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Anatomy of an Economic Meltdown

10/15/2008 --

Ross experts trace roots of financial crisis, lessons learned.

Watch a webcast of the panel.

ANN ARBOR, Mich.—A mix of poor mortgage practices, a housing price bubble, highly levered investment banks, de-regulation and some lax monetary policy turned lethal after a period of prosperity, and helped create the financial meltdown that has poisoned the world economy.

Ross professors, during an Oct. 10 panel, presented this post-mortem on the world's financial crisis and the challenges now facing political leaders and regulators. The diagnosis can serve as a useful guide for the future as governments worldwide seek to stabilize the markets and prevent another debacle. The U.S. government just passed a $700 billion bailout package that allows it to buy toxic assets from financial institutions while both U.S. and European leaders made moves to shore up banks.

"From history and also from the current crisis, financial regulation has always played a catch-up game with financial innovation," said Amiyatosh Purnanandam, Bank One Corporation Assistant Professor of Finance at Ross. "Next time around, we have to make sure that financial regulation at least keeps pace with financial innovation, so that we understand what are the costs and benefits of regulating or de-regulating the financial markets."

Purnanandam was part of a panel, attended by an overflow crowd, which also included Ross professors Sreedhar Bharath, Cathy Shakespeare, Paolo Pasquariello, Maggie Levenstein and Gerald Davis. Ross Professor Joel Slemrod moderated the discussion.

The Slippery Slope

Historically, a period of prosperity and de-regulation precedes market crashes, Purnanandam pointed out. That was true before the 1930s crash that led to the Great Depression and in the late 1980s before the savings and loan crisis.

Financial innovation, generally, is a good thing, Purnanandam said. Banks innovated most recently by taking mortgages, packaging them, and selling them off. Derivatives such as credit default swaps created new investment opportunities. Those moves, coupled with relaxed regulations, allowed banks to share risk and offer more loans. Globally, it increased interconnectedness among banks and world financial markets.

But some cracks along the way weakened the foundation. First, some of the big investment banks, which invested heavily in securities backed by mortgages, had leverage ratios of 30 to 1 or more. Thus, even a small decline in the value of those mortgage securities would have a profound, negative effect.

Also, the way mortgages were sold off and repackaged created incentives for brokers to write loans and dismiss concerns about their quality, said Shakespeare, the PricewaterhouseCoopers-Norm Auerbach Assistant Professor of Accounting at Ross. Banks and investors did a poor job of estimating the effect of defaults, she said.

Meanwhile, speculation created bubbles and monetary policy didn’t channel the massive inflows of capital into the U.S. properly, argued Levenstein, an adjunct associate professor of business economics at the school.

While the values of homes were rising in the U.S., incomes were not and too many people took loans beyond their ability to pay. The expectation was that housing values would increase, which would allow borrowers to make good on debts.

To add insult to injury, monetary policy in the U.S. created cheap credit, which meant the massive inflows of world capital into the country were directed at consumer lending instead of "productive investment,” said Levenstein.

"Regulators didn't make sure policies were prudent," she noted.

The Federal Reserve cut the target interest rates, but allowed effective rates to fall below the target, added Bharath, assistant professor of finance. "The Fed was rather lax in its policy."

When housing prices declined and interest rates increased, people with adjustable rate mortgages began to default. Subprime mortgages went bad and foreclosures jumped.

That lowered the value of mortgage-backed securities, putting highly levered financial institutions in a bad position. The market for mortgage-backed securities has dried up and now banks are afraid to lend to one other, literally freezing the credit markets.

How bad are the losses? Bharath estimated that credit market losses total about $620 billion while losses in the derivatives market could be $980 billion. So far, about $550 billion in losses have been taken, so there may be another $1 trillion in losses to be recorded.

The blame doesn't just fall on Wall Street. With most people invested in 401(k)s and mutual funds, Wall Street and Main Street are inseparable, said Davis, the Wilbur K. Pierpont Collegiate Professor of Management at Ross. He pointed out that the personal savings rate turned negative in 2005, and people were spending on their wealth position --- which included the increase in their home value and capital gains ---instead of their wages.

The real estate boom provided superficial cover on other cracks in the economy, he argued. Financial institutions and people on Main Street were banking on home values increasing. But home values from 1890 to 1990 were virtually unchanged. The big spike didn't come until after 1990.

Davis reminded the audience of President George W. Bush's quote that Wall Street "got drunk."

"We all got drunk," he said. "Wall Street was just the bartender."

Fixing…Or Making Things Worse?

The Ross professors questioned some of the moves the government has made in response to the crisis.

Imposing limits on short-selling was a mistake, argued Pasquariello, assistant professor of finance. There is no evidence that short-selling had anything to do with what happened, he said. Banning the practice, meanwhile, made the market less efficient and limited hedging opportunities in which an investor buys one thing and sells something else. The ban may have limited the selling, but it also killed the buying.

But the worse blunder was letting Lehman Brothers go into bankruptcy, said Pasquariello: "This is probably the biggest mistake we will remember from this crisis, letting Lehman go."

Pasquariello noted that Lehman signed thousands and thousands of derivative contracts with other institutions, meaning the firm's Chapter 11 filing had a ripple effect and banks became increasingly afraid to lend to each other.

Shakespeare noted that banks are working to get "mark to market" accounting rules changed, and the bailout bill passed by Congress has provisions that allow the Securities and Exchange Commission to suspend fair value accounting and review the provision.

The rule means that banks have to take their securities and value them according to market prices. The problem is that, right now, there is no market. But Shakespeare defended the practice and said banks cannot blame the accounting rule for the crisis.

"You can't mark [an asset's value] to what you hope it will be," she said, adding that maybe lawmakers should change the capital rules instead.

For investors, the risk right now is a political one, meaning that the government may change the rules of the game while the game itself is being played, Pasquariello said. Investors are not buying because they're trying to decide what the government is going to do.

"Like any other kind of risk, it will be priced," he said, noting that the effect is lower stock markets and higher costs of borrowing.

Recovery Signals

Bharath and Shakespeare said the problem right now is that banks are still sorting out the "peaches and lemons" on their balance sheets. Once they sort that out, they will be more comfortable lending to each other and the credit markets will loosen up. That will allow companies to obtain capital for expansion and job creation.

The restoration of interbank lending will be one of the first signs of a recovery, said Purnanandam. Another will be when we see world financial markets less connected with each other's performance. When we see some markets up while others are down, that will be an early sign of a turnaround, Pasquariello said.

And the government is fully aware of the importance of the handoff to the new administration that will take power next year. Shakespeare said the U.S. Department of Treasury is asking both candidates to identify --- with a promise of confidentiality --- their proposed treasury leaders so they can begin working on the transition right away.

The economic team selected by the next president will be the one that has to present a more permanent resolution.

"The next administration will have its hands full," Davis said.

—Terry Kosdrosky

For more information, contact:
Bernie DeGroat, (734) 936-1015 or 647-1847, bernied@umich.edu