Harvard Business School faculty members, looking at the U.S. financial crisis from a variety of disciplines, urged caution and prudent analysis in a recent panel discussion.
The discussion titled "Turmoil on the Street: Fathoming the Financial Crisis" was held September 23.
Jay O. Light, professor and Dean of the Faculty, provided a brief outline of the landscape as well as thoughts on how to view the proposed bailout. Lecturer Nicolas P. Retsinas, Director of Harvard University's Joint Center for Housing Studies, then gave a brief history of housing in the United States and shared his insights to set the stage. Senior Lecturer Clayton S. Rose, who for 20 years worked at JP Morgan & Company and headed global investment banking and global equity there, discussed the implications of change in commercial and investment banking. Professor and historian David A. Moss stressed the importance of risk management and oversight. Robert C. Merton, the John and Natty McArthur University Professor, similarly expressed concern about the unintended consequences of change on Wall Street, closing with the assertion that innovation should and must continue.
Leverage, Transparency, Liquidity
Dean Jay Light began his introductory remarks by characterizing the crisis and collapse of housing prices as a test that has exposed how fragile the recently evolved U.S. financial system is. "Leverage, transparency, and liquidity lie at the heart of much of what's going on. The system has proven to be unexpectedly fragile in a way that I think nobody I know really understood," Light said.
To illustrate his point about the interlocking nature of housing and the U.S. financial system, Light said that for decades beginning in the 1930s, the ratio of median home prices to median income remained relatively stable, about 3 to 1. Over the last 20 years, however, the financial markets that financed the housing system in the United States changed remarkably. Local markets once dominated by tightly regulated savings and loans—a simple system of buy and hold—evolved into something much more complicated due in part to the development of mortgage brokers. The new system fueled a bevy of mortgage backed securities and derivatives that were terribly difficult for experts to comprehend, he said.
Too much leverage combined with too little transparency meant that the markets froze. Liquidity vanished. Similar to mortgage-backed securities, highly leveraged loans and other transactions were characterized by a lack of transparency. "When one looked at an institution, it was very hard to understand who had what risk. In a world like that, liquidity disappears. So too does the liquidity of institutions. … That in fact is where we are today," Light said.
Just as a hospital treats patients by focusing on three tasks, so too should we remedy financial turmoil, he said. First, stabilize the patient, in this case the markets. Second, fix the problem through either surgery or other medical care. Finally, prepare long-term rehabilitation. Those three tasks must be accomplished in order.
As for the $700 billion proposal described as a bailout by Treasury Secretary Henry Paulson, it is deliberately void of many details that would be hard to pre-specify, Light said. "It isn't clear it's a bailout at all. … It may in fact be a very profitable investment. And at what price are the assets to be purchased? You see, it's actually needn't be a bailout proposal at all. It's in fact a proposal to try to re-liquefy markets by reducing leverage, by increasing transparency, and by increasing liquidity by establishing a set of pricing processes that involve the private market as well as whatever this public entity is.
"How is this exactly going to work? Nobody knows," Light continued. "The details have yet to be described."
Light recommended designing various auction processes that treat differently the questions of what is bought, from whom, and at what price. "In order to try to re-liquefy the markets, get some price discovery and begin to understand what these assets are worth. It is a big job in the intermediate run. And in the long run we've got to have a system that substantially readdresses leverage, transparency, and liquidity.
"It will be in fact a whole new ballgame that takes many years to play out. It will be years before we figure out where the crucial financial functions lie, in what new institutions, governed how, and regulated how," Light concluded.
Home Ownership: "back To The Future"
Housing was Topic A for panelist Nicolas Retsinas, who before arriving at Harvard served as assistant secretary for housing in the U.S. Department of Housing and Urban Development. Offering a brief historical background, Retsinas said that prior to the Depression, people who wanted to buy a home were typically required to make a 50 percent down payment. They were issued a 5-year interest-only note, and effectively crossed their fingers that they could refinance at the end of five years. Not many people owned homes or could borrow under such conditions. As a response, the modern housing finance system undergirded by the federal government arose during the New Deal to make credit and liquidity available to people wanting to buy a home.
