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Emerging from the Economic Abyss

4/3/2009 --

Ross professors assess short- and long-term solutions posed by Obama administration.

ANN ARBOR, Mich.—Toxic assets. AIG bonuses. Automakers on the brink.

Keeping up with the current economic crisis and its daily twists and turns can be a bit daunting. But three of the Ross School's thought leaders recently offered Executive MBA alumni some clarity on how we got into this fix, as well as some ideas on how to get out of it.

Professors M.P. Narayanan, Joel Slemrod, and Martin Zimmerman provided a roadmap for business on the financial crisis, tax policy, environmental policy, and the automotive industry. Each presented a case and engaged in some give-and-take at the Executive MBA Alumni Residency March 21.

A common theme emerged early in the program. There are short-term steps needed to spark a recovery but the government also needs to draft long-term, fundamental solutions. Sometimes those will conflict, because what needs to be done now -- stimulating consumers and funding projects, for example -- is the opposite of the long-term need -- personal savings and deficit reduction, Narayanan said.

That could help explain why the government's actions seem a little ad hoc.

"There seems to be a little bit of a knee-jerk aspect to it," said Narayanan, the Robert Morrison Hoffer Professor of Business Administration and chair of finance. "But that's inevitable. It's not like we have a template for this."

Fixing the Financial Sector

The roots of this economic crisis lie in the residential real estate market where the securitization model replaced the traditional model. In the traditional model, the original mortgage lender kept the loan on its books. In the securitization model, originators sold off the loans. Mortgages were then pooled into special purpose vehicles, and investors could buy securities backed by the mortgages.

The problem is that the incentive to make sure a loan is solid is not as high if the mortgage is being sold off. In recent years, more people signed up for mortgages they could barely afford. Investors in these mortgage-backed securities should engage in due diligence, of course, but it's hard to sort out a pool of, say, a thousand mortgages.

Ratings agencies should have been able to provide better guidance, but they were paid by the issuers of the securities.

All up and down the line, incentives were "messed up," Narayanan said. But he warned against buying into populist arguments against securitization. When managed properly, securitization improves access to capital for homeowners, spreads risk among investors, and creates a nice market for investors who want bonds with a higher risk/return profile.

"Don't fall into the populist mode of thinking something is always good or something is always bad," he said. "We should always ask, ‘what are the pros and what are the cons' so we can know what do about it."

While banks that invested in the mortgage securities saw their balance sheets suffer -- which helped freeze the credit markets and bring the crisis to Main Street -- the credit default swap (CDS) sector also collapsed. Credit default swaps, insurance against failure, operated with little regulation and no clearing house. AIG was a major player in the CDS market and ran out of money when holders demanded more capital.

So what to do? In the short term, the government needs to unclog the financial channels. The plan is to use a public/private partnership to buy "toxic" mortgage assets, thereby creating a market for them. Banks will be able to provide clarity on their balance sheets and hopefully that will spur lending.

Narayanan said the foreclosure tide needs to stem, so loans should be restructured. President Obama's stimulus package should be targeted to increase consumer confidence.

The hard part will be setting prices for the toxic assets. If the price is set too high, taxpayer money will be wasted and the new administration will face political peril. If the price is set too low, it won't help the troubled banks and the credit markets will remain cold.

Long term, the government and the market need to improve the securitization model but not kill it, said Narayanan. One way is to make sure originators keep some of the liability. That should be part of an overall streamlining of financial regulation that includes reforming the issue-paid credit rating system and oversight for credit derivatives such as default swaps. The government also should look at capital requirements for banks, he said.

Fannie Mae and Freddie Mac serve two masters -- Congress and investors -- and that needs to change, possibly by fully privatizing them.

Taxing Questions

The U.S. tax system certainly was not a cause of the crisis, but the rules might have helped exacerbate some things, said Slemrod, the Paul W. McCracken Collegiate Professor of Business Economics and Public Policy.

The tax code encourages more debt finance and leverage and it increases susceptibility to bankruptcy for both corporations and individuals, he said. Debt payments are tax-deductible, for example.

For now, the government needs to stimulate spending. But for the long term, it needs to encourage people to increase savings.

"The policy dilemma we face is, when do we change our short-term orientation of getting people to spend more to the long-term orientation of getting people to save more, which is the total opposite of what we need now," he said.

The Obama administration is trying to stimulate the economy with government spending and some tax breaks. Slemrod is studying the response to tax rebates. Early results show that for the 2008 rebate, only one-fifth of the people said they would spend most of the rebate. The majority said they would pay down debt.

The tax cuts coming this year won't be in the form of a rebate check. Instead, tax withholdings will be reduced, giving people more in their take-home pay. There's an argument that format will increase spending more than getting a check, since it's considered steady income and not a one-time payment.

