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[Music]
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this podcast is brought to you by
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knowledge at Warton please visit
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knowledge. won. up.edu for more
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information I'd like to add my welcome
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uh to the fourth uh teach in on the
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global economic crisis uh thanks to Tom
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Robertson and vice uh Andy Jane for
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sponsoring the event um and also to the
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panel members who were just introduced
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uh it's not hyperb to say that the world
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is a different place today than when we
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started the semester only about seven
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weeks ago uh the US Treasury and the
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Federal Reserve have bailed out and in
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some instances taken ownership positions
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in the largest uh mortgage insurance and
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banking institutions in the country
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there are large investment banks that uh
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either cease to exist or no longer exist
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in the same form they've become Bank
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holding companies with substantially
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different leverage
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limitations uh asset Market volatility
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has led us to be relieved on days when
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movement is only about 3 or 4% rather
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than 8 or 11 uh even those not actively
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involved in uh financial markets are
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horrified when they open their 401K
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envelopes or they choose not to open
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them uh hoping that uh stocks in fact
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really will be right for the long run uh
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we Face the Spectre of a serious
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economic downturn uh with a policy
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Arsenal that's already challenged the
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federal funds Target rate for the FED is
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already near a historic low it's at 1
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and a half% it's it's only gotten down
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to to 1% before and we're at record
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budget deficits even before we factor in
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the uh bailout package which is yet to
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be implemented so fiscal policy and
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monetary policy already strained and
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we're facing uh a spectre of a a fairly
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significant downturn uh there have been
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unprecedented coordinated Global
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responses uh to the credit Market issues
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uh central banks uh have taken efforts
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to increase liquidity and lower interest
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rates of course we're in the midst of a
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presidential election and though we uh
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do not intend to make any partisan
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statements there certainly are
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challenges for whoever should Prevail in
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two weeks from now uh so this afternoon
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the four panel members will uh provide
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some insights on a number of things uh
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including um the causes of the current
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crisis measures that are presently being
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taken to alleviate the crisis uh
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remaining challenges to both financial
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markets and the real economy and their
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effects on us and then implications for
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further policy measures including the
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possibility of regulatory issues uh to
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prevent
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recurrences um the each panelist will
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have 10 to 12 minutes to make a
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statement after which they'll be able to
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discuss uh the the statement just made
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uh after the four uh panelists have
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finished with their remarks we'll open
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the floor to questions and there will be
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floor mics run around and so you just
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raise your hand to indicate your
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interest in asking a question obviously
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make your questions succinct don't make
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a speech asking for uh saying is that
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right at the end otherwise you'll force
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me to use my incredible Powers as
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moderator uh but with that I think we
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will go ahead and start with Professor
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Richard
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marsten well thanks a lot Mart uh I'd
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like to begin by saying that Tom
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Robertson was wrong it wasn't Wharton
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that caused the crisis but according to
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the financial times this morning it was
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Harvard Business School it's definitive
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they were having their anniversary
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celebration and Drew fa uh who is the
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president of Harvard and used to be a
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professor of History here she actually
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said um you know you ought to change
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your model it shouldn't be for you to do
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well in the world but to do well for the
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world and I think that's interesting
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that Tom actually uh talked about
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something similar um this financial
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crisis is spread everywhere um what I
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want to do is is just begin to talk
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about it and then we have uh three of my
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colleagues to uh talk about other
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aspects of it and I thought I would
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begin by talking about Where it All
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Began you know it sort of helps to uh
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identify the beginning of the crisis um
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this time it was in the mortgage market
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so what I want to do is I want to show
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you four charts about housing and um I
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think they'll be a little surprising the
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first one is um about when the housing
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crisis
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began began in November 200
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five is that amazing because that's
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confusing to me because during 2006 and
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into
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2007 maril Lynch and City group and Bank
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of America etc etc etc were adding to
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their mortgage back Securities were they
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unaware that housing had already peaked
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and it was on a downhill slide where it
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was it's now 62% below where it was
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before bit of a puzzle you know bit of a
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puzzle um are they so insulated in New
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York you know they don't have very good
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Communications there there's so many
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Towers it's difficult to get cell phones
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so so possibly they didn't know about
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the housing crisis in America but but
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somehow um as a result they took a lot
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of positions even in 2006 into 2007
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second chart what has happened to house
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prices since that time well you can see
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the these are these are wonderful
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indices from uh case and Schiller uh Bob
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Schiller used to be a professor here um
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what it does it shows you that uh the
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pain is distributed unevenly across the
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country if you're from New York you're
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from Boston you're from Chicago there's
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been relatively little decline in prices
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only 10 or 11% uh but in some regions of
