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Financial Crisis, Faculty Perspectives: Part 2

9.26.08

On the afternoon of September 25, President Drew Faust hosted a discussion on "Understanding the Crisis in the Markets: A Panel of Harvard Experts," before a full house in Sanders Theatre and a webcast audience. (An archive of the webcast is available here.)

Faust noted the "unsettling news" of disappearing financial institutions and the assumption of huge new responsibilities by the federal government, and introduced the panelists. The first and last, Harvard Business School (HBS) dean Jay Light and McArthur University Professor Robert Merton, played the same bookending roles in the business school's similar panel two days earlier (for a full account, "Financial Crisis, Faculty Perspectives: Part 1," see here). Between them, new panelists offered sharp perspectives on the weakened condition of the American middle class, a blistering critique of unregulated financial products such as the subprime mortgage loans that are now defaulting at unprecedented rates, and warnings about the interdependence of the United States economy with (and dependence on) the larger global economy.

After summarizing the current situation, Light characterized the proposed $700-billion injection of federal funds into the market for financial institutions' damaged assets not as a "bailout" but as an auction mechanism to make now-frozen credit markets functional again—perhaps an even more alarming way of looking at the problem. The short-term goal, he said, was to "allow price discovery to work," implying that at present, the market mechanism is completely inoperable, or nearly so, given fears about further loan losses, the incomprehensibility of some of the complex investments, and financial institutions' impaired capital cushions.

HBS professor of management practice Robert Kaplan—a Goldman Sachs alumnus who on June 30 completed eight months of service overseeing the University endowment as interim head of Harvard Management Company, on whose board he now serves—agreed that there is a financial crisis. But, he said, it is only symptomatic of a "severely weakened middle class in the United States." Citing wage stagnation and the rising costs of essentials—food, energy, education, healthcare [and of course, during the housing bubble, shelter itself]—he said middle-class Americans had rationally sought the most available source of funds: the rising value of their largest asset, their houses. Serial refinancings tapped equity and enabled families to make ends meet, he said. They are fundamentally unable to do so at prevailing wage levels, he argued—and now, of course, the support provided by rising house values has been kicked away. Consumer "deleveraging" is now an institutional imperative, too, prompting the rounds of asset write-offs, efforts to raise capital, and bank and investment bank failures.

The proposed $700-billion federal financing, he said, is "unfortunately necessary"—but not sufficient to get institutions to lend again, nor to "rebuild the middle class," the engine for the economy as a whole. To that end, he said, although the injection of funds into financial institutions will end up costing only "a fraction of the headline cost," the country faces hard choices and expensive investments—for which it will need reserve financial capacity—to address necessary changes in tax policy, energy, healthcare, deteriorating infrastructure, fiscal discipline more broadly, and incentives for savings. In the long run, he said, such steps are essential for any shorter-term financial fix ultimately to work.

Gottlieb professor of law Elizabeth Warren in a sense took Kaplan's stance as a starting point. "The middle class is in big trouble," she said, and has been for a generation or more. The housing crisis is merely symptomatic of "the effects of beating up someone who is already sick." Overall, she argued, the $700-billion federal financing plan addressed the back end of the nation's economic problems; the solutions, she maintained, lie in addressing the front end: the restoration of the middle-class core of the economy.

Housing, Warren said, has traditionally been the way middle-class people accumulate wealth. Local lenders evaluated their borrowers, made loans, and held the risk in their own portfolios; if a repayment problem arose, the local lenders knew how to work with their debtor-customers to resolve the issues most effectively, minimizing foreclosures and all their attendant ill-effects on the homeowners and their neighbors. In the new, broker-driven environment that Dean Light outlined, Warren said, financial institutions took advantage of their unregulated status to market higher-priced mortgage products with misleading teaser rates and terms that made comparison shopping difficult—in effect foisting loans that were "from day one" unsustainable onto the public.

The widespread use of subprime loans, beginning in 2000, she said, was not an accommodation to make housing available to the poor; just two years later, in fact, 80 percent of subprime loans were used in brokered refinancings of existing mortgages, "ripping out" equity and putting borrowers into expensive, unsuitable loans under the cloak of 24-month teaser rates. She characterized the entire market as a "Ponzi scheme." (Warren spelled out these arguments in detail in "Making Credit Safer," published in the May-June Harvard Magazine; there, she called for a Financial Products Safety Commission that would review loans, credit cards, insurance, and related services much as physical products, such as toasters or cribs, are now vetted.)

Given the need to work out millions of inherently failed home loans, Warren said, the proposed federal financing addresses "the wrong end of the dog." With the loans themselves deconstructed into "zillions of fractionalized shares" of mortgage-backed securities and other derivative instruments, she said, merely assuming ownership of such assets represented no progress toward the essential task of working with families, sorting out those mortgages that had to be foreclosed from those that could be revised, with the goal of keeping the maximum number of householders in their homes. In her view, some sort of bankruptcy reform, aimed at the individual loans, affording a neutral forum for working the problems out, is the key. There is not enough money to support the whole market for the financial assets held by weakened institutions, she said, nor could the country afford to do so "because you can't throw that many people under the bus."

