If someone had told you five years ago that some bad mortgages in the suburbs of Florida could lead to the bankruptcy of a country like Iceland, you wouldn’t be the only one not to have believed it. Fast forward to today, and there are few doubters left as to how incredibly interconnected – and perversely incentive-driven – our global economy has become.

I am far from the only one who has warned of the negative effects of financial incentives. As I wrote inRotman Magazinein the fall of 2004, just as animal trainers can use the right set of incentives...

On 11 September 2001, two commercial airliners full of passengers were hijacked in the air and flown into the two buildings of the World Trade Center. A third was flown into the Pentagon and a fourth crashed into a field in Pennsylvania. I have a tape of CBC Radio’s news coverage from that day. While reporters filed stories – disjointed bits and pieces on what seemed to be happening – anchors struggled to put the pieces together, to summarize what was known and to distinguish the known from the rumoured, to try to explain it, to put it in a context. There...

To understand the crisis that has paralysed the world’s financial markets since August 2007, it is first necessary to look at the U.S. housing market during the 2000 to 2006 period. This period was characterized by a huge increase in what is termed subprime mortgage lending. Subprime mortgages are mortgages that are considered to be significantly riskier than average. Before 2000, most mortgages classified as subprime were second mortgages. After 2000, this changed as financial institutions became more comfortable with the notion of a subprime first mortgage.

Subprime first mortgages made house purchase possible for many families that had previously...

This quotation from Thomas Jefferson has received a lot of play in the last month and rightly so, for, now as in Jefferson’s day, the implications of a fractional reserve system on credit creation and destruction are of paramount importance. Over the last year we have seen the following institutions fail, be taken over, or be effectively brought under state control: Fannie Mae, Freddie Mac, Washington Mutual, Wachovia, Bear Stearns, Lehman Brothers, Merrill Lynch, American International Group (AIG), and National City in the United States; Bradford and Bingley, Northern Rock, and HBOS in the United Kingdom; Fortis in Belgium, the...

The current financial crisis is now in its seventeenth month. News about massive mortgage defaults and concerns about the viability of certain mortgage and investment banks began to appear in the media around May 2007. The stock market went pretty well sideways for the next year, actually hitting a new high in May 2008. However, the bad news accelerated in the summer of 2008, resulting in a market meltdown which started in July and August 2008 as a ripple and then accelerated to a firestorm in September and early October. From 28 August to 10 October 2008, Toronto’s S&P/ TSX...

In February 2008 one of the guest speakers in Value Investment, the course taught by my colleague, Eric Kirzner, claimed that the subprime crisis was over and thus he could now shift his entire portfolio to Citigroup. Several of my students in Financial Statement Analysis, the second-year elective that I teach in the Rotman MBA program, have approached me and asked for my opinion. My response was that the subprime crisis, far from being over, is in a relatively early stage.

It should be noted that, while the crisis was predictable, I failed to predict either its timing or its...

My task in this discussion of the great financial crisis of 2008 is to consider the impact of the crisis on what I will call the ‘real’ economy – that is, the economy of GDP growth, employment, inflation (and, perhaps, exchange rates), and related elements. I mean nothing disparaging by referring to the ‘real economy’ in contrast to the world of finance: it is simply a convenient label. The real and financial economies are intimately linked and it is the nature of that linkage that I propose to discuss.

I should state at the outset that I am by background a...

The current crisis is the latest in a long series of financial crises that stretch back into the mists of time. But it is one of the first truly global crises in which all open economies have felt its effects. Our responses should recognize that, while we cannot eliminate boom and bust, careful regulatory responses can reduce their frequency and magnitude. Modern financial systems provide uniquely useful services. They reduce information asymmetries between borrowers, who know a lot about their ability to repay loans on time and in full, and lenders, who do not. They facilitate payments in economic exchange;...

We are in the midst of a tectonic-plate movement in the financial world that now appears to be shaking the ‘real’ world quite dramatically. The purpose of this chapter is not to review the causes and potential consequences of our current situation but to explore the possibility that once again, in the world of publicly traded companies, boards of directors have let us down.

If we go back to the bursting of the South Sea bubble in London in 1720, we can record the first time shareholders bellowed this refrain: ‘Where were the directors?’ Following the collapse of the Great...

A common refrain of late is that fear and greed drive financial markets. We hear that boom periods such as the ‘tech bubble’ of the late 1990s are fuelled by investors buying stocks at ridiculously overinflated prices in hopes that they can later resell to someone even greedier who is willing to pay even more. Conversely, conventional wisdom holds that during market crashes, investors panic and sell stocks en masse, causing prices to plummet even lower. These actions on the part of investors are often characterized as mistakes. Yet, according to academic research in finance, although individual investors may not...

First, a confession. When I wrote to the pension-fund community this past summer that ‘returns on most risky assets will likely be below their long-run averages for some time yet,’ I was not imagining the compressed financial trauma we have been experiencing since September. As the global financial system continues to teeter on the edge of an abyss, stock prices have been rising and (mainly) falling daily by amounts that used to take years. What was originally perceived as just a Wall Street issue has now become very much the Number 1 issue on Main Street. In light of all...

Have you ever seen a really spectacular display of tumbling dominoes? You know – where knocking over one begins an intricate, cascading pattern that ends up who knows where? That seems to describe what we’re witnessing right now. The collapse of the U.S. subprime mortgage market led to a couple of highly publicized bankruptcies, which contributed to a global credit crunch and a historic sell-off in the world’s equity markets. If you know what shoe will drop next, you’re a better man than I am, Gunga Din.

However, even as events unfold, there is a rush to judgment to determine what...