Record roundtable: credit crisis 101

Jake Gorelov ’09 sat down with economics professors Jerry Caprio, Kenneth Kuttner and Tanseli Savaser to get their expert perspectives on the deepening credit crisis and its economic implications for both Williams students and the country.

For all the non-econ majors at Williams, could you please explain the crisis in layman’s terms, and what has led to it?

Caprio: Whenever interest rates get really low on government bonds, investors might try to take more risks because they can’t make a very high return on their money, and investors sort of moving out in search of greater risk, you could argue, is one ingredient.

Kuttner: Well I think we should move it back even one step. I think basically it’s a whole mound of debt from loans that went south. Jerry [Caprio]’s comments are really about why did we get so much bad debt? I’m a little skeptical of the low interest rate explanation although there’s a lot of folklore to that effect.

I would place the blame, if you will, much more on the structural changes in the financial system that’s really decoupled the origination of loans from the people who ultimately hold the loans – Today, you have mortgage brokers originating the loans – they don’t care if they’re any good. They’re going to sell them to somebody else. And they’re going to repackage them and sell them to somebody else so each person along the chain has no real incentive to really check up on the credit quality of those things. This is kind of what economists like to call a principle-agent problem.

With the collapse of Lehman Brothers, Bear Stearns and Bank of America’s acquisition of Merrill-Lynch, how do you foresee investment banks conducting business in the future?

Savaser: Well, all the big ones have disappeared. The last two, Goldman Sachs and Morgan Stanley, decided to perform their business as a commercial bank. Given that they don’t have as much expertise in the commercial banking side of the world, you can perhaps foresee their acquisition. The investment banking business, it seems, would be left to the boutique-type of companies that do this type of service.
So are you saying that Morgan Stanley and Goldman Sachs can be acquired by other commercial banks?

Savaser: They don’t have the expertise of the Citibanks and Banks of America. So if they can’t find a niche for themselves in the commercial banking business and can’t abide by the capital-equity requirements and provide a service that’s different and better than already serviced by existing big ones, they could be.

Kuttner: And whether they continue existence as a big holding company or whether they’re bought, I think there’s a real fundamental transformation: these institutions will now be subject to the same regulations and oversight that banks are subject to. I think the conversion of these investment banks to bank holding companies may be a force for increased stability in the future.

With the transformation of the banking industry, what advice would you give the many students at Williams who are looking to go into finance?

Caprio: Start thinking about jobs with government agencies; they’re going to be expanding employment. If the Paulson plan goes through, they’ll be needing people to manage these assets. Now, there is some discussion that they may subcontract some of this work out to private sector firms. There are a lot of firms that sprung up in the wake of developing country crises that focused on restructuring and will be expanding. But old-style hiring on Wall Street might be pretty dead for a while.

Kuttner: The Federal Reserve system is probably hiring more in supervision and regulation areas.

Caprio: Some consulting firms that focus on restructuring will probably increase their want for workers.

Kuttner: Bankruptcy law firms?

Caprio: Yes, bankruptcy lawyers will do pretty well today.

Can you briefly talk about what impact the crisis has had on our economy? The value of the dollar?

Kuttner: The financial system plays a key role in basically taking the funds that savers had available and then channeling those funds to the people who need them. The problem we’re going to see is if the process of any mediation – over the transferring of funds from those who have it to those who need it – breaks down. I think the risk we see is that all the investments in this economy may come to a screeching halt. And the people who have worthwhile things they’d like to do with funds aren’t going to get them. So that’s what is sometimes called a credit crunch.

Savaser: So aside from that credit crunch or credit effect … there will be a balance sheet effect, and people will feel like their assets are valued less and that might also lead to a slowdown in the economy. People will consume less and hold off their consumption perhaps thinking that the prices may go down-
If this was an emerging market, we would probably see the dollar losing value, interest rates hiking up. So in the future, we might see the danger of that because now that we have this huge mounting debt that we need to get rid of; it would be hard to resist the temptation to use inflation to get rid of that debt.

What do you think about Henry Paulson’s $700 billion bailout plan? Do you think it will help ease the crisis?

Kuttner: Paulson’s plan is basically a carte blanche: it is basically Paulson saying to Congress, “Look, give me 700 billion dollars and I will just buy up these securities that are backed by the bad debt.”

Will that help? Surely it will. It’ll get all this bad debt off the balance sheets of financial institutions. The question is, are there smarter ways to do it? This is really just throwing money at the problem. A lot of the criticism of Paulson’s plan has come under is those who say, “Well, this is going to have a lot of unintended consequences that may be undesirable.”

Caprio: The plan can be far more expensive because it removes any accountability for the Treasury department so we don’t know how much they’ll really pay for the bad assets they are going to buy.

If you look at other countries that have been through this for good and bad practices, as well as U.S. history and the depression, the programs that were really careful with taxpayer money, that were very transparent, forced very hard conditions on banks. If they were going to get any money from the government, they had to accept a lot of tough conditions – limits on salaries and no dividends for shareholders – until the government got its money out. And the taxpayers got all the upside, and what I think we’re worried about is that American taxpayers may be getting the downside which will then really make the consequences dangerous for the dollar.

Kuttner: By letting institutions really off the hook without imposing these kinds of conditions, I think a big worry is that this kind of a bailout would not discourage excessive risk-taking in the future.

Changing subjects again, with the election looming, how do John McCain and Barack Obama differ in their solutions to the credit crisis?

Kuttner: Well they’re both pretty vague at this point, I would say. They haven’t really weighed in on anything specific that I’ve noticed.

Caprio: Yeah, I think one put it well: you can’t expect political campaigns whose job is to get a few basic messages out on their candidates to be able to deal with a major crisis like this and formulate policy details.

Kuttner: I think both are emphasizing the need to increase the conditions and make the terms of the bailout, if you want to call it that, considerably tougher than in Paulson’s proposal.

So last question. Can each of you say how you think the crisis will play out?

Caprio: There are going to be major changes in regulation in the financial sector. That’s a relatively easy forecast. Which way it’s going to go is harder to know. There are a lot of people who are saying that this represents the failure of deregulation, and I just think that’s fundamentally misleading.

Kuttner: The macroeconomic consequences so far have been pretty modest and I think we have yet to feel the whole brunt of the full fallout from this situation. I think that house prices still show no signs of bottoming out; I think consumer reaction to that is going to take some time. It’ll take time for that to sink in, time for them to adjust their habits. We’re in for a bumpy ride the next few months, year or two.

Savaser: I also think it would be very difficult to resist temptation for inflation given the amount of debt that we have currently.

Caprio’s research focuses on financial sector development, financial history and money and banking. He worked as director of financial sector policy at the World Bank from 1998 through 2005. Kuttner specializes in international economics, monetary policy implementation and Central Banks’ efficiency. He has served as assistant vice president of the Federal Reserve Bank of New York from 1997 to 2003. Savaser’s work focuses on financial economics and currency market microstructure.

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