01 Dec 2008


No Easy Fix for the Financial Crisis

HBS and Harvard Experts See the Need for Quick Action and New Regulations
Re: George Bush (MBA 1975); Hank Paulson (MBA 1970)
by Roger Thompson;Martha Lagace

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How did we get into this mess, and how do we fix it? Those were the key questions that three separate expert panels — two convened by HBS and one by Harvard University — addressed for standing-room-only audiences in late September as the nation’s financial crisis spread from Wall Street to Main Street, raising the specter of a credit market collapse that would cripple the economy.

“It is an anxious time. It is probably even a dangerous time. It is a historic time. And it is a time that we’re going to be teaching about in our classrooms for years to come,” HBS Dean Jay Light told the students, staff, and faculty who packed Burden Auditorium on Tuesday, September 23, as Congress hotly debated the then newly proposed $700 billion financial rescue legislation. The second panel convened two days later by Harvard President Drew Gilpin Faust filled Sanders Theatre. The third panel was added at the last minute to the Friday morning schedule of HBS fall reunion participants, who nearly overflowed Burden.

While the panelists at all three sessions brought different perspectives to the crisis, a consensus emerged that lax regulatory oversight had contributed to the problems at hand, and that more oversight will be required in the future.

Highlights of remarks made at the three sessions follow.

Framing the Problem

Dean Light, the only participant who appeared on all three panels, gave an overview of the market events leading up to the crisis and outlined a three-part process for dealing with it.

Using the metaphor of an emergency room, Light explained, “Just as a hospital treats patients by focusing on three tasks, so too should we remedy financial turmoil.” First, stabilize the patient, in this case the markets. That’s what the $700 billion rescue plan (signed into law by President Bush MBA ’75 on October 3) aimed to accomplish: stabilize the institutions holding toxic mortgage-related securities.

Second, diagnose the problem and treat it. The rescue bill calls for the government to auction banks’ distressed mortgage assets to “try to restore the price discovery process so we can figure out what these things are actually worth.”

Light challenged the description of the rescue package as a “bailout” for Wall Street. “It may, in fact, be a very profitable investment,” provided the government ultimately sells the distressed mortgage assets for more than the purchase price, he noted. (On November 12, Treasury Secretary Henry Paulson MBA ’70 abandoned the original plan to buy distressed assets from financial institutions.)

Finally, prepare a long-term rehabilitation plan. For the country’s financial system, this means a new regulatory structure. “It, for sure, will be reregulated because the government had to be so deeply involved in the rescue,” said Light. “And a new regulatory structure is something that will take years.”

Home Ownership: Back to Basics

HBS lecturer Nicolas Retsinas, who before arriving at Harvard served as assistant secretary for housing in the U.S. Department of Housing and Urban Development, offered a historical perspective on U.S. home ownership leading up to the subprime crisis.

“It’s hard to overstate the dramatic buildup in subprime lending by mid-decade,” he said. “Subprime lending represented a minimal share of home mortgages in the 1990s. As recently as 2001, it represented only 2 percent of home purchase originations. In 2005, it represented 20 percent.

“In 2004 and 2005, as these subprime loans started to emerge, it really wasn’t a particular problem because of the lag effect. People who couldn’t pay off these mortgages with toxic terms and exploding payment schedules figured, ‘If I cannot pay off my mortgage, I’ll put a For Sale sign on the lawn, sell it, and walk away.’ As the housing bubble burst, those exit doors were closed,” he explained.

“All of a sudden, we started to see record numbers of delinquencies, defaults, and foreclosures. The question was, who bore that risk? What had happened with these subprime loans is they were taken apart, put in little subsets, and sold as a whole variety of different securities. And no one knew what they had. At that point government had stepped aside, had genuflected at the altar of the market as it relates to our housing financing system,” said Retsinas, arguing that regulation became essentially outsourced and privatized.

“In some eerie way, it looks like we are going back to the future,” he concluded. “If you want to buy a home today, you better have great credit. You better have a down payment.”

Regulation Failed

HBS senior lecturer Clayton Rose shared insights gained from his twenty years of experience at J.P. Morgan & Company, where he headed global investment banking and global equities.

The regulatory structure did not keep pace with two decades of deregulation and product innovation on Wall Street, Rose said. “By the end of the 1990s, legislation that separated commercial and investment banking had been torn down, and banks, investment banks, and insurance companies were in each others’ businesses.

“As a result of deregulation, the derivatives market and the market for mortgage-related securities exploded in both size and complexity,” he continued. And as long as housing prices were rising, derivatives and mortgage-backed securities produced handsome returns. “Until about eighteen months ago, this strategy worked well,” Rose said. But when the housing bubble burst, it was clear that the “checks and balances and oversight that were required in the system were missing.”

The Risk of Moral Hazard

HBS professor David Moss brought a historian’s perspective to the discussion of the nation’s financial crisis. While the $700 billion financial rescue plan may be “reasonable,” said Moss, “I’m concerned that if we don’t structure this bailout correctly, we could create an even riskier financial system in the years ahead.”

Moss’s research has focused on how and why governments manage risk. Throughout its history, the United States has adopted a broad array of public policies for managing risk, from limited liability law to federal deposit insurance. “If you look across these policies, one thing that becomes quite clear is that anytime you shift a risk around, you have to be concerned about the potential for moral hazard,” said Moss. “Anytime you write an insurance policy, whether through the private sector or the public sector, you have to worry that people might get the wrong incentives. Those who are relieved of risk may decide to take on more risk,” he explained.

