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Questions on the Financial Meltdown Answered (1)

Joetta Forsyth, PhD
Joetta Forsyth, PhD

Listeners from across the country submitted questions to Graziadio School faculty during the conference call on America’s Financial Crisis this Tuesday.

With over 200 participants on the call, there were too many questions for the panel to answer in the short time.

Below are responses from panelist, Dr. Joetta Forsyth, Assistant Professor of Finance, to just some of these questions. (Read why she believed a bailout was necessary)

Now that Congress has passed the bailout plan, we are working on answering more of these questions and posting the responses shortly.

1. The Bush Tax Cuts mixed with a boom economy and lack of fiscal leadership led to the largest deficit of our time and the current economic condition.  What would you do as the incoming President to improve our situation?

I have a different interpretation of what happened. There are a number of factors that lead to this crisis, and the list is staggering:

  1. Congress refusing to strictly regulate Fannie and Freddie:
    • Because of lobbying and dollars to congressmen.
    • Because of the desire to encourage home ownership by the poor, with doubtful results.
  2. A flood of money into the U.S. from the Fed after 9/11 and from foreign investors including China, who kept the yuan low to sell us goods.
  3. Lax oversight of banks by the Fed, the Bush Administration, and other regulators.
  4. A confusing tangle of regulators at the federal and state level who oversaw banks and mortgage brokers.
  5. Lax oversight of investment banks and brokerages by the SEC.
  6. Fraud and predatory lending to consumers.
  7. A lack of responsibility at the individual level.
  8. New Mark-to-Market accounting rules. Note: This may have been a good thing, because it caused the crisis sooner rather than later, after even more bad mortgages were underwritten.
  9. Supposedly savvy financial market participants who didn’t understand collateralized securities. What they didn’t understand was that once banks sold securities off, they no longer had the incentive to be diligent about a borrower’s credit quality.
  10. Executives who knew what was going on, but let it continue while reaping enormous compensation.
  11. The failure to regulate the credit default swaps market.
  12. High debt levels at financial institutions, and an aggressive attitude towards risk taking.

2. Stabilization is great, but is there a long term fix? Dynamic capitalistic markets are never without upheavals, but the goal is to create as stable an environment as possible for them to operate in.

The hard part is to get the amount of regulation right, and to write smart regulations. With too little regulation markets get out of control, with too much, we squelch innovation and lose to overseas competitors.

3. Has the problem accelerated this week due to the end of quarter?

Possibly, since banks want their quarterly books to look as good as possible.

4. Please discuss the pros and cons of buying the bad debt versus insuring the bad debt.

The pro to insuring the debt is that we leave the banks, who presumably would be superior to the government, to deal with problem mortgages.

There are several cons. First of all, there would still be fear about the bank’s books since these mortgages are hard to value, which would leave uncertainty in the market. Second, when banks sold mortgages to be collateralized, they sometimes had to agree not to alter the terms of the mortgage. Therefore, bank’s hands are tied when a borrower asks for relief. If the government takes control of the CDOs they could issue a blanket repeal of these provisions, for the CDOs that they own.

A final consideration is that because the mortgages were securitized and sold off, if can be hard to tell who has a claim on what. It is not clear who would be best at trying to untangle the mess, although having all the bad debt centralized in one place (with the government) might help.

5. Isn’t a bailout  tantamount to privatizing profits and socializing losses?  Aren’t these risks that Wall Street and main street chose to take hoping for a return on their investment?  Aren’t losses a part of capitalism?

I agree with you about “moral hazard”. And I think the idea of government getting involved in running businesses is a terrible one. I would hope that the government sells off it’s ownership as quickly as possible.

6. Is there a number at which the Treasury can buy this debt and profit to the tune of paying off the national debt?

This can’t happen. It’s not possible to profit that much.

7. From our understanding, the sub-prime default is approximately 12% of all residential mortgages. How does this equate to the need of a 700 billion bailout?

If an investment bank has 20/1 debt to equity, it doesn’t take much of a loss on assets to make them insolvent. Even commercial banks have relatively high debt levels.

Author of the article
Joetta Forsyth, PhD, Assistant Professor of Finance
Joetta Forsyth, PhD, Assistant Professor of Finance
Joetta Forsyth, PhD, Assistant Professor of Finance
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