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the country it's been awful absolutely
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awful and that's where an awful lot of
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the pain in the Securities Market is
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originating California
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Florida as well as of course Phoenix and
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Las Vegas the sad case is Detroit
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because they never saw a rise in the
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house price in the beginning to begin
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with and yet they're down so far um so
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that's the second chart my third and
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fourth chart address the issue of how
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soon is the housing market going to turn
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around well actually I'm a
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pessimist but I must admit I only have
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one data
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point when you run regressions you
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probably try to have a whole bunch of
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data points but I only have one I can
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only look at the last housing crisis the
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last time we had a boom in housing and
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ask how soon did the housing price reach
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bottom and I'm going to look at
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California on the one hand we reached
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the peak in 1989 when did it turn around
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sometime around 95 96
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997 all right now of course there's
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special things going on in California
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there's always special things going on
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in California so we have to say uh let's
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move to the other side of the country
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with my final graph and it shows you
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basically whoops it shows you New York
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and you can see very similar story
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reached the peak in 1988 didn't reach
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bottom until about 6 s years later there
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are those who say well housing has to
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turn around before the economy turns
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around let me say I hope that's not true
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I hope the economy turns around long
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before housing because I think it's
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going to be a while before housing turns
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around I I told you I only had one data
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point but I think it's a relevant data
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point we'll we'll wait and see whether
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or not housing prices will reach bottom
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sooner rather than later I think it's
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going to be later so then we began with
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a financial crisis
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because of the mortgage back Securities
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originating in housing they started to
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go bad and that generated the financial
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crisis I'm of the belief that that
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Financial Risk spreads were down so low
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that we probably would have gotten a
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financial crisis of some sort from some
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other source if it had not been in
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housing but it happened to be in housing
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so we began the crisis and you know the
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details of the crisis what I want to
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focus on is just a couple of things
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number one has the FED done its job well
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let's think about what what is a central
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bank supposed to do in a financial
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crisis I think there are three things
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they're supposed to do number one you're
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supposed to lower interest rates the FED
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did its job lowered interest rates they
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were five and a quarter or somewhere
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before last and now they're 1 and a
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half% in fact if I were on the Federal
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Reserve board I would vote against any
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further declines the problem in America
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is not the level of the FED funds rate
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it's the fact that you can't get a loan
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anyways and if you do get loan is going
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to be at a much higher interest rate
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than the FED funds rate so the fed's
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done its job in terms of interest rates
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second function is to make sure that the
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banks have lot lots of liquidity that's
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for the discount window what the FED
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does and every Central Bank does is it
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accepts Securities in exchange for
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treasury bills and the treasury bills
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are like cash well let me tell you
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they've had to do a lot of that let's
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begin with by showing you the spread of
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liore over treasuries that's the
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interbank offer rate in in London it's
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the it's the barometer of interbank
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lending in the dollar market and let me
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tell you back in August a year ago it
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looked pretty Grim now normally the
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spread of into bank interest rates is
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about half a percent above treasuries
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half a percent but last August a year
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ago it went way high at that point the
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European Central Bank and the US Central
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Bank stepped in provided a lot of
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liquidity they had to do it again at the
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year end they had to do it again when be
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turns failed in March they had to do it
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again in July when Fanny May and Freddy
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Mack got into trouble and you can see it
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um quite a bit of Crisis now at this
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point um you have to recognize the fed's
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doing its job in fact it's been it's had
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to be pretty Innovative what it's had to
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do is actually accept a lot of
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Securities that it normally doesn't
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accept because they're too risky in
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order to provide liquidity to the banks
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so it's done its job but the third role
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is the mo most controversial
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the central bank is supposed to save the
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largest banks the banks that are
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so-called too big to fail back in the
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1980s that would have meant that the FED
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would have saved City Bank or chase or
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chemical bank or JP Morgan or Bank of
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America and perhaps a few others the FED
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is never specific about how many banks
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it will save but it saves the big Banks
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because they're too big to fail they
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threaten the
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system it's going to do it this time the
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only problem is that the world has
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changed the old model was based on the
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idea that Banks would accept deposits
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and make loans so if you save the big
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Banks you wouldn't necessarily have to
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save the investment Banks you had to
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save the big Banks it would stabilize
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the system and we'd live happily ever
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after the problem is that in the
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meantime securitization has occurred and
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what has happened is the banks no longer
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hold on to their mortgages no longer
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hold on to their loans to a large extent
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what they do is they package them
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together in bonds sell them off you know