"In the 1980s a traditional loan was made by a regulated bank, a deposit-taking institution that most often kept the loan on its books, retaining the credit risk. But over time the banks would sell more and more loans to the secondary market, particularly since the Fannie Maes and Freddie Macs that had evolved since then, in order to relieve the banks of some of the interest rate risk. In the 1990s a couple of things happened that set the stage for where we are today: There emerged automated underwriting and credit scoring. All of a sudden the world of the deposit-taking institution, your neighborhood bank, transformed into large national mortgage banks—a mortgage delivery system that was populated by brokers, mortgage banks, and investors.
"This opened the door to new sources of capital from around the world. Holding that door wide open were Fannie Mae and Freddie Mac. By that time those government corporations had become private corporations, but were still overseen by the government," said Retsinas.
If we look back to that period, one of the arguments for such wide-scale change was to both create more liquidity and minimize risk, he observed. It was believed less risky if banks did not keep all the risk but rather sliced, diced, and parceled out the risk to investors to better set, price, and absorb it. "An ironic argument, as we have learned," he quipped.
The housing boom in the 1990s was led by "strong demographics—people coming to this country needing a place to live," low interest rates, liquidity, and a bustling economy. Early this decade home price appreciation in many markets far exceeded the growth of income, he continued. By 2005 such a high rate of home price appreciation drew ever more investors to the market. Between 25 percent and 30 percent of all home sales were purchased by investors. People who owned their homes took advantage of this equity buildup, some becoming what he termed "serial refinancers."
"What used to be a goal of people like my parents to someday have no mortgage, all of a sudden was forgotten. And the new goal was, how do I capture this equity?" said Retsinas.
On the issue of affordability, home prices rose so high that it became virtually impossible for people to take out regular or prime loans. "It's hard to overstate the dramatic buildup in subprime lending over this period. 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."
By now the system promoted and rewarded the selling of mortgages. Mortgage brokers originated over two-thirds of the mortgages as opposed to the one-third they did 10 years earlier, he said. Mortgage brokers were paid on commission and on the basis of originating a loan; they were unconcerned with whether the mortgage was repaid. In the pursuit of scale, mortgage banks bundled mortgages and worked with investment banks to put them into complex securities.
"In 2004 and 2005 as these subprime loans started to emerge, it really wasn't a particular problem because of the lag effect, because people who couldn't pay off these mortgages with toxic terms and exploding payment schedules did worry.'If I cannot pay off my mortgage, I'll put a 'For Sale' sign on the lawn, I'll sell it, I'll walk away.' As the housing bubble burst, those exit doors were closed," he said.
"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 brokered apart, taken apart, put in little subsets, and put in 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, and the de facto regulator became the credit rating agencies," said Retsinas, arguing that regulation became essentially outsourced and privatized. The credit rating agencies weren't able to perform their function whether due to the attendant complexity or their own eagerness to participate in this system.
"We're in a bad place" today, he said. Builders have overbuilt: Retsinas estimated there are now a million more homes than needed. And just when people need credit, credit is constrained. Subprime lending has vanished.
"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. That all sounds fine and secure, but it certainly leaves behind millions of families who are at the lower end of the wage scale and who have some impairment in credit.
And the future? "We know what happened, we know how we got there. Our short-term strategy is to nationalize the housing market. Is that a good strategy over time? If you nationalize that market, how do you balance between extending credit and making sure you have safety and soundness without burdening the taxpayer? That's the question."
Investment Banking Faces A Crisis Of Confidence
Senior lecturer Clayton Rose shared insights on the turmoil gained in part from his experience at JP Morgan & Company for 20 years, where he headed global investment banking and global equity, and was a member of the firm's executive committee.
