Financial Crisis, Faculty Perspectives: Part 1
Harvard faculty members participated in two panel discussions this week focused on the roiling crisis in the nation's financial markets, the proposal to inject up to $700 billion of public funding to strengthen weakened institutions, and the wider implications for the economy. They concurred that regulation of financial institutions will be changed significantly; worried that the proposed intervention and forthcoming regulatory changes could themselves have unintended and adverse consequences; and pointed to even more severe underlying problems in the "real" economy—a worry described most vividly by Harvard Business School (HBS) professor of management practice Robert Kaplan when he told a Sanders Theatre crowd on September 25 that the current market turmoil is merely symptomatic of a "severely weakened middle class in the United States." (The account of the September 25 forum is available here.)
At a September 23 forum in HBS's Burden Auditorium, a standing-room-only crowd of M.B.A. students—many of them suddenly concerned about their prospects for employment, in finance or indeed any sector, as their questions indicated—heard first from Dean Jay Light, who spoke of "an anxious time, an historic time, even a dangerous time," as the "slow-motion train wreck" among financial institutions during the past 18 months accelerated into a fast-moving collision. He traced the collapse of the housing bubble; its intersection with a largely "new but untested financial system" (as mortgage lending evolved from local savings institutions that made loans to nearby homeowners and held those loans in their portfolios, to a transactional system of nationwide brokers who collected commissions as they made loans, sold them off, and the assets were in turn turned into complex securities and peddled to investors worldwide); and limned the dangers of sharply rising leverage among homeowners, investment banks, Fannie Mae and Freddie Mac, and investors in an era of reduced transparency and of reliance on highly liquid sources of capital (indeed, of using overnight loans to finance portfolios of mortgage and other securities).
Under the circumstances, Light—who is a director of Harvard Management Company, which oversees the University endowment, and of Blackstone Group, the large private-equity firm—prescribed a three-step course of action. First, as in a medical crisis, the patient has to be stabilized, the bleeding stopped—as in the form of the proposed $700-billion federal liquidity facility for frozen credit institutions. Second, the problem has to be diagnosed and repaired. And third, the wider financial system has to be rehabilitated and put back on its feet, not least in the form of changes in regulatory oversight and standards for leverage, transparency, and liquidity. The latter task, he thought, would be the work of several years.
HBS lecturer Nicolas P. Retsinas, director of the Joint Center for Housing Studies, described the dimensions of the housing-price bubble and current crash, given the excess inventory of housing units for sale—he suggested a million units at least—and the turmoil in lending. Ironically, he said, in current conditions, only borrowers with excellent credit ratings and substantial downpayments can purchase houses: the conditions that prevailed a few decades ago, before mortgage lending became the national, brokered business Light described. But of course there are too few buyers in those circumstances, and too few willing lenders, to clear the current inventory from the market.
HBS senior lecturer Clayton Rose, former vice chair and chief operating officer of J.P. Morgan Chase, and of investment banking there, summarized 20 years of deregulation of Wall Street that was unaccompanied by any changes in the prior oversight structure. In an atmosphere of intense business competition, he said, investment banks employed unprecedented levels of leverage (30 times their capital, in the case of many leading firms) to boost returns from their investments, at the same time that the value of those increasingly complex investments—mortgage-backed securities, derivatives, private equity holdings—became much harder to determine. He cited Goldman Sachs, a J.P. Morgan competitor, as an example: it boosted profits fivefold from 2002 to 2007 by assuming much more risk. While banks and bank holding companies remained under strict capital standards, and were overseen, variously, by four or five federal agencies and the Federal Reserve Board, investment banks escaped such capital limits, and were principally overseen by the Securities and Exchange Commission. But all the competitors, he said, placed heavy bets on the value of mortgage securities—the biggest pool of such financial assets—and all made faulty assumptions about default rates, the national prevalence of market weakness, the value of their securities, and the availability of liquid funds on demand.