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that already so things have changed that
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means that the risk that the bank is
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holding is the same risk that is being
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held by pension plans by insurance
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companies by investment Banks and so on
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so the the concept of too big to fail
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has changed and now we realize that the
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treasury and the FED now Define
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AIG and insurance company is being too
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big to fail that's what we found out
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four weeks ago you know by the way
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the treasury and the FED decided that
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Leman Brothers wasn't too big to fail
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and I guess that's the one big mistake
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they've made I must admit at the time I
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thought it was the right decision but
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they should have saved lhan brothers
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because later that week let me say it
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delicately later that week the week of
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September 15th remember that date
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September 15th the week of September
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15th all hell broke loose this is the
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liore rate and what happened to the lior
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rate that week in fact Wednesday
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afternoon Thursday morning of that week
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the 17th and 18th of September I think
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were the scariest two days in financial
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markets in my career they were
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absolutely scary and then sometime in
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the afternoon Thursday
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afternoon word got out was leaked out
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that maybe the treasury was going to
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have a bailout package the market
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started to CL calm down and you know
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things were looking good by the end of
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the week but then of course over the
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next couple weeks we had to watch
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Congress I mean Congress it's watching
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Congress is like going through a salami
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Factory I'm told that somebody who goes
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through a salami Factory becomes a
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vegetarian for the rest of their lives
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let me tell you it was ugly and in the
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meantime a lot of other things H
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happened let me tell you uh let's see
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Washington Mutual had to be taken over
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uh wacovia had to be taken over the
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market fell 20%
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boy oh boy and so the treasury had to go
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what I term to plan B Plan B when do you
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go to plan B when you realize plan a is
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not going to work and what did plan B
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involve well what it involved was the
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following problem the banks had kept
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borrowing and borrowing and getting one
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Capital injection after
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another and it wasn't
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enough in the second column you can see
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an estimate by Morgan Stanley a week ago
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on how much each of the banks had
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lost and on the far column you can see
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the capital injections if you add up the
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numbers at the bottom what you find is
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there's a bit of a gap in other words
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under the best of circumstances the
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banks were deficient they needed some
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Capital injections and so once again the
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treasury in the FED came to the rescue
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and let me summarize what they did what
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this chart does is it shows you the nine
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largest banks with Maryland still
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separate from Bank of America the
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capital injection by the treasury in the
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form of preferred shares and we'll talk
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more about that later on and then
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finally in the last column the actual
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Equity value of the of that particular
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firm right at the time of the injection
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what you can see boy this is a big
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Equity injection let me tell you
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it's a big Equity injection and uh the
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natural question to ask would be uh will
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plan B work that's a natural question
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isn't it let me distinguish between
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meanings of the word work will the plan
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work in the sense that uh the banks will
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be sufficiently capitalized well let me
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tell you the treasury is on the plan now
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if they're not sufficiently capitalized
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we'll come up with more money that's
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clear so in that sense the plan will
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work these banks will not go under
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there'll be other banks that the
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treasury I hope and the FED I hope will
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allow to fail because not all the banks
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should stay in business and I think dick
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Herring will talk about more about that
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later on but uh let me tell you these
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nine banks are not going to fail the
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treasury is determined to keep them open
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so it will work in that sense but the
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larger question is will it help the
00:15:23
economy and that's the question of
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whether or not these banks will start
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lending again and that's the the answer
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to that question we don't know the
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answer we don't know what's going to
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happen what I suspect is the answer is
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at least initially no they will not
00:15:37
start lending again and for that reason
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I think we're going to have a fairly
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serious
00:15:44
recession how bad a recession it's going
00:15:47
to be a worse recession than the last
00:15:48
time it's going to be a recession with a
00:15:50
lot of loss of jobs let me show you the
00:15:52
latest consensus forecast private
00:15:55
consensus as well as the IMF forecast
00:15:57
for next year for the the United States
00:16:00
the European monetary Union U UK as well
00:16:04
as Japan the industrial world is going
00:16:07
into recession I personally believe my
00:16:09
colleagues may not agree with me that
00:16:11
the US economy went into recession in
00:16:13
September because the NBR looks at
00:16:16
monthly data and the monthly data for
00:16:17
September were pretty ugly but we won't
00:16:19
know for sure until they meet another 12
00:16:21
months from now in any case it looks
00:16:24
Grim short term it's going to be Grim
00:16:26
for those of you on the job market um I
00:16:28
I think we're going to have to worry
00:16:29
about just how deep the recession is
00:16:31
going to be and I'm waiting to hear from
00:16:33
Jeremy what he thinks about that um it's
00:16:36
interesting that we've done what we can
00:16:38
but the problem is the banks are
00:16:41
impaired regardless of how much Capital
00:16:43
injection they get they're impaired and
00:16:45
as a result they will not be lending as
00:16:47
much as they did before and I think we
00:16:50
have to face that what will the job
00:16:52
situation be like well I can't tell you
00:16:55
except to say that so far the loss of
00:16:58
jobs has been minor compared with last
00:17:00
time expect worse times ahead uh this is
00:17:04
the last recession you can see in the
00:17:07
rectangle is the actual timing of the
00:17:09
recession and notice that even after the
00:17:11
recession ended in November 2001 we lost
00:17:15
a lot of jobs after that some months we
00:17:17
lost 200,000 jobs so don't expect this
00:17:20
job picture to turn around make your
00:17:23
plans make your placement plans
00:17:25
accordingly uh to try to try to work
00:17:27
around this uh terrible job markets that
00:17:30
we're going to be facing um maybe it
00:17:32
won't be any worse than last time but
00:17:34
last time I remember uh Wharton students
00:17:37
had a lot of trouble with the job market
00:17:39
I want to end leave plenty of time for
00:17:41
my colleagues but I want to end with a
00:17:45
um with a political chart political
00:17:48
chart where does that fit in here well I
00:17:51
want to begin by quoting the chief um
00:17:54
strategist of the Bill Clinton campaign
00:17:57
in 1992
00:17:59
you know his name James Carville he's
00:18:01
now famous um he actually believed that
00:18:04
the economy was the key to the election
00:18:06
we were officially out of recession at
00:18:08
the time but uh it looked like we were
00:18:11