The regulatory structure did not keep pace with two decades of deregulation on Wall Street, Rose explained. Deregulation led to intense competitive pressures to which firms responded by deploying more capital and seeking higher returns. Add to this a lack of transparency and a lack of understanding about the values of many of the assets that were acquired using said capital.
Rose also provided a brief history of the investment landscape as it has evolved over the last few decades. Commercial banks and investment banks were separated by law in Depression-era legislation, and remained distinct for many years. Commercial banks made loans, kept the loans on their books, and took in deposits "through the door." For their part, investment banks mediated between companies that wanted to borrow or issue equity, and between investors such as mutual funds and pensions that wanted to invest in those securities. Investment banks also provided advice on mergers and acquisitions.
In the early 1980s the derivative markets were quite small and relatively unsophisticated, and the market for mortgage-related securities was also in its relative infancy, he explained. "By the end of the 1990s, that had all changed. By the early 1990s the legislation that separated commercial and investment banking had been torn down, and banks and investment banks and insurance companies were in each others' businesses," said Rose.
"As a result of deregulation, the derivatives market and the market for mortgage-related securities had exploded in both size and complexity. By the end of the decade, there were as an intentional result of deregulation, intense competitive pressures in the financial services business. And one of the responses that was universal across all firms was to deploy more of their own capital to seek higher returns. Derivative, mortgage, and private equity markets, to name three, were places were firms went to seek out these kinds of higher returns. Until just a couple of years ago, in fact about 18 months ago, this strategy worked quite well.
"But at the same time that we were seeing substantial growth in the financial services business and a remarkable change in the landscape, the regulatory structure had not kept pace at all. It was stuck in a 1980s mode. The checks and balances and oversight that were required in the system were missing. There was a fragmented, highly complex, deeply inconsistent regulatory structure."
As part of firms' efforts to deploy capital and seek higher returns, the mortgage market was ''in the center of the bull's-eye along with a couple of other instruments," said Rose. "Most of the firms on Wall Street followed each other around to the same parts of the market and ended up mimicking each other, which is a classic strategic failure. So when the subprime crisis hit they were all in the same boat together," he said.
Investors and lenders could not understand some of the assets on the balance sheets of these firms. The assets were complicated, and were not traded, so there was no open market, and the models were difficult to understand.
Commercial banks, however, were in a different position from investment banks, he continued. Commercial banks had more capital as a function of complying with the regulatory requirements. They could access deposits as a stable source of funding, as well as the Federal Reserve discount window, which, if they lost access to all the market sources of funding allowed them a way to go to the government and get funding for daily operations.
"Investment banks, on the other hand, had no access to deposits and no access to the discount window. They were reliant on a market that takes place between financial firms and between firms and corporate clients for short-term funding. There's a taken-for-granted notion in that market that there will always be funding. But to the extent that that market disappears, and it hadn't happened until recently, investment banks had maybe a day, maybe two days before they wouldn't have sufficient funding to continue their operations."
In conclusion, the two investment banks that just announced they will become bank holding companies did not do so by choice, Rose said. "This is a requirement that the Fed imposed on them and that the Treasury imposed on them as one of the costs to keep them viable; they will have greater regulatory scrutiny going forward. The regulatory regime that the Fed is going to impose on them is going to be markedly broader and stronger and deeper than anything they have experienced before. Their capital requirements are going to go up significantly.
"It doesn't take a Harvard MBA to figure out that their return profile is going to go down, and the cultures at these firms are going to change dramatically over the next couple of years."
The Risk Of Moral Hazard
David Moss, professor and historian, identified three interrelated problems driving the ongoing financial turmoil: the collapse of the housing bubble, significant weaknesses in our financial architecture, and a deep crisis of confidence, particularly in the financial sector. He suggested that the first problem was at the heart of things and that we wouldn’t ultimately see improvement until housing prices stopped falling. "Keep a close eye on housing prices," he advised.
