Research

The devil's in the details of the financial market crisis, and he's wearing a green eyeshade

In the last month, financial markets came as close to collapsing as they have since the Great Depression, and the root of their woes was frozen credit markets. The crisis sparked several weeks of furious and futile improvisation by U.S. regulators and lawmakers. By early this week, the proposal — nicknamed the Paulson plan after Treasury Secretary Hank Paulson — appeared to be bringing relief, said financial experts at the W. P. Carey School of Business and in the investment business. Even so, only time will tell whether Paulson's plan can solve the underlying problems, the experts said. As always, the devil's in the details, and this time around, he's wearing a green eyeshade.

2008-10-22

Some say the world will end in fire,
Some say in ice.
From what I've tasted of desire
I hold with those who favor fire.
But if it had to perish twice,
I think I know enough of hate
To know that for destruction ice
Is also great
And would suffice.

— Robert Frost, "Fire and Ice"

Frost got it wrong, at least as pertains to the financial world. In the last month, financial markets came as close to collapsing as they have since the Great Depression, and the root of their woes was frozen credit markets. Worried about rotten mortgages and tainted mortgage-backed securities, banks stopped lending to each other.

They lost confidence in their ability to get repaid after seeing several commercial and investment banks fail or be taken over in government-arranged deals. Wall Street's freeze endangered Main Street because a healthy economy depends on a steady gush of credit. If banks can't borrow from each other, they won't lend to businesses, either. Dam up lending, and economic growth dries up.

The crisis sparked several weeks of furious and futile improvisation by U.S. regulators and lawmakers. At first, no proposal and no amount of jawboning by the president seemed to slow the stock market's plummet, nor loosen lending. Finally, about a week ago, the U.S. Treasury and the Federal Reserve, the nation's central bank, announced a plan to invest at least $250 billion directly into U.S. banks.

The regulators also said that they'd buy up bad mortgage assets, raise federal bank insurance limits and guarantee short-term loans between banks. By early this week, the proposal — nicknamed the Paulson plan after Treasury Secretary Hank Paulson — appeared to be bringing relief, said financial experts at the W. P. Carey School of Business and in the investment business.

Credit markets seemed to be returning to normal, and stock markets worldwide appeared to have stabilized. Even so, only time will tell whether Paulson's plan can solve the underlying problems, the experts said. As always, the devil's in the details, and this time around, he's wearing a green eyeshade.

A frozen market begins to thaw

"Markets, here and abroad, are finally thawing a little bit," said Herb Kaufman, professor of finance at the W. P. Carey School. "It's taken coordinated actions by the Fed, the Treasury, the FDIC [Federal Deposit Insurance Corp.] and regulators abroad, but they do appear to be thawing. It's not happening rapidly, but it's happening."

The confidence on which lending depends will require weeks, maybe months, to fully revive, and investors and lenders remain skittish, Kaufman warned. On Monday, Michael Melvin, a managing director at Barclays Global Investors in San Francisco, saw signs of the thaw in the movement of the London Interbank Offered Rate, or LIBOR. LIBOR, the rate at which banks lend unsecured funds to each other in London, is the world's most widely used benchmark for short-term interest rates.

"LIBOR has come down more today than probably ever before," said Melvin, a former W. P. Carey economics professor. "That's a good sign. LIBOR had been at all-time highs above the Treasury rate, which is considered risk free. The greater the perceived risk, the higher LIBOR is going to be. As it comes down, the risk of one bank lending to another is falling."

LIBOR's move is sweet relief for practitioners like Melvin, who called the financial crisis unprecedented in his career. Over the last two decades, the world has seen several financial crises — including the Mexican peso revaluation in 1994 and the Asian financial flu in the late 1990s — but none had spread as far or as fast as this one.

"Initially, people thought this was a U.S. problem, and it wouldn't have implications for the real economy," he said. "But financial markets are more integrated now, and problems in one asset class in the U.S. — mortgages and mortgage derivatives — traveled around the world." Probably contributing to the sudden slowdown was the bursting of a bubble in commodities prices, Melvin said.

Like real estate prices before them, commodities had seen a long and probably unsustainable surge in value. "People always like to say, 'It's different this time. The fundamentals have changed.' But it never really is different. Big stock market and commodity runs eventually stop. So it's not surprising that we have growth slowdowns. We've always had business cycles and always will."

First steps

Both Kaufman and Melvin said that Treasury's stock-purchase plan had probably reassured investors. But neither was sure that the plan was big enough to stanch all of the bleeding from balance sheets. Even so, both called it a much needed first step. The federal money will be added to the banks' capital, the cushion of invested cash and retained earnings that protects them against operating losses and bad investments.

"The idea is that this will spur further capital raising by banks," Kaufman pointed out. With its investments, the federal government is aiming to give private investors reassurance that they, too, can buy stock without fear that banks will go bankrupt.

Initially, the government is buying preferred stock in this country's biggest banks. (Other countries have initiated similar plans, following the lead of the United Kingdom, the first nation to make such a move.) The Treasury and the Fed, in effect, forced the big banks to take the money, even though several insisted that they didn't need it. The regulators did that in an effort to remove the stigma for banks of taking the federal funds, Kaufman explained.

The thinking was that smaller banks could then ask for the federal money without being seen as signaling their weakness and imminent failure. "There still might be some stigma for those smaller guys," Kaufman warned. "Treasury and the Fed are going to have to figure out some device that lets a bank come to the window without a stigma attached to it. Everybody knows this was a forced on the big guys, so I don't think investors will hold it against them.

