Everyone has questions about the economy
By Susan Trulove
Researching the recent and on-going worldwide economic unraveling — with bank failures, company failures, and massive job losses worldwide — is akin to doing research at the scene of a horrific disaster as paramedics work. But it is just too important an event to wait for the dust to settle. What happened and what questions are academic researchers asking?
Numerous publications and websites, from the New York Times to Wikipedia, offer perspective and breaking news. I asked Virginia Tech finance experts for the “Dick and Jane” version, geared to someone who puts her money in the bank, does not take risks, and does not borrow more than she can pay back comfortably — not the mindset that got us into this mess, and maybe not the mindset that will get us out. As we all know, the morass began with loans to people who could not afford them. Subprime mortgages. Alternate A mortgages. Liar’s loans.
Summer 2007 - Wall Street Sees a Problem
The financial industry became aware of the problem by spring 2007, before the public was aware, says George E. Morgan, the SunTrust Professor of Finance. He points to five events during summer 2007 from the 21-page timeline compiled by the Federal Reserve Bank (Fed) of St. Louis:
• June — Standard and Poor’s (S&P) and Moody’s investor services downgrade more than 100 bonds backed by second- lien subprime mortgages.
• June 7 — Bear Stearns informs investors that it is suspending redemptions from its High-Grade Structured Credit Strategies Enhanced Leverage Fund.
• July 11 — S&P places 612 securities backed by subprime residential mortgages on a credit watch.
• July 24 — Countrywide Financial Corporation warns of “difficult conditions.”
• July 31 — Bear Stearns liquidates two hedge funds that invested in various types of mortgage-backed securities.
“I think the S&P downgrades/credit watch of more than 700 securities may have been critical and started the market paying more attention to problems in subprime mortgage lending,” says Morgan. “Difficulties at Countrywide Financial, a large mortgage lender, were becoming evident in news reports as well. Earlier, in February 2007, the Federal Home Loan Mortgage Corporation (Freddie Mac), which is authorized by Congress to provide a secondary market for residential mortgages, said it wasn’t going to buy subprime mortgages anymore. So between February 2007 and August 2007 is probably where one could say the crisis started to take hold on a broader scale, as opposed to a problem just in a corner of the mortgage markets.”
It was about this time that the BASIS students became concerned about Countrywide and mortgage losses, Morgan recalls. BASIS stands for Bond and Securities Investing by Students. The group, which is advised by Morgan and Raman Kumar, the R.V. and A.F. Oliver Professor of Investment Management, manages a $4.8 million portfolio for the Virginia Tech Foundation. “But I cannot say that we had any inkling at the time regarding the depth to which the problems would fall nor the effects on the economy that would occur in 2008,” Morgan says.
During 2007, BASIS earned nearly 7.5 percent for the foundation on its fixed-income investments, outperforming the market. The students invested a significant portion of the funds in U.S. Treasury securities, but not entirely, and even with a conservative approach, had losses during some months.
Meanwhile, the world became deeply involved as U.S. mortgage lenders began to go to sovereign wealth funds instead of the stock market, says Randall Billingsley, associate professor of finance. These funds had been growing as foreign states’ economic success, abundant resources, or frugality resulted in excess liquidity. Examples are the Government Pension Fund of Norway and the China Investment Corporation. “Troubled U.S. institutions were going overseas to get additional funds, so it didn’t raise as many flags in the U.S.,” says Kumar.
To fund managers outside the U.S., mortgages on U.S. real estate, most of which — after all — were insured by huge companies, seemed safe enough investments and offered greater returns than U.S. Treasury bills.
“It will be interesting to see the long-term impact of the financial crisis on the risk aversion of the overall market,” says Billingsley, speaking as a researcher. “Investors require a risk premium to coax them to invest in more than just Treasury securities. Say it usually only takes 5 percent above Treasury rates to get someone to invest in the equity market. If Treasuries were yielding 3 percent, an investor would have to get an expected return of at least 8 percent to find the equity market attractive. In times of crisis, that premium typically increases a lot,” he says. “I wonder if the breadth and depth of the current financial crisis will cause the risk premium to stay relatively high for a long period of time. That’s an interesting research question.”
