The Morgan group’s goal of dispersing risk to investors, in hopes of lenders to lend without hesitation was the goal. They sold clients with the concept of no risk. This idea was backed by strong lobbying that persuaded the government, and administrative powers to keep from regulating the derivatives trading in any significant way.
The contention was that financiers had a powerful external incentive, which was self-interest in keeping each other honest and do things that are necessary to protect their shareholders and institutions. This turned out to be very wrong. This is evident of the mentality when Alan Greenspan had confessed before Congress
"There was a flaw in my reasoning.” thinking that the banks would manage their risk better. However, J.P. Morgan exercised some restraint in tying the derivatives-securitization mix to subprime mortgage loans. Now, this is an important distinction from what others like Bear Sterns, Merrill Lynch, Lehman Brothers, and AGI peddled, because when the real estate bubble burst in ’06 and ’07, these financial instruments lost value.
As it turned out, Wall Street did not anticipate a national housing crash, and the supposedly benign risk dispersal was uncovered to what it truly was: which was a worldwide pandemic that bred unsafe risk to almost all the major financial institutions.
This dispersal of risk of debt became altered and blurred that the very instrument led to concentration of risk in the hand of a few large institutions.
Lenders who were giving out loans without restrain suddenly froze up, declining even trusted corporate customers-- investors panicked --and the stock market crashed.
There was a kind of group cohesion with financial institutions that developed around credit derivatives. Their quest for innovation, ambition, success, and of course, hefty profits bound them together.
Thus, there was an obscurity on how these derivatives were modeled and priced.
This opacity also justifies why banks passionately opposed the concept of centralized clearing system, because, that would mean transparency in pricing -- which could lead to profit losses.
There wasn’t any real scrutiny and examination because the whole thing was unregulated by the government. Nobody knew whether the buyers and sellers of these products were solvent in the event of a calamity.
Ratings agencies were so confused that they rated these less than spectacular bonds comprising of subprime mortgages to AAA ratings. So when it all went bad-- the financial institutions sank.
Now, in order to understand the actions of these individuals, we must look at the incentives that drove them. Motivation driven by External incentives was the key factor in the development of these financial products. Expectancy theory of motivation specifically comes in to play here. The Morgan group was paid with multimillion dollar bonuses to encourage them and also to help them obscure their creative approaches to benefit themselves. This is different than what Congress and others thought they wanted to give a win-win situation for everyone.
Also, when we look at the high cohesiveness and homogeneity in the group -- it was the ideal environment for groupthink to exist.
This added to the incomplete survey of alternatives, uncalculated risks, biased information, and nonexistent contingency plans.
You really need to look at the culture at the time because self interest was not the only explanation to all these behaviors. The finance sector is usually high on uncertainty and in general they are more likely to make risky decisions.
The result of the vast flow of money that circulated led to the excessive demand of the original debts that became in short supply. This, as a result required even more synthetic and creative formations.
Lenders lost cognizance-- lending more since they no longer had the risk, and their balance sheets no longer had the debts.
Even when