For other banks, future valuations might be contingent on the fact that they had to seek capital from the government." The recapitalization program also imposes restrictions on banks that take taxpayer money. Specifically, it limits executive pay, particularly the large exit bonuses known as golden parachutes, and dividend payments. Banks that take the funds can't raise their dividends for several years.

Some commentators have complained that regulators should have required dividend suspension for banks in which the government invested. Otherwise, these banks will, in effect, be able to take the government's cash through the front door and then hand some of it out the back door to their shareholders.

Kaufman said that he believed that regulators handled the dividend restriction prudently. "Presumably these banks in this first rung of recapitalization didn't really need the money, so one could argue that they would've continued to pay the same dividend regardless," he pointed out. "And if the government put in a mandate to cut dividends, the stocks would've taken a hit."

Financial stocks have already swooned, with the rest of the market. So far this year, the Dow Jones bank-stock index has fallen about 30 percent. And of course, shares in banks with more bad mortgages or shakier finances — the very ones who need the government's money the most — have fallen more.

The good soldier gesture and accounting rules

Jim Boatsman, a W. P. Carey accounting professor, sees the issue differently than Kaufman does. He said that he could understand why the government wouldn't want to force firms to cut dividends. But he argued that banks that take the money should do so voluntarily. "It's not unreasonable for these guys to cut their dividends as a show of good faith," he said. He called such a move "a good soldier gesture."

Boatsman also took issue with an element of the recapitalization plan, namely, the provision of the enabling legislation passed by Congress that gives the U.S. Securities and Exchange Commission the authority to suspend so-called mark-to-market accounting rule for troubled assets. "The SEC has always had that authority," he said. "So that didn't do anything." Even worse, the provision seemed rooted in an attempt by the banking industry to slough off a restriction that it didn't like, Boatsman said.

The mark-to-market rule requires that banks re-assess the marketable securities on their books each quarter and adjust their value to reflect current market prices. Banks carry these investments on their books as assets, so when their value falls, the total value of a bank's assets can fall. Lately, the rule has caused much dread among bankers because the value of mortgage securities keeps sinking.

Thus when banks re-evaluate their portfolios of mortgage securities, they have to write down the value of their assets. In some cases, the write-downs have been so hefty that they've put banks in danger of failing to comply with federal requirements for minimum amounts of capital.

Boatsman argued that some of the proposals emanating from Washington for changing the mark-to-market rule don't even make sense. One would ask that the Financial Accounting Standards Board, the accounting profession's rule-making body, to change from mark-to-market to fair-value accounting.

"They're asking for exactly what the rule is now," Boatsman pointed out. "If you have assets with readily determinable market values, then there's a strong presumption that the fair value is the traded price. Plus, in the rule and in the embellishments since then, there's been a recognition that you may have investments where there isn't an easy-to-observe market price. For those, you can do reasonable estimates of the value."

Even if banks succeed in getting the rule changed, that won't alter the underlying economic realities of their businesses, Boatsman said. Changing an accounting entry won't solve the slump in real estate prices nor stem the resulting slide in the value of mortgage-backed securities.

"The only thing that would be accomplished is that it would change the number on the balance sheet," he said. "That doesn't make the asset worth any more or less than it was before. The fundamental economic stature of the bank is the same. The only thing that this would do is maybe to prevent bank capital from being impaired and stop capital requirements from being enforced. But if people want that moratorium on the enforcement of capital requirements, then do it in a straightforward way."

Few people besides bankers and their lobbyists believe that the FASB should monkey with the rule, he added. "All four of the large accounting firms have weighed in and said suspending mark-to-market isn't a good idea. There's an organization of institutional investors that's said the same thing. [Federal Reserve Chairman] Ben Bernanke said it was a terrible idea."

A European model?

Washington's foibles and its temporary loss of economic authority and leadership notwithstanding, the United States should not lightly succumb to a "grand scheme," European-style, new financial world order with governments taking over the market, said Werner Bonadurer, an clinical professor of finance at the W. P. Carey School and a native of Switzerland.

"In Europe, they're going ballistic on re-regulation," he said. "I won't call it socialism, but it's getting close. The French and Germans are attempting to create a "new form" of capitalism, based on moral values and heavy supervision in all areas of the financial world — they’re very quick to intervene in markets. In my view, it's a regulatory overreaction which will be reversed in just a few years."

Exotic investments gone bad have hobbled banks around the globe, and now taxpayers worldwide are being asked to support their countries' financial institutions. That has created an atmosphere of mistrust in financiers, global markets and the kind of financial engineering that created mortgage derivatives.

But Bonadurer cautioned that people shouldn't lose sight of the benefits that all of these things also brought — and, once the current crisis ends, should bring again. "Globalization, lighter regulation and financial innovation brought us tremendous welfare, and now we're giving back some of it," he pointed out. "But we shouldn't lose sight of the fact that they led to significant welfare — particularly throughout the emerging markets."

Bottom Line:

• In the last month, financial markets came as close to collapsing as they have since the Great Depression, and the root of their woes was frozen credit markets.
• The crisis sparked several weeks of furious improvisation by U.S. regulators and lawmakers. Then last week, the U.S. Treasury and the Federal Reserve announced a plan to invest at least $250 billion directly into U.S. banks. The regulators also said that they'd buy up bad mortgage assets, raise federal bank insurance limits and guarantee short-term loans between banks.
• By early this week, their proposal appeared to be bringing relief. Credit markets seemed to be returning to normal, and stock markets worldwide appeared to have stabilized.
• These actions provided a much needed first step, but the financial system is complex and experts differ on the details of how the plan should be implemented going forward.

Real Estate Economics Finance Faculty