still in recession and most Americans
00:18:12
thought we were still in recession and
00:18:14
so he forced the entire campaign to
00:18:18
focus on the economy with a phrase It's
00:18:20
the economy
00:18:22
stupid and he hung the sign in the
00:18:25
campaign headquarters and in fact I
00:18:27
think that was the key to Bill Clinton
00:18:29
winning the election what about this
00:18:31
time well what I'd like to do is share
00:18:33
with you the timing of the rebound of
00:18:39
Obama in the campaign the way I'm going
00:18:43
to do it is by using Futures contracts
00:18:46
intrade.com intrade.com has Futures
00:18:50
contracts on Obama winning the
00:18:52
presidency the prices I'm going to show
00:18:54
you are cents on a dollar so if it's 50
00:18:57
cents on a dollar
00:18:59
it's a 5050 race okay at the beginning
00:19:03
of the week when Leman Brothers was
00:19:06
about to fail AIG was going to be taken
00:19:09
over and as I said indelicately all hell
00:19:13
broke loose in the financial
00:19:15
markets this was the price of
00:19:19
Obama it's a coincidence of
00:19:22
course it's a coincidence that on
00:19:25
September 15th we we reached the bottom
00:19:27
of the Obama
00:19:29
presidency according to the Futures
00:19:31
market and ever since that time it's
00:19:33
been up and up and up let me give you my
00:19:36
interpretation of my panelists can
00:19:38
disagree with me I actually think what
00:19:40
happened is the economy turned very sour
00:19:44
the average American became very worried
00:19:47
about the economy and it's natural to
00:19:49
blame the current Administration for the
00:19:52
economy that's always the case that was
00:19:54
the case with Jimmy Carter's
00:19:56
Administration it was the case with H
00:19:58
W's Administration and I think it's the
00:20:01
case with the Republicans this year so
00:20:03
I'll end on this note isn't that a
00:20:05
dramatic graph there's probably some
00:20:07
other explanations of course there's
00:20:09
more than one thing affecting the
00:20:11
election but you probably think it's
00:20:13
because of all the other things in the
00:20:14
election think at least of the
00:20:17
possibility that the financial crisis is
00:20:20
what is going to lead Obama to become
00:20:23
the next president thank you you know I
00:20:27
agree totally with
00:20:29
uh dick on on the um Leman bankruptcy on
00:20:33
the 15th um and uh I think that's when
00:20:37
we held the first panel was right on
00:20:41
that day or uh or the day before that
00:20:45
day day after that day the day after
00:20:48
that day that was and and and it turned
00:20:51
out that that is a it turned a a a
00:20:55
hugely a pivotal day um uh I didn't
00:20:59
imagine how much uh uh debt Leman debt
00:21:03
was out there uh I mean I was shocked
00:21:06
when you know the bankruptcy courts
00:21:08
finally you know looked at it and you
00:21:09
said something like you know $800
00:21:11
billion doll worth of debts now some of
00:21:13
those were covered definitely with
00:21:14
assets but it just it just completely um
00:21:19
dwarfed anything else uh a very
00:21:22
important rate um uh and and and and and
00:21:26
uh Professor Maron mentioned was the
00:21:27
liore rate rate um it's I'm not going to
00:21:31
go it's rather interesting that the rate
00:21:32
is actually determined in in London by
00:21:35
the British Bankers
00:21:36
Association uh by surveying 16 Banks and
00:21:40
their cost of funds over various time
00:21:42
periods in various currencies although
00:21:44
the dollar has usually been the key one
00:21:47
only three of the 16 banks are American
00:21:50
Banks which has some significance also
00:21:53
uh JP Morgan City group and and Bank of
00:21:55
America uh lior rate are huge in terms
00:22:01
of basing loan rates to uh not as much
00:22:06
as individuals individuals have Prime
00:22:08
rates which are it's it's it's it's
00:22:10
quite interesting uh the difference is
00:22:13
more marked now uh but in terms of
00:22:16
commercial firms industrial firm big
00:22:17
businesses borrowing uh at uh some
00:22:21
spread over usually three-month Liber
00:22:24
sometimes one month uh lior rates uh you
00:22:27
have trillions ions of dollars of loans
00:22:29
that are actually based on on liore and
00:22:34
um oops let me get over and this is the
00:22:37
um this is the graph over here I don't
00:22:41
know if this also has a um does it have
00:22:44
a uh there we go it does have a laser
00:22:46
pointer uh this is going back a couple
00:22:49
of years normally Li this is the graph
00:22:53
of liore
00:22:55
against the FED funds Target I I think
00:22:58
it's more important uh Richard talked
00:23:00
about it against treasury bills but the
00:23:02
FED funds Target is directly
00:23:04
controllable and actually treasury bills
00:23:06
have sort of disconnected also and
00:23:09
normally it's it runs 1015 basis points
00:23:12
this is precrisis this was the crisis
00:23:15
last year in August again in October
00:23:19
it's it it went outward but then there
00:23:21
was a period of three months where it
00:23:23
stayed at a very stable 50 basis points
00:23:27
above uh the FED funds Target the FED
00:23:30
funds Target was
00:23:32
2% uh and the liore rate was two and a
00:23:35
half now that is that's a large spread
00:23:37
but it it's a doable spread and it was a
00:23:40
very stable spread this is September
00:23:44
15th and you can just absolutely see
00:23:47
what happened the spread widen to
00:23:50
337 basis points I I bet if you ask any
00:23:53
money manager 6 months earlier could
00:23:55
that ever happen they say that is
00:23:57
impossible that could never happen that
00:24:01
you get that increase now the
00:24:03
significance of that increase is is is
00:24:06
absolutely huge um
00:24:09
because people's loans are based on
00:24:11
liore and the spread is going up when
00:24:15
the FED lowered by 50 basis points as
00:24:19
they did about two weeks ago in a
00:24:21
concerted action of central banks it was
00:24:24
completely drowned out by the effect of
00:24:26
the widening of the spread so in essence
00:24:30
instead of it it did not have any effect
00:24:33
of lowering the cost of capital to
00:24:35
anybody based on
00:24:37
liore uh it did have an effect if you're
00:24:41
based on the prime rate because the
00:24:43
prime rate is strictly TI is strictly
00:24:45
tied to the FED funds Target at 3
00:24:48
percentage points above the FED funds
00:24:49
Target uh so that moved in the right
00:24:52
direction but the liore did not move in
00:24:56
um uh the direction and this
00:25:00
actually causes a situation that we used
00:25:04
to only teach in history books something
00:25:05
called the liquidity
00:25:07
trap because the liquidity trap which
00:25:11
goes back to can's is even if the
00:25:14
Central Bank lowers to zero it is not
00:25:17
low enough to induce uh uh either
00:25:21
lending or borrowing uh the cost of
00:25:24
capital is not going down to the firms
00:25:27
and the Central Bank can't cannot go
00:25:28
anywhere below zero and that that is
00:25:33
that was really kind of scary in the
00:25:35
sense that my goodness the FED is moving
00:25:37
and the borrowing rates are moving in uh
00:25:42
the opposite direction many times we
00:25:44
really had ever seen this before was in
00:25:47
the Great Depression in the US situation
00:25:50
and around the world actually kan's
00:25:52
wrote about it in the UK and in Japan
00:25:54
after their bubble burst in 1990 and
00:25:57
they also went down to zero rates and
00:26:00
also could not get uh the banks uh
00:26:04
lending um now I want to talk a little
00:26:07
bit about uh the the plan of
00:26:11
action uh the the equity injections that
00:26:16
are were done under the pson plan and
00:26:19
have been done in
00:26:21
Europe um there's an old expression you
00:26:23
can lead a horse to water but you can't
00:26:25
force them to
00:26:26
drink um you can give Banks Capital but
00:26:29
you cannot force them to
00:26:32
lend uh the there's a lot of people who
00:26:36
think the only problem with lending was
00:26:37
that they were short of capital well
00:26:39
that was one problem but not the only
00:26:41
problem the other problem was that they
00:26:44
feared for the solvency of who they are
00:26:47
lending to uh you know you could you
00:26:50
could give me Capital you can give me
00:26:51
borrowing rates at zero but if I think
00:26:53
there's a 10% probability the person I'm
00:26:55
lending to is going to go bankrupt I'm
00:26:57
not going to lend to them
00:26:59
uh and I don't care how much Capital you
00:27:01
give to me I'm not going to lend to them
00:27:03
I think too little attention has been
00:27:05
paid to that question uh I I did
00:27:09
remember Paulson went out and said uh uh
00:27:14
we we want the banks to lend you know
00:27:16
like you know that's that that
00:27:19
exhortation is going to let them make
00:27:21
them lend uh that's not necessarily
00:27:23
going to going to be the case um let let
00:27:27
me say something else
00:27:28
and then I'm going to go through a
00:27:29
couple other
00:27:31
things when the central banks lowered by
00:27:34
50 basis points and that did not
00:27:36
help I think that really scared the
00:27:39
equity market like it hadn't been scared
00:27:41
in in decades the central bank is
00:27:44
finally out of options lost power you
00:27:46
can go down to zero and that's not going
00:27:48
to help and that is uh kind of a panic
00:27:52
situation because you always felt the
00:27:54
FED could come to your rescue and what
00:27:57
was happening with live B rising at the
00:27:59
same time fed funds Target was falling
00:28:01
was exactly the opposite again an
00:28:03
absolutely unprecedented situation um I
00:28:07
was actually proposing some other things
00:28:10
that could be done and may still have to
00:28:12
be done if the situation gets worse
00:28:14
again um how about rebasing liary to the
00:28:17
FED funds rate like the prime rate is uh
00:28:21
the bank maybe the Federal Reserve could
00:28:23
go in and said hey we're if you if the
00:28:25
banks rebase to Fed funds Target instead
00:28:27
of Li will will guarantee the lines of
00:28:29
credit or some such inducement to get
00:28:33
them to do so and then you can guarantee
00:28:35
the cost of capital is going down maybe
00:28:38
back up interbank borrowing now there
00:28:40
has been some of that among the European
00:28:42
Banks not really here in the US uh one
00:28:46
of the problems is Banks fear other
00:28:48
banks are going to go under and that's
00:28:49
one reason the liore which is the
00:28:51
interbank borrowing rate has gone up so
00:28:53
much the FED could guarantee in bank
00:28:56
borrowings to some extent and lower uh
00:28:59
lower those costs guarantee private
00:29:02
lending the bank Federal Reserve has
00:29:05
already set up a commercial paper
00:29:07
facility uh the first time in its
00:29:09
history that is going to uh guarantee uh
00:29:13
these the smooth turnover per of
00:29:15
commercial paper to non-financial
00:29:18
firms never done it to non-financial
00:29:21
firms at all remember the broker dealers
00:29:23
and the investment Banks were all
00:29:25
classified as Financial firms uh
00:29:28
um um maybe the government will have to
00:29:32
guarantee certain commercial paper and
00:29:34
lines of credit these are Extreme
00:29:37
Measures I'm saying there's measures
00:29:38
that can in fact uh be taken uh later on
00:29:43
and then of course there always the
00:29:44
question if stock market doesn't stop
00:29:45
falling you can always buy stock index
00:29:47
Futures actually there is precedent
00:29:49
there are countries who have done that
00:29:51
uh as a way to support uh the stock
00:29:54
market now obviously if you're going to
00:29:56
do uh any of the guarantee on lending
00:30:00
backing it up you've got to take an
00:30:02
equity position and and in fact the FED
00:30:04
has taken Equity positions in in these
00:30:07
uh uh uh uh infusions uh warrants on the
00:30:11
purchase of uh the common price uh
00:30:14
common shares but my main point is that
00:30:16
there are there are other measures these
00:30:17
are emergency me measures uh I I I felt
00:30:22
that people were slip were falling into
00:30:25
the the chasm of the FED is out of
00:30:28
options and there are other options
00:30:31
emergency options the FED in fact can
00:30:34
take care of um I'm going to talk about
00:30:38
the markets a little
00:30:40
bit uh stock market and its valuation as
00:30:44
a result of the plunge around the world
00:30:47
uh this is a a Bloomberg screen I just
00:30:49
took it this morning it is the PE
00:30:53
