What role did the human factor play leading to the financial crisis?  What are the difficulties of regulating shadow banks?  Dr. Richard F. DeMong spoke of how the financial system goes awry when risk goes to zero. Listen to the podcast and you’ll also learn the meaning of “moral hazard” and how it played a role in the financial crises of 2008.

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Dr. Richard DeMong is the Virginia Bankers Association Professor Emeritus at the McIntire School of Commerce, University of Virginia. Dr. DeMong received a bachelor’s degree from California State University at Long Beach, an MBA from the College of William and Mary, and a Ph.D. from the University of Colorado. He is the author of numerous articles on subprime lending, managerial finance, investments, small business, and banking in leading finance and banking journals. Colonel DeMong is a retired United States Air Force pilot.

Dr. DeMong spoke at the Wednesday, January 9, 2013 meeting.  The program was moderated by SSV board member Tom Boyd.

Program Summary

Dr. DeMong began by stating that his goal for the presentation was to look at the financial crisis and some of the background so we could be aware of the influences that caused and created the crisis and perhaps prevent them in the future. He described how the overall economic condition developed well in advance of the crisis, and that we should have seen it coming. Yet as humans we get over optimistic that everything is going to continue just as it is today.

He showed how things got off track without the proper infrastructure, regulation, and proper behavior of all the players. At almost every level we had weaknesses that economists would call moral hazards–not understanding the risks people were taking at every level, all the way from the borrowers and investors through the lenders.

Things have changed since he began in banking in the 1950s when banks would use customer’s savings to lend out. That all changed in the 1990s-2000s with the development of shadow banks. Also, the credit was changed—-where AAA securities historically were supposed to have a very low default rate, this was changed by offering subprime loans. These were originally intended for artists, entrepreneurs and others who have erratic income patterns, but soon these loans were being offered to just about anybody and then bundled together as securities with AAA ratings.

Many lenders began using short-term financing for long-term investments because they felt they could sell the securities at a profit, as it seemed there was no limit to continually increasing home prices. What happened then in September and October 2008 was that many of these investors—-including large investment banks–couldn’t roll over their short-term debt and couldn’t meet their obligations. All of this was taking place outside of the regulated banking system.

Dr. DeMong identified the many actors leading to the crisis, the specific mechanisms employed, and why it will continue to be difficult to institute effective regulation.