College Profs Examine Financial Crisis

By Aditya A. Sivaraman | Friday, October 31, 2008

On Thursday, October 16, the Rockefeller Center hosted a panel on the current financial crisis. Four Dartmouth economics professors spoke in front of a packed audience about the causes and implications of the current financial crisis. The panel, moderated by Professor Andrew Samwick, featured Professors Bruce Sacerdote, Eric Zitzewitz, and Nancy Marion.

Professor Samwick opened the discussion with a few general remarks about the financial crisis. He placed the blame in large part on a fundamental cultural misunderstanding about the use and misuse of debt. Samwick clarifies that debt is a good thing, but only if it is secure. He argues, however, that lately Americans have increasingly had a “why not” attitude toward consumption—whereas previous generations had a stronger sense of financial responsibility, the free availability of credit (or debt) today has fueled a national myth that anything can be bought now and paid for at some undetermined point in the future.

If this argument applies to retail bankers, it is certainly amplified when considered in the context of large investment banks and financial institutions. Severe leveraging occurs when an attractive (albeit risky) investment can be bought now with borrowed money and paid for later with expected returns (that is, money a bank expects or hopes it will make in the future but really does not have).

This shortsighted view of investment leads to the inflation of the credit bubble, with loans being collateralized with other investment vehicles—a growing balloon increasingly inflated with hot air, not hard cash. Samwick accurately described this situation as “not the use of leverage but the misuse of leverage.” Samwick thinks that credit must be grounded in the idea that real investments must be paid with real money eventually.

Professor Sacerdote opened the discussion by arguing that the government’s fears are warranted, and that a bailout is a necessary economic choice. He, like Samwick, also traced the crisis back to a misuse of leverage based on bad loans, but also indicated that this was a broader economic problem. He argued that market rules, a slowdown in the housing market, and outright panic on the part of investors had added fuel to the fire and contributed to the rapid downfall of so many large institutions.

To illustrate the point, he showed slides of Lehman Brothers’ balance sheets shortly before the bank went bankrupt. At its peak, Lehman was leveraged over thirty times, which means for every dollar of real money, it had thirty dollars of debt—a dangerously high amount, considering that $2.755 trillion of these assets were in the form of subprime debt. Shortly before bankruptcy, Lehman tried desperately to reduce its leveraged position, only to find that fears of hedge-fund solvency (accurate or otherwise) made it impossible for the bank to raise the required capital in time.

All things considered, this did not have to be a huge problem, as subprime mortgages made up a relatively small part of Lehman’s total net worth. Rather, as Sacerdote explained, “The fundamental issue was that our financial institutions managed to bet heavily on the most imprudent loans.” The skittishness of the hedge-funds, combined with the integral nature of the financial sector to the world’s economy, led Sacerdote to argue that government intervention to provide liquidity was necessary in this case. He pointed out that bailing out banks is not a new phenomenon in our nation’s history; the tradition goes back as far as 1797, when Alexander Hamilton deposited Treasury money in troubled banks.

Professor Zitzewitz agreed that the government should buy bad loans. He argued that the alternative to this was for the government to directly buy stakes in banks after their equity cushion was wiped out in order to save those banks—that is, to nationalize the bank. He explained this alternative by first outlining the nature of the financial sector.

One of the main problems that leads to the banking contagion, according to Zitzewitz, is essentially a classic case of prisoner’s dilemma: when a bank is doing poorly, the optimal solution would be for all investors to take a loss, and simply move forward. However, this kind of deal often breaks down because any investor can refuse to this and demand that he is bought out entirely of his equity stake before the deal can move forward.

Common human nature suggests that this is the basis of financial contagion—literally, a run on (or in this case, out of) a bank. Nationalization could be a cure for this, as the government is able to perform as a unitary actor. Another advantage is that the publicly traded equity of a nationalized bank would be a constant frame of reference to the bank’s actual worth. The chief downside is that the government must watch a virtually limitless number of transactions. In addition, other disadvantages are the increasing transaction costs and the potentially adverse effects on the availability of credit as a result of lower profit margins for lenders.

The other disadvantage, of course, is the intervention of government in the private sector and the troubling implications this has for corporate governance. Government ownership of financial institutions opens a wide array of avenues for abuse. One solution Zitzewitz proposed to this problem was to give the government non-voting preferred stock—however, it seems strange that the actor who put up the cash and wrote the rules for a particular bank subsequently has no say in how that bank is run.

Zitzewitz also looked at the situation from the perspective of a small (presumably commercial) bank. These banks, which tend to be deposit-rich, have largely avoided many of the problems faced by the bigger banks because their daily business operations rely on lending money to people directly, and later being repaid with interest.

This type of bank already faces stiff competition from the larger national banks, which have the latitude to offer loans to riskier clients at lower rates. A government bailout seems like a vindication of failed private financial strategy at the expense of those companies that did nothing wrong. In some ways it even punishes them, because it means that within a year or two, these commercial banks will once again have to contend with large government-backed banking institutions.

Professor Marion compared the current crisis with the 124 other systemic banking crises that have occurred around the world since 1990. She argued that in most of these cases, a general recognition that financial institutions are in danger is a harbinger for a broader economic crisis.

Almost all of these cases resulted in government intervention in the form of “partial nationalization” of the banking sector. However, government purchases of toxic assets have historically been an exception rather than a rule. Typically, bailouts come in the form of subordinated debt, common shares, or government bonds (that is, an injection of liquidity and not a literal bailout).

Marion pointed to a typical trend in the lead-up to a financial crisis: deregulation, credit boom, increased foreign borrowing, and a spending binge, all of which were present in our current crisis. Given that 50 percent of the financial crises cited by Marion have involved foreign intervention, the American crisis has the potential to get much worse before it gets better.

Most countries are cut off from international borrowing when they enter troubled financial times; the United States, as the home of global currency, has managed to avoid this trend. With the U.S. borrowing at unprecedented rates, the American current account deficit has risen to 5.1 percent of our national GDP, a figure which would have cut the U.S. off from international credit a long time ago if it was a developing country. Developing countries, Marion explained, typically have to take “pro-cyclical” measures in times of market turmoil, such as cutting spending as a result of the lack of credit; the United States, on the other hand, has continued to expand government spending, which could easily be making an already bad situation even worse.

Fundamentally, the financial crisis will force Americans to rethink their standard of living. The American Dream—the idea that everyone can own a house, a car, and a college education—will have to be fundamentally reconsidered in light of the reality that we, as a nation, have been living beyond our means. Perhaps the answer lies in eliminating government institutions such as Fannie and Freddie that create this illusion. Perhaps stricter regulation is the answer. Most frighteningly, perhaps there really is nothing we can do. One thing is clear: we’re not out of the woods yet.

College Profs Examine Financial Crisis

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