ratios of the major markets around the
00:30:56
world and the final three columns the uh
00:31:00
third column from the right is the price
00:31:02
earnings ratio on the basis of the last
00:31:03
12 months of reported earnings current
00:31:06
year estimate is on the basis of 2008
00:31:08
estimated earnings next year is
00:31:12
2009 um the average historical PE ratio
00:31:15
of the US market is around 15 just to
00:31:18
give you a little bit of a
00:31:20
benchmark on what the
00:31:22
valuations uh are today they they are
00:31:26
extraordinarily low now I know your
00:31:28
earnings are going down and I'm going to
00:31:30
address that in in just a moment but as
00:31:33
you can see on the basis of the Dow the
00:31:35
SNP uh 12 uh 1012 this year and next
00:31:40
year NASDAQ is a little bit higher uh
00:31:43
the Toronto is uh 10 and8 Mexican Bola
00:31:47
is 10 and N take a look at Europe that
00:31:50
that's the middle grouping there I've
00:31:52
never seen Europe so low the Europe
00:31:54
stock 50 is uh is seven across the board
00:31:58
even on when you do it on the basis of
00:32:00
the last 12 months of earnings and going
00:32:03
forward on
00:32:04
earnings um and you can see markets is
00:32:08
as far down as four and five PE ratios
00:32:11
we the last time we got down to single
00:32:13
digit PE ratios in the market was the
00:32:17
1970s that was the last time that we had
00:32:19
actually gotten down this low in the
00:32:23
market and we had a very bad situation
00:32:26
there because there we had a lot of
00:32:28
inflation and we had instead of low
00:32:30
interest rates we had extraordinarily
00:32:32
High interest rates where someone could
00:32:34
buy a treasury bill and bond and
00:32:36
guarantee themselves 15% interest take a
00:32:38
look at the third group in Asia um I
00:32:42
don't know I'm going to have to ask uh
00:32:44
uh dick marsten about this I don't I've
00:32:47
never seen the Nick selling an 11 and 12
00:32:49
times
00:32:50
earnings um it's usually at 25 even
00:32:53
after the bubble burst usually at 25 and
00:32:55
30 hangen is nine uh 10 the Shanghai
00:33:00
index that Shanghai index a year ago was
00:33:03
selling at 55 times
00:33:06
earnings it's at 15 today uh the S&P
00:33:11
that's the Australian index 8 9 10 11
00:33:13
times earnings The Straits times is the
00:33:16
Singapore
00:33:18
index it's around the world now what
00:33:21
about the objection yeah but we're in a
00:33:25
recession earnings are going down as
00:33:26
fast as stock price some people even say
00:33:29
faster I think we have to look a little
00:33:31
bit at how you would value stocks um
00:33:36
this is the quarterly earnings of the
00:33:37
S&P over the last approximately 15 years
00:33:42
and uh with this is the recession of
00:33:43
1991 this is a recession of 2001 now
00:33:47
we're in the the downshift right over
00:33:49
here um uh this is the regression trend
00:33:55
line people who talk about earnings
00:33:57
going down down have to remember stock
00:34:01
prices are not just based on the next 12
00:34:04
months of earnings in fact when you say
00:34:07
that a stock has a 15 PE ratio you're
00:34:10
saying it's worth 15 times the ongoing
00:34:14
earnings only 115th or
00:34:17
6% of a Stock's price on average is the
00:34:20
earnings of the next 12 months 94% is
00:34:24
after that you have to look to the long
00:34:26
run unless you think we're going to be
00:34:27
be in a permanent recession for the next
00:34:30
you know 10 or 15 years which hasn't
00:34:32
been the case um I have 3 minutes left I
00:34:35
will I will get done uh at that time um
00:34:38
let me just mention the red line over
00:34:40
there uh is now at a trend line of $23
00:34:44
this is quarterly earnings on the S&P
00:34:47
500 so I'm kind of giving you the
00:34:49
trend uh this morning the P the S&P was
00:34:54
at
00:34:55
$981 $92 share is a PE ratio of
00:35:00
10.7 now based on normalized earnings as
00:35:04
I say um you don't often get down that
00:35:08
low that's an earnings yield of between
00:35:10
9 and 10% uh going forward um I think
00:35:17
extremely attractive here now let me
00:35:19
give you a 40-year graph of the stock
00:35:22
market um this is the S&P
00:35:25
500 over the last 40 years going all the
00:35:28
way back to 1970 it's a regression line
00:35:31
with one and two standard
00:35:33
deviations uh off the regression line um
00:35:37
if you as I do I do believe in mean
00:35:39
reversion in long-term stock returns so
00:35:42
that there you know you deviate in the
00:35:44
short run but you eventually return to
00:35:46
the to the mean uh we see getting down
00:35:50
to the the green line in
00:35:52
1970s uh 1982 which was at uh was
00:35:57
actually at the bottom of the greatest
00:35:58
bull market in US history uh over the
00:36:01
next 20 years you also see by the way
00:36:03
that in 2000 right over here in the
00:36:05
bubble we were uh above the two-standard
00:36:09
deviation uh and at risk uh let me
00:36:13
mention that at the bottom where we were
00:36:17
two weeks ago you see the fallof right
00:36:19
there we were three and a half standard
00:36:22
deviations below never had been that low
00:36:24
in the last five decades below
00:36:28
uh the
00:36:30
mean um you know that doesn't guarantee
00:36:32
that you're going to get back there that
00:36:34
fast but certainly it is saying that uh
00:36:40
unless unless our economy is permanently
00:36:43
going to fall apart which I don't
00:36:45
believe is going to be the case um and
00:36:48
we can talk about later about whether we
00:36:51
you know how longterm and serious this
00:36:53
is compared to the 30s or even the
00:36:55
Japanese situation um uh the uh the case
00:37:01
for equities is pretty is pretty uh
00:37:04
persuasive and let me say one last
00:37:06
sentence um I think we all recognize
00:37:10
Warren Buffett as a great
00:37:13
investor and um there's not very many
00:37:18
times that an ordinary investor can buy
00:37:21
a stock that he buys at a price cheaper
00:37:24
than he
00:37:25
bought but about three weeks ago he
00:37:28
bought into General Electric um he
00:37:30
bought into Goldman Sachs uh and took
00:37:34
warrants and options on that at strike
00:37:37
prices that are below that are above the
00:37:41
current price of those two stocks um and
00:37:46
which means the ordinary investor can
00:37:47
now actually get into the market even as
00:37:50
as it's risen and it's you know it's up
00:37:51
about 10% or 15% almost from it's its
00:37:55
low uh at a price that uh Warren Buffett
00:37:59
uh uh got in at a higher price so uh he
00:38:03
has a long-term look and he thinks there
00:38:05
as low as they were in the 1970s I say
00:38:07
they're as low as they were in the 70s
00:38:09
if not even lower uh and are attractive
00:38:14
um for uh investors thank you we uh know
00:38:19
we're in a little bit of trouble when
00:38:21
Jeremy quotes canes favorably and so but
00:38:25
I I agree with him that stocks are
00:38:27
probably at this point not a bad
00:38:30
investment for for the long run um I'm
00:38:32
going to shift focus a little bit um
00:38:35
more towards thinking about uh
00:38:36
government regulation and how people
00:38:39
behave in this current market and I
00:38:42
don't have any overheads for my little
00:38:44
diet tribe here and so but let me kind
00:38:46
of uh start off by with some modesty and
00:38:49
that is we're in many ways all shooting
00:38:51
from the hip here and so there's lots of
00:38:54
information that's kind of unfolding
00:38:55
over time and certainly I'll
00:38:58
likely we can't 30% of what I say within
00:39:01
6 months from now as more information
00:39:02
gets released even by next weekend but
00:39:04
at this point like I'm the academic I'll
00:39:07
speak with great force and uh pretend
00:39:09
like I'm have great Authority and know
00:39:11
what I'm talking about here um in terms
00:39:13
of uh let me go through basically I
00:39:15
think three points here that I'm I'm
00:39:17
trying to cover first is I think people
00:39:20
do in fact contrary to what lot of
00:39:24
Comas will say act stupid
00:39:28
even when their own money is on the line
00:39:30
so that's kind of my first point and so
00:39:33
in many ways I'm uh traditional uh
00:39:37
rational expectations Economist but I
00:39:39
think people do in fact make fundamental
00:39:41
errors and I will go through some of
00:39:43
that but whereas Joe stiglet and others
00:39:46
would Trace these problems to principal
00:39:48
agent problems within the firm I'm going
00:39:50
to argue and therefore he would argue
00:39:51
for more government regulation we need
00:39:53
government regulation to protect people
00:39:55
from their themselves and their mistakes
00:39:57
I'm going to argue just the opposite I
00:39:59
think government regulation in fact is
00:40:02
encouraging people to act very stupid
00:40:04
and government regulation itself instead
00:40:07
of we thinking that we need more
00:40:09
government regulation we ought to really
00:40:10
be rethinking a lot of the government
00:40:12
regulation that we currently have and
00:40:14
that's kind of uh wrapping up with my my
00:40:16
third Point whereas where a lot of
00:40:18
people are calling for more government
00:40:19
regulations I I'm going to argue that
00:40:22
bad regulations are actually much worse
00:40:24
than no regulations when people
00:40:26
understand their own assets are on the
00:40:28
line so let me the first point about
00:40:31
people acting very stupid I I think uh
00:40:34
the usual belief in the economics of
00:40:36
course is people are rational I
00:40:37
basically agree with that um because if
00:40:39
people are are really dumb then smart
00:40:41
people can come along and Arbitrage away
00:40:43
their money and figure out how to take
00:40:45
their money from them and that's not
00:40:47
going to be some like people who last
00:40:49
and sustain for a very long time the
00:40:52
last big mistake that the market
00:40:54
supposedly made was in the year 2000 and
00:40:57
after the do bust and it was actually
00:41:00
not clear that people investors in year
00:41:03
1999 with high PE ratios were actually
00:41:06
in fact making a mistake um that they
00:41:08
were actually being irrational at that
00:41:10
point in particular one can always tell
00:41:13
stories about how Bubbles are really not
00:41:15
bubbles some people even defend that the
00:41:17
Dutch tulet bubbles were not really
00:41:18
bubbles that there were reasons behind
00:41:20
it that made total sense I'm not going
00:41:22
to go that far but if you believe that
00:41:24
the 2000.com bus was was so easily
00:41:27
predictable most of those lots of those
00:41:30
assets were publicly traded you should
00:41:31
be shorting those assets and made a lot
00:41:33
of money so I think lots of claims that
00:41:35
people make after the fact that the 2000
00:41:38
problem was largely foreseeable is just
00:41:40
kind of ego and um a lot of hindsight uh
00:41:44
but in the current market I think lots
00:41:46
of the default rates uh on the in the
00:41:49
current situation were in fact very
00:41:52
foreseeable it it was well known at the
00:41:54
time lots of the loans were going to
00:41:56
reset and and in particular given the
00:41:58
underwriting standards that evolve over
00:42:01
time with no doc loans with negative arm
00:42:03
loans where people aren't even making
00:42:05
the full interest payments that a lot of
00:42:07
people were going to be in really bad
00:42:09
shape and in fact I was first made made
00:42:11
aware of this problem a couple years ago
00:42:14
spending lots of time in the San
00:42:15
Francisco Bay Area a lot of my friends
00:42:17
were telling me about these great deals
00:42:19
that they're getting in their mortgages
00:42:21
and um with the three and fiveyear
00:42:23
resets with the loan where the interest
00:42:25
rates suddenly go up and that would be
00:42:26
kind of them little warnings and saying
00:42:29
it's kind of crazy you can't really
00:42:30
afford that what's going to happen 3 to
00:42:32
5 years and they'll say oh no no there's
00:42:34
no problem at all even if I have to sell
00:42:36
in three to five years of course I'm
00:42:37
going to make a big capital gains and
00:42:40
you know I'll be making a lot of money
00:42:42
maybe I'll find a flight place I can
00:42:43
actually afford now that's not a bad
00:42:45
strategy if you're the only one playing
00:42:47
that game but if everybody's playing
00:42:49
that game that's obviously a fallacy of
00:42:50
composition prices are going to go down
00:42:53
but the difference between now and then
00:42:55
is that it's a little harder in the sub