Effective Nov. 15, 2007 — perhaps too late for more accurate disclosure to foreign investors — the Financial Accounting Standards Board required “Fair Value Measurements” of assets. Known as “mark-to-market,” this meant that a company had to value its assets at their market value, not their purchase or loan value. It wasn’t a problem while real estate prices were going up, but as prices dropped and defaults began, institutions had to report gigantic losses rather than maintain loan values on their books. “Companies that filed their fourth quarter results and their annual reports for 2007 were forced to reveal greater losses than might have been anticipated based on past reports,” says Morgan.
Summer 2008 - Crisis Reaches Main Street
Real estate values dropped and defaults became rampant.
“Now, everyone was aware of the drop in value of mortgage-backed securities (MBS). There were no buyers in the MBS market — only sellers,” says Kumar.
“Lehman Brothers was using money market funds (short-term debt) to buy MBS and support their operations to package and sell MBS,” says Morgan. “They owned the most toxic MBS. When prices dropped, Lehman and others had to report the lower value of their securities. Like the homebuyers whose mortgages were higher than the value of their property, Lehman owed more than the value of their securities. Unlike the homebuyers, Lehman had to pay back the money market in days, rather than years. Like many homebuyers, Lehman defaulted.”
“When the money markets shut down, the day-to-day operations of many businesses suffer,” says Kumar. “Lehman’s failure allowed the crisis to jump from the long-term debt market to the money (short-term debt) market. At this point, every business was in trouble, not just the financial institutions, because practically every business uses short-term debt to finance its working capital (day-to-day operational needs),” says Kumar.
Commercial paper is one of the instruments that is used by corporations to borrow short-term funds for working capital needs like buying inventories and meeting payroll. During the crisis, the commercial paper market largely shut down. “Commercial paper is generally cheaper than bank loans, but now businesses had to go to banks,” says Billingsley.
Even companies like AT&T had trouble meeting their payroll, and other companies had trouble buying supplies for their next big job — whether installing plumbing or spraying insecticide — because they could not borrow for a 10-day period, for instance, until their money comes in. “GMAC and GE Capital used money market funds to make loans to people who want to buy cars, for instance,” says Morgan.
“The freezing of the money markets (short-term funds) is, in some ways, more damaging than the temporary shutdown of the capital markets (long-term funds),” says Kumar. “The analogy for households for the freezing of money markets is as if there were no funds to buy food, and the analogy for households for the temporary shutdown of capital markets is not having funds to immediately replace the aging refrigerator.”
Enter the $700 billion Troubled Assets Relief Program (TARP).
With banks in trouble and credit drying up, the Fed and U.S. Treasury are like the pilot and co-pilot of a jet liner headed for the Hudson River — trying to make the best decisions very quickly. “With something like 15 to 20 percent of subprime mortgages in default, a popular misconception was that the TARP would help homeowners, but it was used to unfreeze credit markets,” says Kumar.
“It was initially assumed that the TARP would be used to buy the toxic MBS. But the Treasury decided to buy preferred stock,” says Morgan. “It is a better deal for the taxpayers to have preferred stock in a larger entity than only the toxic assets purchased for more than they are worth.”
“Preferred stock is a wedge between common stock and debt,” says Kumar. “By buying it, the Fed enabled banks to use the funds and attempt to unfreeze the debt market without directly rewarding common stockholders for making bad investments. When the payback comes, preferred stockholders will get their money first, before the common stockholders can get any benefit from the bailout.”
Morgan says his question for future research is the issue of regulation of capital adequacy — requirements that financial institutions have sufficient backing to do business without endangering depositors. Would a different structure of the regulations have improved the situation?
Kumar is also interested in this question. “What is the appropriate level of capital adequacy for banks? If the capital adequacy requirement is raised too high, it will push up the cost of borrowing. It is cheaper to lend depositors’ funds than shareholders’ funds. If the capital adequacy requirement is too low, it increases the risk of bank failures in bad economic times.”
Another Fed strategy has been the Debt Guarantee Program, in which the Federal Deposit Insurance Corporation (FDIC) is also guaranteeing bonds issued by banks. “Banks are the borrowers,” explains Morgan. “Whoever buys the bonds is making the loan. So if a bank that issues bonds is later unable to make the payments, then the FDIC will repay the bondholders.”
This backstop on the new bonds has further implications, Morgan says. “Those who already hold a bank’s bonds will see that even if the bank is on the verge of defaulting on existing bonds, the bank can issue new guaranteed bonds to raise the funds to make payments to the old bondholders. This gives the old bondholders more confidence in the quality of the bonds that they hold.
