be accomplished. The most important implementation activities for introducing changes to organizational structures and process are communicating, mobilizing and evaluating (Battilana et al., 2010). Leaders who are willing to call for radical changes have to emphasise both the task-oriented and the person-oriented behaviours that are necessary for the comprehensive implementation of more effective organizational designs (Battilana et al., 2010). Person-oriented leaders have to realise that post-crisis change projects require building coalitions that can support the process of redesigning organisations. Therefore, they have to consider careful approaches to all groups of stakeholders in order to overcome growing concern over the impact or restructuring of organizational settings.

Lack of innovation made a significant contribution to the severity of the financial crisis of 2007-2008. Even though this did not directly contribute to the financial meltdown, numerous think tanks and government agencies agree that it was a significant symptom of a more generalized problem resulting in this crisis (Hausman & Johnston 2014, p. 2722). Effective leaders have to consider how to stimulate innovations that can significantly contribute to a strong economy, thereby preventing similar negative developments in the future.

Another important lesson that senior managers should take away from the crisis is that it is essential to utilize both quantitative and qualitative forecasting methods during the process of seeking signals. It will help them to better understand the specific risks of an approaching crisis as well as eliminate some of the unrealistic assumptions created by macroeconomic models.

Conclusion

The economic crisis of 2007-2008 had the most far-reaching financial repercussions for the U.S. economy since the Great Depression. It was caused by numerous factors ranging from defaulting mortgages to mispricing of CDSs. Taking into consideration the fact that the crisis put an at-risk financial system of the country, it is necessary to consider important leadership lessons of the situation in order to avoid similar events in the future.

Organization leaders can guide their organizations through a financial crisis by utilizing quantitative and qualitative forecasting tools such as role-playing, Delphi, analogies, extrapolation, rule-based forecasting, and economic models, among others. Taking into consideration that situations that were brought about by the 2007-2008 crisis do not lend themselves to experimentation, role-playing can be effectively used to test alternative outcomes of a particular intervention or an event. Economic models is a quantitative method of forecasting that can help organization leaders to use well-establish theories in order to identify key variables and relationships between them.

Effective leaders should also make use of the crisis management models such as the crisis arc proposed by Hilburg, James model, and Gonzalez-Herrero model, among others. Organization managers have to find structures and processes that mobilise members of their organizations and challenge thinking while retaining productive power-resistance relations. Moreover, they should possess the perspective, mentality, confidence, and authority necessary for implementing radical structural changes in order to avoid similar crises in the future.

Reference List

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