00:42:57
crime case for smart people to clear the
00:42:59
market as easily in particular um while
00:43:02
it's true some smart people took bets in
00:43:05
terms of the subprime problem and with
00:43:07
some there's some limited um trading
00:43:09
instruments and and it's also true lots
00:43:12
of the banks could have issued fewer
00:43:14
asset back Securities it's hard to
00:43:16
directly short another person's home
00:43:18
price in particular in other words if I
00:43:21
think your home price is is too high
00:43:24
it's there's not much I can really do
00:43:26
about it to to short that that that
00:43:28
price and uh yeah there's other
00:43:30
instruments I can trade that are
00:43:31
correlated with that risk and I can
00:43:33
maybe U make some money off that but
00:43:35
there's no reason to believe that home
00:43:37
prices overall were going to be were
00:43:38
going to be efficient that there is some
00:43:40
market clearing mechanism and so lots of
00:43:43
the asset back Securities the CMOS and
00:43:45
others were basically pooling these
00:43:48
loans and it was well known that they
00:43:49
were highly leveraged and exposed to
00:43:51
even very small default rates and they
00:43:54
allowed Equity holders to make loans on
00:43:55
barreled money and sell off the loans
00:43:57
make more loans of proceeds and so forth
00:43:59
so Banks and Brokers became Originators
00:44:02
of debt but they are no longer bearing
00:44:04
the risk associated with the
00:44:05
underwriting and this leads to an
00:44:07
obvious moral hazard problem whenever
00:44:09
you divorce the underwriting from the U
00:44:11
from the risk risk-taking at first
00:44:14
glance you would wonder why would
00:44:16
anybody buy these packages of Securities
00:44:19
um given that they should be huge hugely
00:44:22
full of junk given that people are
00:44:24
underwriting aren't bearing the risk
00:44:26
well this is where the r agencies came
00:44:28
in the rating agencies were supposed to
00:44:29
be the control for moral hazard in
00:44:31
particular junk stuff was going to get
00:44:33
priced lower and because it get got a
00:44:35
lower rating better stuff would get a
00:44:37
higher rating therefore priced better
00:44:39
the markets were supposed to be
00:44:40
efficient again the rating so the rating
00:44:43
agencies played a very crucial role in
00:44:45
all this but what they basically did is
00:44:48
that they rated too much based on what's
00:44:50
called a preferences of the underline
00:44:52
Securities that is they would divide
00:44:54
these things up into different tranches
00:44:56
and basically say if if you're first in
00:44:57
line will give these a AAA if you're
00:44:59
second in line will give this a little
00:45:01
bit of lower rating and so forth that
00:45:03
strategy that trick usually works pretty
00:45:05
well when you're talking about stuff
00:45:07
that's uh a lot of risk subject to firm
00:45:10
specific risk but it doesn't work so
00:45:12
well when we're talking about stuff
00:45:13
that's heavily based on system systemic
00:45:16
risk and where it doesn't really matter
00:45:17
if you're first or ninth in in in line
00:45:20
and the the fact of the matter is S&P
00:45:22
and moody moody the two main rating
00:45:24
agencies had pretty lousy models and
00:45:27
certainly there will be a lot of
00:45:29
discussion about how they face conflicts
00:45:31
of interest and how they are paid and so
00:45:33
forth economists would generally argue
00:45:35
they care about their reputation that
00:45:37
that conflict of interests should not um
00:45:40
be be such a problem I I I think there
00:45:43
there are issues there but a central
00:45:45
mistake that investors played in all of
00:45:47
this was that they were trusting the
00:45:49
rating agencies way too much there there
00:45:51
are endowments Pension funds and many
00:45:54
others who basically looked at the
00:45:57
looked at these um asset backed debt
00:46:00
said hey they're the highest rating not
00:46:02
really understanding why they were had
00:46:04
they were paying a 10020 basis points
00:46:06
more than the other AAA ratings and so
00:46:08
they would buy this stuff and the rating
00:46:10
agencies really just play the role of
00:46:12
providing cover and they were more more
00:46:15
than willing to do that for for our
00:46:16
price going forward there's another
00:46:19
crisis emerging it's much bigger than
00:46:22
the subprime one and that's the
00:46:24
entitlement problems that the United
00:46:25
States facing uh in terms of our social
00:46:28
security Medicare and Medicaid programs
00:46:30
um you think the one or two trillion
00:46:32
dollars that the government will spend
00:46:33
on subprime M that's a lot of money we
00:46:36
Face a present VAR shortfall in those
00:46:37
Pro those entitlement programs about $70
00:46:40
trillion a much bigger problem so a
00:46:43
train wreck is coming the subprime mess
00:46:46
is not the train wreck but but there is
00:46:49
it's more like an appetizer to mix my
00:46:51
metaphors for a much bigger train wreck
00:46:54
that's that's on its way and right now
00:46:55
the rating agencies are once again doing
00:46:57
a lousy job by looking at a simply
00:47:00
explicit paper that that that's printed
00:47:03
and not looking at uh the the implicit
00:47:06
debt the second main point I want to get
00:47:09
across is I actually think instead of
00:47:11
talking saying people are myopic we need
00:47:13
more government regulation government
00:47:15
regulation itself is a cause of lots of
00:47:17
myopia in particular I think instead of
00:47:21
thinking about government regulation
00:47:23
meaning is to save people from
00:47:24
themselves we all think about how
00:47:26
government regul
00:47:27
really gives a false sense of confidence
00:47:29
and and
00:47:30
relaxation five examples really quickly
00:47:33
here the first one is
00:47:35
mortgages it was Freddy and Fanny were
00:47:38
always a ticking Time Bomb it it was it
00:47:41
was obvious that this problem was going
00:47:42
to happen why Congress basically used
00:47:45
Freddy and Fanny to basic and as well as
00:47:47
other Community Development programs to
00:47:49
try to increase the amount of home
00:47:50
ownership somehow home ownership do the
00:47:53
neighborhood Network effects was a good
00:47:55
thing we wanted to promote this thing
00:47:56
the the problem is fenny and Franny were
00:47:58
technically private Market vehicles and
00:48:01
they were privatized some time some time
00:48:03
ago they weren't explicit obligations of
00:48:04
the US government but it was well known
00:48:06
that they were moral obligations the
00:48:08
federal government would come in members
00:48:09
of Congress talked about this and that's
00:48:12
a basically the worst possible setup
00:48:14
that you can have a private entity out
00:48:16
there that is has an implicit guarantee
00:48:19
associated with it but you have no way
00:48:21
of controlling Its Behavior there you're
00:48:23
just begging for lots of lots of moral
00:48:26
ha there was nothing that was being
00:48:28
priced into their actions the way to
00:48:30
think about regulation it's like a good
00:48:33
game of tennis a good play of tennis in
00:48:35
tennis you want to play aggressively at
00:48:37
the net or you want to be pretty relaxed
00:48:40
and play at the Baseline you never want
00:48:41
to play in between and regulations
00:48:44
really have to be that way either you're
00:48:45
going to be aggressive you're going to
00:48:46
do it right or you're going to play at
00:48:48
the Baseline and be pretty minimalistic
00:48:50
about it but you don't play in between
00:48:52
and this is a clear example where the
00:48:53
government's playing in between and
00:48:55
everything got screwed up
00:48:57
California saw it this the same way I I
00:49:00
was teaching at Stanford at the time
00:49:02
California decided to deregulate
00:49:04
electricity but they didn't really want
00:49:06
to deregulate all the way so they kind
00:49:07
of went halfway in the middle and so
00:49:10
because they wanted lower prices but
00:49:11
they still wanted government control
00:49:12
what did we have we had rolling the gym
00:49:14
multiple times the lights would go out I
00:49:16
mean rolling blackouts and so forth
00:49:18
because the government regulation wasn't
00:49:20
at the net wasn't at the Baseline
00:49:23
another example of poor tennis play was
00:49:26
basically how the FDIC Works following
00:49:29
um the deregulation of the glass deagle
00:49:31
act in
00:49:32
1999 in particular the FDC of course you
00:49:35
know guarantees Banks deposits and it it
00:49:37
requires therefore Bank Reserves and
00:49:39
it's which is a function of the loans
00:49:41
that are outstanding in made but after
00:49:43
the
00:49:44
deregulation Banks were able to take off
00:49:47
some of those loans off its balance
00:49:48
sheets with securitization they were
00:49:50
able to reduce the amount of um assets
00:49:53
that they needed to hold in their
00:49:54
balance sheets but using complicated
00:49:56
transactions they were still
00:49:58
fundamentally exposed to a lot of the
00:50:00
risk and so the the bottom line there is
00:50:02
again the government has this guarantee
00:50:04
it's not properly regulating it's kind
00:50:06
of plain again in the middle I also
00:50:09
think the government screws up in how it
00:50:11
validates rating agencies in particular
00:50:13
federal government rules around
00:50:15
commercial paper money market accounts
00:50:16
and so forth give a legal authority to
00:50:19
select National rating agencies S&P
00:50:21
Moody and and I think they just get too
00:50:24
much government backing too much valid
00:50:27
um the fact of the matter is rating
00:50:29
agencies stink Moody stinks S&P stinks
00:50:32
they basically are good at predicting
00:50:34
Sol insolvency risk about 24 hours
00:50:38
before it happens they they basically
00:50:40
are terrible in predicting insolvency
00:50:43
risk at the time Dimension that's
00:50:44
actually useful for writing contracts
00:50:46
there and why would you give such
00:50:49
validation to such incompetent
00:50:52
institutions and so I think we should
00:50:55
really have more capital m in this area
00:50:57
more information more and being
00:51:00
exchanged and certainly allow more
00:51:02
contracts being uh designed on more
00:51:04
sources of of information and speaking
00:51:07
of information I I told you I was going
00:51:09
to be in my Soap Box sarbanes oxay
00:51:12
sarbanes Oxley I think is a is a bill I
00:51:15
was part of the administration when we
00:51:17
wrote that bill it gives a a tremendous
00:51:19
Source uh uh a sense of a false sense of
00:51:22
accountability and a sense of uh
00:51:25
accomplishment it has whole provisions
00:51:28
on risk management but the the
00:51:30
provisions of sarban oxy for risk
00:51:32
management are extraordinarily weak and
00:51:35
they really provide nothing other than a
00:51:37
a a false sense of confidence I agree in
00:51:40
my last example here I agree that
00:51:42
September 15th was a was a big day but I
00:51:46
also want to say that just don't look at
00:51:48
the reduction in stock market prices and
00:51:50
say there's a role for government here I
00:51:52
want to turn it around and say
00:51:53
government plays a role in causing some
00:51:56
of those things too treasury in the FED
00:51:59
itself I think produced a sense of
00:52:00
urgency that was was interpreted by the
00:52:04
market is having some inside information
00:52:06
keep a mark As Jeremy pointed out
00:52:08
markets are forward looking I was also
00:52:10
often been asked by reporters during the
00:52:12
last couple weeks was Leman and AIG were
00:52:15
they really all in that bad of shape and
00:52:17
my honest answer is I don't know because
00:52:20
the thing about these 144a placements
00:52:23
and other contracts is that we really
00:52:24
don't know their exposure until they
00:52:26
they declare bankruptcy that's kind of
00:52:28
the irony of of of all this we don't
00:52:31
really know how bad in shape they they
00:52:33
were until until that happens I think
00:52:36
Treasury and the FED played a kind of a
00:52:38
role of of a signaling by saying there's
00:52:40
a big urgency there's a big problem the
00:52:42
market said they have inside information
00:52:44
there must be a big problem there must
00:52:45
be an urgency here and so did they do
00:52:48
the right thing my inclination is maybe
00:52:50
they did do some the right thing but
00:52:52
don't simply look at stock prices and
00:52:54
say we needed government intervention
00:52:56