Now, the contagion has spread to all classes of assets, and lenders, frightened by losses and the looming unknowns, have shut off the credit that the economy needs to operate. Banks, with less leverage, more capital, and access to the Federal Reserve for backup funding, are less threatened than investment banks, he said—witness the forced merger of Bear Stearns into J.P. Morgan Chase; the bankruptcy of Lehman Brothers; the hasty merger of Merrill Lynch into Bank of America; and the involuntary conversion, as he described it, of Morgan Stanley and Goldman Sachs into bank holding companies, under Federal Reserve supervision, on Sunday night, September 21. In the long term, he said, the investment banks' returns will decline, and their cultures and management will change from the style that has prevailed until recently.
McLean professor of business administration David Moss, author of When All Else Fails: Government as the Ultimate Risk Manager, agreed that the housing crisis underpinned all of the current problems, and that the resulting weakness in the financial architecture—excessive leverage, distorted compensation incentives, conflicts of interest on the part of credit-rating agencies, and the sheer complexity of current financial instruments—had created a genuine crisis of confidence, nearly to the point of precipitating a twenty-first-century run on banks last week as funds were pulled from the multitrillion-dollar money-market-fund industry.
Moss's greatest concern, however, is that whatever steps the public sector takes to ameliorate the risks must also be accompanied by parallel measures to control the resulting "moral hazard." Thus, he explained, federal insurance of bank deposits could encourage banks to engage in more risky lending—but generally does not if coupled with appropriate regulation; workers' compensation might encourage malingering—but it is also tied to compensating steps [no one wants to be injured, replacement income is limited, the business is regulated]. Federal disaster relief, he said, has the opposite effect when it encourages rebuilding of hurricane-damaged communities in precisely the most hurricane- or flood-prone locations.
Thus Moss defined the problem as successful versus unsuccessful government management of risk. So far, he said he saw in the rapid movement toward the $700-billion federal financing plan no offsetting steps to apply appropriate oversight and other measures that would discourage future, inappropriate risk-taking by the institutions which would be resuscitated as they sell damaged assets to the government.
McArthur University Professor Robert Merton, a 1997 Nobel laureate in economics for his work on options pricing and risk analysis, advanced the importance of "functional analysis of the financial system." (His experience with the system is both theoretical and actual; he was a principal in Long Term Capital Management, the extraordinarily leveraged investment firm whose collapse in 1998 nearly precipitated a world financial crisis and necessitated a bailout negotiated by the Federal Reserve; see a review of books on that precursor of the current situation here).
Although current concerns focus on liquidity and the credit markets, Merton said, it was essential to note that as too-high housing prices deflated, perhaps $3 trillion to $4 trillion of actual wealth had been lost in the last year alone—and was unlikely to return. With each successive decline in the value of an asset held on a leveraged basis, he said, an owner's effective risk and effective leverage ramped up at an accelerating rate, underlining the destruction of the financial institutions that held the underlying failed mortgage loans and securities based on them. In addition, such deterioration prompts "feedback": for instance, banks and thrift institutions held Fannie Mae and Freddie Mac preferred stock as part of their presumably safest, most reliable capital; when the government took control of those institutions, the banks' and thrifts' capital absorbed immediate, large losses—instantly increasing their own leverage and decreasing their ability to make loans, worsening the underlying housing crisis.
Financial innovation and "engineering" are widely blamed for causing, or worsening, the current crisis, and in a sense, they have, Merton said. Innovations inherently involve the risk that some ideas will fail, and inherently outrun existing regulatory structures. But rather than clamping down so severely that financial innovation is choked off, he argued that regulation must allow for further, future innovation as an engine of growth, because the functional needs—consumers' need to finance their retirements, developing nations' ability to fund economic development—remain intact. Thus, he urged that the focus remain on the necessary financial functions, and not on saving any particular form of institution that currently meets those needs, or did until recently.
Jobs in finance, he told the anxious M.B.A.s, would be "tough" to come by. But the solution for society would not be to rid financial institutions of highly trained, innovation-oriented financial engineers. Rather, he insisted, management teams, boards of directors, and regulators needed much more such expertise in their own ranks so they could understand the products they were offering and acquiring—as they so apparently did not in the recent past.
Part 2, on the University forum held on September 25, is now available here.