The second broad problem facing the United States is weakness in its financial architecture, with excessive leverage across much of the industry, distorted incentives embedded in executive compensation packages, and credit rating agencies that miss the mark. The third problem is a crisis of confidence, which began to look almost like a bank run last week. Historically, such crises have proved very dangerous, he said.
While the $700 billion proposal may be "reasonable," Moss suggested, "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 work as a historian 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 more risk. If you've ever had a rental car where you were fully covered against damage or loss, perhaps you drove a little less carefully or parked in a more dangerous place. That’s moral hazard"
When the government manages risk, it also must worry about the potential for moral hazard, he said. A good example is federal deposit insurance. By guaranteeing bank deposits, the federal government could inadvertently invite banks to take excessive risk. The reason this doesn’t happen most of the time, he suggested, is because we not only insure the banks (through FDIC), but also carefully regulate them (through FDIC, the Federal Reserve, and the Comptroller of the Currency). In fact, the original legislation that created FDIC in 1933 had two important parts, providing for both bank insurance and bank regulation. The two have to be paired, he suggested.
"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. To be sure, there's been a lot of discussion about oversight of Secretary Paulson, and that's a compelling objective. But we haven't seen nearly as much discussion about what this bailout means in terms of the oversight of financial institutions that will be required. 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,” said Moss.
One public policy that should serve as a warning is our system of Federal Disaster Relief, designed to help the victims of natural disasters, he continued. The policy provides relief but does not include land use regulation or risk-based premiums. "We see more and more building in hazard prone areas. The losses keep spiraling up disaster after disaster, because there has been more and more construction in hazard prone areas. And it’s possible that the existence of federal disaster relief actually helped stimulate some of that building. The point is that if we’re going to provide the relief, which I support, we also need to try to control the moral hazard.
"The same holds true for the bailout that Secretary Paulson and Chairman Bernanke have proposed. I just want to make sure that if we’re going to manage this extraordinary risk in the financial sector, we also remain attentive to the sort of oversight that is then necessary to make sure we don't create a bigger problem going forward. Anytime the government manages a risk, it must also manage the moral hazard, and the current crisis is no exception," Moss concluded.
Innovation Will Continue
University Professor Robert Merton, who received the Nobel Prize winner in economics in 1997, began his remarks by noting that in the current turmoil a large amount of wealth—between $3 and $4 trillion—has been lost without any offset in gains. Loss in wealth will be borne by house owners, those who finance them, and the general population to the extent that the government becomes engaged. "This is not simply a liquidity crisis or simply a problem of a messed-up financial system," said Merton.
Standard financial models remove some of the mystery about what has happened and make the financial crisis comprehensible, he continued. But his larger message to students in the audience was to highlight the relation 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. 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 crisis. He reminded the audience that banks and insurance companies, the sources of some of these problems, are among the most regulated entities other than hospitals in the United States. While regulation is important and needed, "it's not magic," he said. Poorly done regulation could have a long-term negative effect.
"I hope we'll have careful analysis and pathology before we start to set the regulations," Merton continued, suggesting the creation of the equivalent of the National Transportation Safety Board for examining financial crises in a technical, determined way.
Finance as a profession does not look bright, he acknowledged. It will be tough to get jobs on Wall Street. But the good news is that innovation will continue.
"The financial functions of the system, whether providing for retirement or transactions, still have to be performed. This is a global and growing business, and it's one that can have very significant impact on economic development and growth.
"Some commenters say, 'We have to get financially sophisticated people out of the system.' The worst is to say 'financial engineer.' I suggest it's just the opposite. The problem, in part, is that senior managers, regulatory overseers, and members of boards of these financial institutions don't have a good understanding of all of this. And it would be perverse if the solution was to dumb down or limit what the institutions can do in terms of what they develop, to fit the existing managers. I think the longer-run solution is that general managers have to become far savvier."
The finance job market is global, and there remains a strong need for talent. People skilled in general management combined with highly technical training to develop a functional perspective are best equipped to navigate the changes ahead, Merton concluded.