Likewise, when government manages risks, it must also worry about the potential for moral hazard, he said. “My concern right now is that although there’s an enormous amount of discussion about the $700 billion, the discussion may not be sufficiently sensitive to the need for reasonable oversight of the financial system. ... We have to be serious and smart about this. If we don’t structure it correctly, the bailout could very well calm the current crisis but also provoke even greater, and even more dangerous, risk-taking in the future.”

Innovation Will Continue

University Professor Robert Merton, who received the Nobel Prize in economics in 1997, focused on the relationship between financial innovation and crisis.

“Is there a structural relation between innovation and crisis? I think there has to be,” Merton said. Successful innovation will always outstrip the infrastructure to support it, at least for some considerable time. That’s true because most innovations fail, so it’s not practical to build a new infrastructure to support every innovation until you find out they succeed. So it’s inevitable they will be mismatched for some time.

“We have to have oversight,” he continued. “But if it is too strict, we’ll never get innovation. There really is a tradeoff, and we have to be prepared for that.” Merton expressed concern about potential unintended consequences of efforts to confront the current financial crisis. While regulation is important and needed, “it’s not magic,” he said. Poorly done regulation could have a long-term negative effect.

Rebuild the Middle Class

HBS professor of management practice Rob Kaplan, a former vice-chairman of Goldman Sachs who served recently as acting head of the Harvard Management Company, observed that the financial crisis is symptomatic of another very serious issue, a severely weakened middle class.

“For the last eight to ten years, if you look at the statistics, real wage growth among working-class Americans has been relatively stagnant,” said Kaplan. Meanwhile, “the cost of everything a middle-class family pays for — food, energy, education, and health care — has gone up.”

Facing this squeeze, middle-class Americans did something very rational, he explained. “They looked at the most valuable asset they had, their home, which was appreciating, and they decided to take out another mortgage and take advantage of the equity in their home so that they could continue to spend and make ends meet. This phenomenon masked a continued, fundamental deterioration in their ability to pay for goods and services from their wages.”

Simultaneously, lending standards continued to deteriorate “until we got to the point where we had very lax standards, and we started to see defaults. And what we see now in full force is really a massive consumer deleveraging. This, in turn, has created defaults among financial institutions.”

In this context, Kaplan maintains that the financial rescue plan was necessary but not sufficient by itself. “There has to be a second step, and it is critical. We need to rebuild the engine of our economy — the middle class.”

Consumers Need More Protection

Harvard Law School professor Elizabeth Warren is a bankruptcy and commercial law expert and co-author of The Two-Income Trap: Why Middle-Class Mothers and Fathers Are Going Broke.

Warren noted that the financial rescue plan did not do enough to help families facing foreclosure. She advocated a change to the bankruptcy laws to allow a neutral arbiter like a bankruptcy judge to rewrite the terms of a loan, adjusting both the amount owed and the interest rate.

She also advocated more regulatory protection for borrowers. “This subprime mess started with a dirty product that was a consequence of deregulation. Our government decided at some point it was OK to sell instruments that were known to be dangerous.

“You can’t go anywhere in America and buy a toaster that has a one in five chance of bursting into flames,” she continued. “We have regulations in the United States for every physical product you touch. And we say if it doesn’t meet certain basic safety standards, you can’t sell it to consumers. But we have nothing like that for financial products. More than 60 percent of the subprime mortgages issued in the last five years had no — zero — federal regulation. So my bottom line is we need a financial product safety commission that ensures some basic safety for American families.”

Don’t Expect CEOs in Handcuffs

Harvard economics professor Gregory Mankiw, former chairman of the President’s Council of Economic Advisers from 2003 to 2005, said he was surprised when presidential candidate John McCain blamed the nation’s financial crisis on “greed and corruption on Wall Street.” “I don’t think corruption is a major part of the story,” he observed. “Certainly, there were elements of corruption here and there, but you’re not going to have CEOs walk off in handcuffs. This is not an Enron kind of situation. People made some bad bets, maybe even some stupid bets, but even though I’m not a lawyer, I don’t think stupidity is a crime.”

Mankiw outlined the two basic objections of academic economists to the financial rescue plan then awaiting congressional approval. “The first is the fear that the Treasury is going to take these toxic assets that are now at very low prices, pay too much for them, and basically bail out a bunch of rich guys who don’t deserve bailing out.”

The Treasury’s response is, “No, we’re not setting arbitrary prices. We’re going to set up an auction mechanism, and we’re going to take the lowest price we can,” explained Mankiw. “Whether that’ll be successful or not is hard to say because these assets are very complicated and setting the auctions is far from trivial.”

A second criticism is that the rescue plan doesn’t do enough to recapitalize banks. The Treasury’s view, he said, is that creating a market for distressed assets will help recapitalize the banks to the extent that its actions make these assets more liquid and more easily sold. (Treasury Secretary Paulson, however, reversed course and announced on October 14 a plan to recapitalize U.S. banks with $250 billion of the $700 billion approved for the financial rescue plan.)

For more faculty views on the global economic crisis, visit www.hbs.edu/economic-crisis/.

— Roger Thompson and Martha Lagace, senior editor, HBS Working Knowledge

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