But Slemrod is skeptical.

"The problem is, though the argument is plausible, there's really not a lot of evidence to make me sure it will increase spending more than the checks will," he said. "I think a typical consumer puts almost no information content into whether a tax cut is labeled temporary or permanent by Congress. They can take back the tax cut next week."

He said the spending in the stimulus package will have more impact than the tax cuts.

So far, the new president's tax plan is consistent with his campaign promise. He plans to let the Bush tax cuts expire, restoring the top rate to 39.6 percent from 35 percent. He also advocates raising the capital gains tax from 15 percent to 20 percent.

But Slemrod said he sees little structural tax reform. The U.S. tax code is still a delivery system for social policies.

The bigger problem is that the tax code pays little attention to a long-term fiscal problem: The difference between government spending and entitlements from Social Security and Medicare and the taxes coming in is $52 trillion over the next 75 years.

A combination of entitlement cuts and tax increases will be needed to avoid either the elimination of all non-entitlement federal spending or incredibly high taxes, Slemrod said. Raising rates on high-income earners alone won't work.

Slemrod also is beginning research on the role that tax avoidance on the "slice and dice" derivatives played in the financial crisis. Owners of financial instruments such as collateralized debt obligations would "funnel" the income flows in a way that created the most advantageous tax situation.

"In order for you to get the most tax-advantaged capital flows, you might accept a different risk pattern than you otherwise would," Slemrod said. "You change your risk outlook to gain the tax advantage. This lowers risk diversification."

Climate and Autos

One of the priorities of the Obama administration that could have the most long-term impact on the industrial sector is climate change legislation, said Zimmerman, the Ford Motor Company Clinical Professor of Business Administration. The new president prefers some sort of cap-and-trade legislation and is leaving it to Congress to work out the details.

Under a cap-and-trade system, the total amount of carbon allowed to be emitted would be capped, but companies could purchase permits, or credits, on an open market to emit more carbon.

But what would the cap be and what will the permits and credits cost? How high would it drive the price of electricity? Could the permits be pulled forward or can they be held for later use? Industry already is concerned about the unknown costs, Zimmerman said.

The politics are complicated because energy policy in the U.S. is not a partisan issue but rather a regional one.

"A Democrat in West Virginia typically isn't going to go against the interests of the coal industry," Zimmerman said. "And a Republican in California is typically going to want to go against the coal industry."

Still, there are some proposals that would help business deal with the transition. One is a so-called safety valve. If the cost of permits goes over a certain price, the government would issue more permits. While that would decrease the certainty on carbon emissions sought by environmentalists, it would add some much-desired certainty on costs.

Another idea is to do cap-and-trade, but have a review period. The concern is that if the United States sets such a system and other nations don't, the costs of our goods rise and the country becomes uncompetitive. Writing into law a mandatory evaluation after a few years is a way to deal with that, Zimmerman said.

Slapping a tariff on goods from countries that don't limit carbon emissions is a "dangerous idea," meanwhile, since it's just using climate change to justify trade protectionism, Zimmerman said.

Some in the industrial sector are starting to favor a carbon tax instead of cap-and-trade, Zimmerman said. That's because the cost at least will be predicable.

As for the auto industry, it's a fair question to ask whether the U.S. would be throwing good money after bad if it extended General Motors Corp. and Chrysler LLC more loans.

"That is a real risk and I wouldn't trivialize it," Zimmerman said. "On the other side, what would happen if they fail, particularly with GM because of its size?"

On the whole, it's probably wise for the government to extend aid to the auto companies, he noted. A General Motors failure would cause the failure of many parts suppliers, creating a cascading effect on unemployment.

What's going on now -- with the unions and bondholders being asked to take haircuts -- is akin to a bankruptcy proceeding without the formal court orders. The problem with putting an automaker into Chapter 11 is that it could wind up a Chapter 7 liquidation. Some consumers won't buy cars from a company in Chapter 11, so revenue could fall to fatal levels.

But the key for the auto companies is fixing the economy, Zimmerman said. The automakers have not gotten credit for the massive restructuring they've done in the past few years. The problem was that it wasn't fast enough, certainly not enough to prepare them for such a deep recession.

And Zimmerman said the recovery this time will be slower than in past recessions.

"Fixing these companies is a good idea, but unless the economy is fixed, none of these companies are fixed," he said.

But there is one risk not often discussed. The auto companies that take government money could be under pressure from special interests to launch electric vehicles or pursue other ventures that take years to become profitable.

"Too many objectives put into the pot will make it more difficult to do what you're trying to accomplish, which is turn around these companies," Zimmerman said.

—Terry Kosdrosky



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