“The same would be true for the commercial paper market,” says Morgan. “If the buyers of commercial paper see that guaranteed bonds could be issued in the event that the company had a potential problem paying back the short-term loan, then the risk of the commercial paper is substantially reduced. Especially with commercial paper, the fear is that in 30 days, or whatever the maturity period is, the corporation or bank or GMAC won’t be able to refinance. The government guarantee on the new bonds reduces that uncertainty.
“The direct effect is that if new bonds can be issued to finance lending or other uses of the funds, that should help to increase the long term viability of the institution,” says Morgan. “The uses could be loans to car buyers — if one believes that in a recession car buyers are a good risk when it comes to paying back the money — or to buy low-risk Treasury securities. Uses could also be loans to companies or to buy other banks, either to rescue them or to shore up the prospects of and market confidence in the purchasing bank.”
“As of early 2009, it is difficult to say whether the investments have been enough,” says Billingsley. “But we can’t afford to wait and see. Having the government own such a large piece of private enterprise is hard to be comfortable with in a free-market economy. But it is hard to consider the alternative in such a dramatic economic downturn.”
Additional research questions are: What policy initiative happened and when? Did the Fed do the right thing and at the right time?
Billingsley has already looked at whether banning short sales protected the price of stocks. Short sales are when an investor borrows an asset they don’t already own and sells it in hopes of actually buying it back later for less than the sales price. Billingsley says, “Banning the practice appears not to have been as helpful as the Securities and Exchange Commission (SEC) hoped. Indeed, the effect of the recent short-sale ban on security valuations was temporary, lasting only as long as the banned period.”
The SEC might have succeeded in its attempt to curb excessive price declines during a particularly turbulent few weeks. However, Billingsley’s findings draw into question whether such policy initiatives provide net benefits to affected firms beyond the period of the ban.
“There will be a wide range of opportunities for research on whether changes in policies were good or bad and what actions had what consequences,” says Morgan. “The effects on the functioning of markets and the financial institutions of the mark-to-market rules, the new capital adequacy regulations, SEC policies, the policy decisions regarding Freddie Mac’s promotion of housing, the purchase of preferred stock by the Treasury before cleaning up the toxic assets, the decision to let Lehman Brothers go to bankruptcy court, and the incentives of the TARP package for future risk-taking are just a few of the fascinating research questions,” he says.
The researchers agree that better decisions are being made now than in 1929 and 1930. This time, the Fed stepped in quickly, which did not happen in the crash that led to the Great Depression. And this time, world governments came together. “Several countries have lowered interest rates and have had bailouts of their financial institutions,” says Kumar. “During the Depression, every country tried to help itself at the expense of others by curbing imports, and the countries collectively lost export-related jobs.”
“A concern now is that people in other countries have huge savings. That will drive interest rates down,” says Morgan. “No one is consuming. If there was huge consumption internationally, then it would be good for people in the U.S. to save. It’s the savings that occurred elsewhere that created the ‘tsunami of liquidity’ that was invested in MBS and drove the prices up.” One way for international investors to get their money back would be for the Treasury to buy toxic assets, says Morgan.
By April, it looked like so-called toxic assets would be addressed — not out of consideration for international investors, many of whom had sold their bad assets and invested in U.S. Treasuries, according to Kumar. The concern was the slushy — if not frozen — state of bank lending despite infusions from the Fed because of the legacy of bad loans remaining on banks’ books. In early March, President Obama’s finance team proposed a public-private investment program (P-Pip) in which the taxpayers via the Treasury, the Fed, and the FDIC would partner with business to buy maybe not-so-toxic assets. A student member of BASIS explains that the assets being considered are “legacy loans — the stuff lenders had on the books and had to mark to market.” They are not all worthless — just worth less than was loaned on them.
Depending on the type of asset (MBS or loans), the Fed, Treasury, and/or FDIC would guarantee up to 85 percent of the purchase price and match the balance of private investment dollar for dollar. “The private buyers will set the purchase price. The idea is that competitive bidding will take the price to the right level,” says Billingsley.
While critical that the Fed (a lender) is increasingly taking over roles of Treasury (investment), Kumar is optimistic about P-Pip. “Prices will get off the floor and there may be recovery in the market,” says Kumar.
• Actions to Restore Financial Stability, The Region, published by The Federal Reserve Bank of Minneapolis
• The Financial Crisis, A Timeline of Events and Policy Actions, by the Federal Reserve Bank of St. Louis