The problem, she repeated, "began with a dirty product" sold knowingly by its creators, who took advantage of a deregulated environment. Avoiding such problems in the future, she suggested, would depend on addressing such abuse at the outset.

Beren professor of economics N. Gregory Mankiw, who teaches the perennially popular Economics 10 introductory course and and is the author of the core introductory textbook in the field, said that "the basic problem facing the financial system is that lots of people made very big bets that housing prices could not fall 20 percent," despite evidence to the contrary in the Great Depression and more recently in Japan. The resulting losses wouldn't matter in classical economic theory, he said—taking risk entails absorbing loss—except that the simultaneous large bets undercut much of the financial system all at once, and that system, as readers of his textbook know, is vital for the economy as a whole. Federal Reserve chairman Ben S. Bernanke ’75 (access his June Commencement address here) focused on just this problem in his examination of the role of bank failures in worsening the Great Depression, Mankiw noted.

How should one view the proposed $700-billion federal financing initiative, Mankiw asked. One theory, advanced by President George W. Bush the night before, was that financial institutions' damaged assets have value greater than their current price, and only the federal government has the resources to buy and hold them to maturity. Wall Street economists, Mankiw said, like that interpretation. Their (tenured) academic counterparts are skeptical: the Treasury, they say, will overpay, thus bailing out failed managers who don't deserve it; and/or the funds will be insufficient to recapitalize banks, given the real magnitude of the losses they face.

Academic economists' alternatives are three: let the market handle the situation (as hedge funds and private-equity funds step forward where they see attractive opportunities to invest fresh capital); have the government somehow take equity positions in troubled banks and other institutions, directly infusing them with capital but benefiting as they recover (much as investor Warren Buffett put $5 billion into Goldman Sachs, with the right to invest $5 billion more on favorable terms); or force banks to raise capital, no matter what (in the friendly manner, Mankiw suggested, of a Mafia enforcer dropping by for a chat with management).

As for the presidential candidates, Mankiw said, Barack Obama, J.D. ’91, seemed to be saying that the market had run wild, inflicting on the public the downside of unfettered capitalism. Recalling his service from 2003 to 2005 as chair of the president's Council of Economic Advisers, Mankiw said that he had tried to rein in the government-sponsored Fannie Mae and Freddie Mac. Predecessors in the Clinton administration, he said, found the task impossible, too. This was a known "time bomb," he said, not a market problem. Nor was it simply a problem of lax underwriting standards for loans.

Of John McCain's emphasis on Wall Street "greed" and "corruption," Mankiw said, there was scant evidence that corruption was the problem. Many people made ill-advised bets, he said, but that was not criminal. And he suspected that greed would be a factor in the markets that any future administration would encounter.

Cabot professor of public policy Kenneth Rogoff, former chief economist and director of research for the International Monetary Fund, tried to put the "truly incredible" recent developments in some larger context.

The financial sector of the economy, he said, had become "bloated"—accounting for 7 to 8 percent of jobs (including insurance employees), but capturing 10 percent of wages and 30 percent of profits. Such evidently huge returns naturally attracted torrents of new investment, making the financial sector as a whole a bubble: "It is too big, it is not sustainable, it has to shrink" even beyond its already depleting ranks. The problem, he said, is not merely bad debts held by institutions, but "bad banks" themselves: the whole sector of financial enterprises begs to be restructured. (Rogoff noted that he had for several months forecast the collapse of at least one large investment bank, but even he was surprised at the near-collapse of nearly all the principal investment banks virtually overnight.)

Much as auto makers or steel companies in the past argued that they were basic to the economy and therefore required federal support, he said, today the "country is being ransomed by the financial sector" in the demand for the $700-billion bailout, which would have the effect of maintaining management salaries, bidding up the prices of stock and bond holdings in their companies' portfolios, and so on. Today, unlike during the Great Depression, Rogoff argued, the shrinkage of such institutions would be "not unproductive" for the economy as a whole. (As an aside, he noted that all those Harvard students who marched off to investment banking "will be freed to go into other activities.") Given the difficulties of conducting auctions to buy distressed assets with the government's largess without letting excess funds leak back into the financial sector, Rogoff was sympathetic with Warren's argument for focusing on the needs of homeowners.

In international perspective, he said, the United States "has been running spectacular deficits" for 15 years or more. The availability of foreign funds has enabled the country to keep interest rates low—maintaining abundant liquidity—but has exposed the fragility of the system if federal budget deficits balloon. In the present instance, he said, the issue becomes a question of whether Beijing wishes to lend the United States $700 billion to repair American financial institutions. Americans aren't immediately going to be the source of those funds, he noted: "We're supposed to keep consuming." In other words, the country is saying, "We borrowed too much, we screwed up, so we're going to fix it by borrowing more."

He said a better strategy was required—but not at the expense of excessive regulation that would choke off innovation, one of the few flagships of American economic growth and strength in recent decades (a point also made by Merton at HBS on September 23, and again after Rogoff's presentation). After the dot.com bust of 2000-2001, Rogoff said, the technology sector regained its footing. Today, it is equally important not to overreact, so that a dynamic financial sector, corrected by "tough love," can resume its proper and important role in the economy and in future growth.