sometimes government intervention
00:52:58
creates its own need and we we need to
00:53:00
in fact um ask ourselves and these are
00:53:02
some of the comments that might be
00:53:03
amending in six months as more
00:53:05
information comes out but we can't just
00:53:07
simply assume markets are bad therefore
00:53:09
we need government sometimes it can it
00:53:11
can also work um the other direction so
00:53:15
in the last two minutes let me ask the
00:53:17
kind of the question so what do we need
00:53:18
to do going
00:53:21
forward and there will be certain lots
00:53:24
of especially with the new the new
00:53:26
Congress and new president um trying to
00:53:30
discuss and their first inclination in
00:53:32
fact the writings on the wall always
00:53:33
talking about we need more
00:53:35
regulation my first suggestion is let's
00:53:38
first pause stop and really have an open
00:53:42
honest discussion some reasonable steps
00:53:45
obviously can be can be uh taken we need
00:53:48
a balanced discussion but we also part
00:53:50
of that discussion is not what more
00:53:52
rules to add but looking at the existing
00:53:54
rules and how they contribute to the
00:53:57
problem sarbanes oxy is an example of
00:53:59
Regulation that was done in a very
00:54:02
reactive way and that probably in in
00:54:05
many ways cause more harm than good many
00:54:07
of the provisions of sarban oxy only
00:54:10
reward accounting firm and law firms
00:54:12
many what I call legitimate firms that
00:54:15
don't that doesn't include law firms um
00:54:17
Now list on the London aim precisely
00:54:21
because of the enormous complexities um
00:54:23
that sarban oxy cause especially for
00:54:25
small midcap firms um and sbin hly also
00:54:28
creates I think an enormous sense of of
00:54:31
secur a sense of security and there's
00:54:34
there's a lot of parallels between these
00:54:35
events uh today and then I was at
00:54:38
treasury ad minist uh at that time I
00:54:40
advised the Federal Open Market
00:54:41
Committee and the financial VY uh
00:54:44
regulatory panel at at the time Congress
00:54:47
had other ideas though they had to they
00:54:49
had to make a statement so first they
00:54:54
issued a subpoena to of my box including
00:54:57
every in email that included the word
00:55:00
Enron and and other people in the
00:55:02
administration's inboxes but then they
00:55:05
decided Well we really need to pass this
00:55:07
very tough law this law Sor Oxley was
00:55:11
very reactionary and it was overstepping
00:55:13
at the time the logic but that we had
00:55:16
though was that it was okay to go too
00:55:18
far because what we could always do if
00:55:20
we went too far is we could always
00:55:22
unwind later it was better to be safe
00:55:25
than sorry what is what we kept on um uh
00:55:28
uh saying and so what we have now is we
00:55:32
have a law that has very high complexity
00:55:34
very high compliance cost that clearly
00:55:36
hurts in my opinion shareholders of
00:55:39
small and midcap firms in particular and
00:55:42
it's not true that those e it's now easy
00:55:45
to unwind those parts now and the reason
00:55:48
why is because once you make a bad law a
00:55:51
whole cottage industry of accountants
00:55:53
and legal forms ously is created to
00:55:56
support that law and they hire a
00:55:58
lobbyist and they they argue for
00:56:00
continuing that law cuz that's how they
00:56:02
get fees the small midcap in Minnesota
00:56:05
doesn't have a chance and so we're not
00:56:08
going to see much unraveling of sarbanes
00:56:10
oxy even though it clearly was an
00:56:13
overreaction uh uh uh to the problem so
00:56:16
I I'm afraid of the same type of
00:56:17
overaction happening today and we need
00:56:20
to be I think very careful and 15
00:56:23
seconds I think the f one thing I would
00:56:26
do is I would impose instead of having
00:56:30
Congress design a law like with sarban
00:56:32
Oxley let's create a panel and of
00:56:36
experts much like we did when we
00:56:38
Congress couldn't actually pull the
00:56:39
trigger and require the expense of the
00:56:41
stock options that was too political you
00:56:43
had too many people from Blue States um
00:56:46
who are supposed to be anti- business
00:56:49
but in this case they were they they
00:56:50
favored um um bad accounting and so they
00:56:54
they uh what Congress did is they set up
00:56:57
a separate panel that actually
00:56:58
eventually did it sometimes we need to
00:57:00
have that cover and so my my suggestion
00:57:03
is that we it be very suspicious of
00:57:05
anything that Congress Rush rushes out
00:57:08
after the first session um next year and
00:57:11
we we need to uh proceed very carefully
00:57:15
and with great purpose thanks well it's
00:57:18
um probably not optimal to follow uh
00:57:21
four star speakers um and uh uh so I'm
00:57:25
going to doing a lot of editing on the
00:57:27
Fly I guess I would add one even more
00:57:30
depressing detail to Kent sm's speech
00:57:34
the glass deagle act you may recall was
00:57:36
passed in the depression the early days
00:57:38
of the depression in fact and after a
00:57:41
mere two years uh Senator Carter glass
00:57:43
went to the floor of the Senate and and
00:57:46
uh recanted and wished that they would
00:57:48
uh in fact roll it back well it didn't
00:57:51
happen until Graham leech Bley in 1997
00:57:54
so it can take a a very very long time
00:57:57
to unw unwind bad
00:58:00
legislation what I'm going to do is take
00:58:02
you through um a lot more rapidly than
00:58:05
um uh I had meant because um a lot of
00:58:08
this material has been covered but I
00:58:10
wanted to give you a little bit of my
00:58:12
the background of uh what I saw as the
00:58:15
cause and um why I'm so concerned about
00:58:18
uh what the consequences may be um
00:58:21
securitization was as many people have
00:58:23
mentioned actually modeled on the uh
00:58:27
actions of the government sponsored
00:58:28
entities even before they were
00:58:30
government sponsored entities um they
00:58:33
were in fact government Enterprises they
00:58:35
were spun off by uh lynon Johnson who
00:58:38
wanted to pay for guns and butter and
00:58:40
thought if he could put these uh
00:58:41
entities off balance sheet which
00:58:43
Congress has certainly liked then he
00:58:45
could have his policies and not pay for
00:58:48
them and uh that has been a winning
00:58:50
solution with Congress for a very long
00:58:52
time well when you thought about how you
00:58:54
would replicate that with private
00:58:56
securitizations the key challenge was
00:58:58
how you substituted for the government
00:59:01
guarantee against credit risk you had to
00:59:03
have some means of making up for the
00:59:05
fact that the government was not going
00:59:07
to guarantee private
00:59:09
securitizations um and there were
00:59:11
essentially three ways of doing that one
00:59:14
was to develop very good statistical
00:59:16
models that would tell you how much of a
00:59:18
buffer you had to create in order to
00:59:21
make some of the Securities in a
00:59:23
securitization equivalent to uh a a able
00:59:26
a whatever you liked but usually
00:59:28
investment grade risk um this was uh
00:59:32
also buttressed by ratings from the
00:59:35
statistical ratings organizations
00:59:36
Moody's Fitch S&P as we've heard um and
00:59:41
um uh Kent's Judgment of of their
00:59:44
performance I think has um certainly
00:59:46
shown up in in recent times although
00:59:48
they've really done a rather good job uh
00:59:51
on corporates until very recently
00:59:53
although he's quite right that they're
00:59:54
never uh ahead of markets it's always a
00:59:57
lag and uh uh never really um forward
01:00:01
looking at all um and then finally if
01:00:04
you were really really worried you'd
01:00:06
want to have some monoline insurance
01:00:08
backing up the credit risk so that you
01:00:10
could be very very sure that your
01:00:12
security was actually worth what it was
01:00:14
rated to be the result was um an
01:00:17
absolute explosion of uh Innovations um
01:00:21
we had R&B's cdos CDO squared a asset
01:00:26
commercial paper sivs SIV lights and
01:00:28
went on and on and we developed a huge
01:00:31
off-balance sheet banking sh system
01:00:34
private that amounts to about $ 111
01:00:37
trillion um it helped feed what was a
01:00:41
regulatory induced and this sort of
01:00:43
feeds into Kent's story as well a
01:00:45
regulatory induced demand for very high
01:00:48
quality assets The Regulators uh in many
01:00:52
cases required institutions to hold at
01:00:56
least investment grade and sometimes
01:00:58
triaa rated Securities well it turns out
01:01:01
there not that very that many AAA rated
01:01:04
corporations in the world and so by
01:01:06
securitization you could synthesize AAA
01:01:10
rated Securities by essentially
01:01:12
developing a structure that would give
01:01:14
you the equivalent in terms of default
01:01:17
um and uh that was uh used even with
01:01:20
subprime mortgages where no one of the
01:01:22
mortgages would have been remotely uh
01:01:25
labeled AAA
01:01:26
but through the magic of securitization
01:01:28
you could easily transform as much as
01:01:31
85% of them into AAA this just gives you
01:01:33
a a quick overview of the structure um
01:01:36
but it could get uh hideously complex
01:01:39
very quickly I took it out to CDO
01:01:41
squared where you're taking the lower
01:01:43
tranches and retrenching and retrenching
01:01:45
them but noticing each time you're
01:01:48
ending up with some AAA tranches and I
01:01:50
could have gone out to CD Cubes but
01:01:53
that's enough to give you an idea that
01:01:54
the people who are buying in products
01:01:57
either had to do a hell of a lot of
01:01:58
homework to find out what was underlying
01:02:00
it or simply we're just looking at the
01:02:03
ratings um it became a very very
01:02:06
important source of income to um lcf I
01:02:10
is is U the kind of uh language that the
01:02:14
bank of England and IMF use for the most
01:02:16
important banks in the world there about
01:02:18
16 of them and you can read the peus and
01:02:21
chartreuse blocks as being a sort of
01:02:24
proxy for the fees they were making
01:02:26
on securitization so it became a really
01:02:29
important source of income and it's one
01:02:31
of the reasons we've seen investment
01:02:33
Banks collapse so readily um they were
01:02:36
so dependent on this source of income
01:02:37
which has dried up and may have dyed up
01:02:40
for the foreseeable future that uh they
01:02:42
really are going to have to reinvent
01:02:44
themselves all of this came to a halt
01:02:46
when uh they were confronted with the
01:02:48
brute fact that they were really dealing
01:02:51
with uh assets that weren't nearly as
01:02:54
good as they thought they were uh keep
01:02:56
your eye on the left screen if I could
01:02:57
figure out how to use the um but I can't
01:03:01
uh anyhow take a look at the subprime
01:03:03
section um we should have a laser
01:03:05
pointer uh that uh I haven't really
01:03:08
quite figured out but the blue was
01:03:11
thought to be the worst that could ever
01:03:12
happen uh 2000 was just before the
01:03:15
recession in this kind of lending uh for
01:03:18
reasons that can't described you expect
01:03:21
the peak default rate to be about 3
01:03:23
years after the loan was issued because
01:03:25
in sub prime lending the custom is to
01:03:27
give a teaser rate that's very very low
01:03:30
and then at the third year you jump it
01:03:33
up sometimes with a four or 500 basis
01:03:35
point spread above lior so you go to a
01:03:38
very from a very very low rate to a very
01:03:40
very high rate after three years and
01:03:41
that's where you expect to see Peak
01:03:44
defaults um the idea was not that
01:03:46
anybody was ever going to pay those High
01:03:48
rates but that house prices would rise
01:03:50
so rapidly that by the time you got to
01:03:52
that point you could refinance and keep
01:03:54
going and that was the context of what
01:03:56
was basically 75 years of upward price
01:03:59
movements well notice that in the more
01:04:01
recent
01:04:02
vintages um 2005 as dick Marson pointed
01:04:06
out was sort of a turning point that
01:04:08
nobody seemed to recognize 2006 and 2007
01:04:12
especially you were seeing delinquency
01:04:15
rates that exceeded the peak rate that
01:04:18
you thought was the worst possible
01:04:20
within months which meant that some
01:04:22
people were walking away from the houses
01:04:23
without ever having made a payment
01:04:26
um that led to um a uh breakdown and it
01:04:30
