Crisis on Campus_ A Bold Plan for Reforming Our Colleges and Universities - Mark C. Taylor [31]
As the bull market, which began in 1982, continued to flourish, individuals and institutions started to borrow money to invest in increasingly speculative derivatives. A derivative is a financial asset whose value derives from some other underlying assets. There are three primary types of derivatives—futures, options and swaps—each of which can involve underlying assets like stocks, bonds, interest rates or currencies. Instead of trading an underlying asset, investors and speculators agree to exchange cash or other assets to hedge against the decline in the value of the underlying asset or to bet on its increase. In this way, derivatives provide a way to shift risk from people who do not want it to people who are willing to bear risk for the possibility of a more profitable return. The growing popularity of these financial products over the past twenty years created secondary and tertiary markets for derivatives. As the derivative drifts farther and farther from markets grounded in underlying assets, its relation to real value becomes more distant and tenuous and markets become much more volatile.
In addition to the explosion of derivative markets, many financial firms, start-ups and traditional businesses became more highly leveraged than ever. A leveraged investment is purchased with borrowed money for which the investor must have a certain percentage of liquid assets (known as collateral) to insure the loan. Throughout the 1990s, regulators allowed a decline in the percentage of required collateral, thereby amplifying the risks attached to loans and increasing the volatility of financial markets. In some cases derivatives were so leveraged that a small change in the value of the underlying asset could cause a big drop in the value of the derivative. As new investment opportunities emerged, investors started borrowing heavily to speculate in financial markets. At the same time, the nature of collateral changed. Instead of securing loans with cash or material assets like factories, equipment and inventory, investors used the very securities they had purchased with the borrowed money as collateral for loans. This practice is dangerously irresponsible because when the price of the security goes down, the value of the collateral declines and the creditor demands more collateral through what is called a margin call. If borrowers have inadequate liquid assets, they have to sell the very stock they used for collateral in order to meet the margin call. This naturally drives the stock price lower and creates a downward spiral in which the decline in stock price leads to a decrease in the value of the collateral, which triggers another margin call that requires the borrower to sell off even more of the stock that is supposed to be securing the loan. This spiral is one of the devastating traps in which university endowments have been caught.
In the 1980s, deregulation even transformed the traditionally cautious savings and loan industry. With most of their assets tied up in long-term loans for home mortgages, which were held at artificially low rates by government regulations, S&Ls were not able to compete with other financial institutions. When the federal government eventually deregulated the interest rates banks could offer investors, rates quickly rose as high as 18 to 20 percent. But this did not solve all of the S&Ls’ problems, so the federal government also allowed banks to make real estate investments. Since most bankers had no experience in this area, they made many unwise investments, and many local banks failed.
At the same time that banks were under increasing pressure, the nature of financial markets changed. The introduction of computers on trading floors in the late 1970s and the networking of computers in the 1980s created an opportunity for more complicated derivative products. Thousands of new products for investors were soon introduced. When computers became more sophisticated