was very clear that there was a huge
01:04:32
breakdown in underwriting standards at
01:04:34
many different levels and it undermined
01:04:36
the three pillars of that under that
01:04:40
were the uh foundation for support for
01:04:42
private securitizations and that was
01:04:44
statistical ratings models ratings
01:04:47
agencies and monoline insurance all
01:04:49
three collapsed uh first the ratings
01:04:52
models the um Institution that had the
01:04:56
strongest incentives to build the best
01:04:58
models were those that were underwriting
01:05:01
the most of this debt and they were also
01:05:05
the institutions that showed the largest
01:05:07
losses and showed them first and they
01:05:09
showed them them repeatedly which
01:05:11
indicated that not only did they not get
01:05:13
it right first time the first time they
01:05:15
couldn't get it right the second or
01:05:16
third time either uh bear Stern which
01:05:19
was one of the leaders of the pack had
01:05:20
two hedge funds that blew up uh City
01:05:23
Group maril Lynch UBS uh on on and on um
01:05:27
had repeated write Downs that were
01:05:29
basically because they hadn't modeled
01:05:31
things appropriately then it came to the
01:05:34
ratings agencies well people were
01:05:36
accustomed to thinking about corporate
01:05:38
ratings the very worst year in corporate
01:05:41
rating history was
01:05:44
2001 the yellow represents Three Notch
01:05:47
downgrades um which is pretty severe but
01:05:50
notice that in the corporate world 2001
01:05:53
being where we lost Enron and WorldCom
01:05:56
there were really negligible Three Notch
01:05:58
downgrades except in the below
01:06:01
investment grade uh range which
01:06:04
everybody knew was very volatile and was
01:06:06
not very surprising but look at what
01:06:08
happened in the 2007 uh 2008 and it's
01:06:12
only very it's I guess of 1312 2008 to
01:06:16
the subprime backed Securities look at
01:06:20
the Triple B category in particular 68%
01:06:23
of those were downgraded Three Notch
01:06:25
which took them from investment grade to
01:06:27
below investment grade which meant that
01:06:29
many of the institutions that were
01:06:31
holding them had to get rid of them now
01:06:33
you might think looking at this that
01:06:35
they did a much better job at triaa but
01:06:38
it simply reveals a flaw in their in the
01:06:41
way in which they approached it in these
01:06:43
nested Securities you had to sort of
01:06:45
start at the bottom and work up until
01:06:47
you got to the AAA to know just how bad
01:06:49
it was uh these have now been selling
01:06:52
for uh 50 60 cents on the dollar and so
01:06:55
didn't really fair much better and as
01:06:57
soon as monol line Insurance looked like
01:06:59
it was going to have to pay up um the
01:07:02
stock prices of monoline insurers
01:07:05
collapsed and the credit default uh
01:07:07
spreads went up to a th basis points um
01:07:11
the IMF has something very clever uh
01:07:13
called a heat diagram that shows how
01:07:15
quickly the crisis spread and um in this
01:07:19
diagram it's good to be green that means
01:07:21
you're within one standard deviation of
01:07:22
the way you're usually priced if you're
01:07:25
yellow it's not so good you're within
01:07:27
one to four standard deviations of the
01:07:29
way you're usually priced but uh if
01:07:32
you're red it's really terrible you're
01:07:34
being priced within four standard
01:07:36
deviations of the normal and what you
01:07:38
see is the pattern of exposure it began
01:07:42
with subprime and it really began um
01:07:46
dick noted that that that one really
01:07:48
should have known about it in 2005 but
01:07:50
it was completely unambiguous in
01:07:52
February 2007 when HSBC made a full
01:07:56
account of its subprime losses and its
01:07:58
American subsidiary household finance
01:08:01
and if you kept dancing as Charles
01:08:03
Prince did after that you were simply
01:08:05
not paying attention or you had a very
01:08:07
severe case of cognitive dissonance um
01:08:10
it spread to Banks uh it continued of
01:08:13
course with subprime and then as we
01:08:15
found more and more Banks were involved
01:08:18
Banks and other financial institutions
01:08:20
became involved then all sorts of
01:08:22
instruments that that relied on the
01:08:25
three pillars of
01:08:27
privatization either they relied on
01:08:29
ratings or they relied on monoline
01:08:31
insurance like municipal bonds or they
01:08:34
relied on um a statistical models for
01:08:37
their value for a long time there was a
01:08:39
discussion of decoupling that the
01:08:41
emerging markets were going to be able
01:08:43
to manage on their own that they had
01:08:45
self- sustained demand and you had China
01:08:48
and and uh India that were sort of
01:08:50
leading the way and I think Jeremy's
01:08:52
shown you how that's unfortunately ended
01:08:54
the wrong way way it should have been
01:08:57
apparent in August 2007 that this was a
01:09:00
crisis of decapitalization there were
01:09:02
major losses that were uh absolutely
01:09:05
apparent although not revealed um and
01:09:08
there were losses because of holding
01:09:10
some of these Securities some of these
01:09:12
institutions were dumb enough to eat eat
01:09:14
their own cooking uh and there were
01:09:16
losses from honoring implicit guarantees
01:09:19
uh that were backing up off-balance
01:09:22
sheet commitment to this this whole
01:09:24
private uh system of uh off-balance
01:09:27
sheet banking there were also losses of
01:09:30
pipelines of assets that could no longer
01:09:32
be taken to the market and securitized
01:09:35
that was basically the northern Rock
01:09:37
story and um as we saw it was a very
01:09:40
important source of Revenue that that
01:09:42
simply had disappeared from future
01:09:44
earnings which um is one of the points
01:09:47
that Jeremy was making about how you
01:09:49
think about what the price of a stock
01:09:51
should be um the capital challenge was
01:09:54
not only to replace it and Dick showed
01:09:56
that they've really not been uh keeping
01:09:58
up with the amount they've had to write
01:10:00
down um but it was also stockpiling
01:10:03
capital and that's one of the reasons
01:10:05
the recovery is usually so slow because
01:10:08
uh the market starts to demand a whole
01:10:10
lot more Capital than Regulators do um
01:10:13
and the unknown of course is how much of
01:10:15
the off balance sheet stuff is
01:10:17
ultimately going to have to be brought
01:10:18
back on the balance sheet the variations
01:10:21
in disclosure across countries have been
01:10:23
very harmful because this is an
01:10:25
integrated Global Market with very
01:10:27
different disclosure practices the SEC
01:10:30
requires quarterly disclosure Europe um
01:10:33
is more principles based uh less
01:10:36
prescriptive um the CFO can exercise
01:10:38
professional judgment about the scale
01:10:40
and timing of lost recognitions which is
01:10:43
one of the reasons that you saw a lot of
01:10:45
shod and Freud in in Europe until they
01:10:48
all panicked in in August because they
01:10:50
they took their time in letting out the
01:10:52
bad news uh but the upshot is that the
01:10:55
same asset can be valued quite
01:10:57
differently in different
01:10:59
institutions the peacemeal release of
01:11:01
increasingly larger losses was a really
01:11:04
bad strategy if indeed one could call it
01:11:07
that it raised questions about the the
01:11:09
Integrity of financial reporting and it
01:11:13
really in the end raised questions about
01:11:15
whether management understood its own
01:11:17
its own risk
01:11:18
positions um the fed I'm not quite sure
01:11:22
what happened to our framing here but uh
01:11:24
the bail out of bear was where things
01:11:26
got really panicky and it's because um
01:11:29
the Fed was really afraid of submitting
01:11:32
what they considered to be a very large
01:11:34
very opaque institution that they had no
01:11:36
oversight of to um B the process of
01:11:40
resolution um and the reason is that one
01:11:43
of the the common tools of bankruptcy
01:11:46
courts everywhere is to exercise stays
01:11:49
and stays can be fatal in markets that
01:11:52
trade literally 247
01:11:55
where people have to worry about their
01:11:57
positions and and how they're going to
01:11:58
end up um so the the real concern was
01:12:02
that it could have fatal damage to the
01:12:04
primary dealer Market well in the
01:12:06
meantime the man the government managed
01:12:08
to bail out Freddy and Fanny uh and when
01:12:10
it got to Layman uh a number of people
01:12:13
thought it was obvious that they would
01:12:15
have to bail out Layman because Layman
01:12:17
was at least twice as big as bear and
01:12:19
probably much more complicated uh and
01:12:22
indeed if you're talking about the
01:12:23
deserving insolvent l had actually tried
01:12:26
harder than bear to to keep itself from
01:12:28
the brink um but they didn't um in the
01:12:32
wake of the fanny and Freddy uh uh
01:12:35
bailouts they seemed to want to show
01:12:39
that there was some limit to their
01:12:40
willing to subsidize um and the FED had
01:12:44
had examiners in all four of the
01:12:45
remaining investment Banks daily since
01:12:48
then and felt they could predict um uh
01:12:51
what the consequences could be
01:12:52
Unfortunately they didn't uh they didn't
01:12:55
realize that it was held by um major uh
01:12:59
money market mutual funds they didn't
01:13:02
realize that Layman had comingled uh
01:13:05
customers money with its own money in
01:13:07
London where lots of hedge funds were
01:13:09
relying on uh access to their Prime
01:13:12
brokerage accounts and couldn't get it
01:13:14
and um so that is and I I've agreed with
01:13:18
all the panelists that was really um the
01:13:21
time that things turned to Terror um by
01:13:24
an intervention policy that seemed
01:13:27
increasingly ad hoc and desperate you
01:13:30
saw that that central banks Were You
01:13:32
could argue if you were trying to make
01:13:34
the best possible case for the central
01:13:35
bank that it was their old favorite
01:13:37
policy of constructive ambiguity which
01:13:40
I've never believed in but I would argue
01:13:42
instead it was really destructive
01:13:43
ambiguity because nobody knew who would
01:13:45
be next um this is a cartoon from The
01:13:49
Economist that um is of course the
01:13:51
Humpty Dumpty fairy tale and uh one of
01:13:54
the king's horses in one of the King's
01:13:55
Men is saying it appears this uh is
01:13:57
having a fairy tale ending you may
01:13:59
remember it didn't end well for Humpty
01:14:01
Dumpty uh you can see AIG teetering on
01:14:04
the brink and at the rest you see Fanny
01:14:06
and Layman and so forth uh with the
01:14:08
sulter behind Layman saying shares and
01:14:10
glue should be rising high but there was
01:14:13
Terror throughout the market because you
01:14:15
really couldn't predict what the
01:14:16
government might do next markets react
01:14:20
really negatively to uncertainty you had
01:14:22
a massive flight to Quality and to
01:14:24
simplicity
01:14:25
there were huge outflows from what some
01:14:28
people believe are the safest of funds
01:14:29
next to treasury bills institutional
01:14:31
money funds and we saw that uh the
01:14:34
reserve primary fund and put putam fund
01:14:37
actually uh had to close and uh that led
01:14:40
to real terror in the marketplace uh it
01:14:43
was a loss of confidence in the
01:14:44
financial system the punch line there is
01:14:46
can I interest you in a faith-based
01:14:48
deposit um which began to show signs of
01:14:52
panic where you have a man here saying
01:14:54
give me all my money or else uh to a a
01:14:58
situation where Banks became
01:14:59
increasingly desperate for liquidity
01:15:01
that you began to see in uh interbank
01:15:05
markets with with huge uh markups now I
01:15:09
I would have a disagreement I think with
01:15:11
um some of the interpretations you've
01:15:14
heard of uh the interbank rate spread uh
01:15:17
but we'll we'll hold that to later this
01:15:19
is simply showing how incredibly um
01:15:23
Innovative the FED has been taking all
01:15:25
sorts of collateral uh from all sorts of
01:15:27
people for all sorts of terms um without
01:15:31
um until very recently having much
01:15:34
impact at all on conditions and I think
01:15:37
it's fundamentally because they were
01:15:38
trying to deal with what was really a
01:15:40
solvency shock and should have been
01:15:42
apparent as a solvy shock by supplying
01:15:45
more liquidity and that just doesn't
01:15:46
work this is what's happened to the
01:15:48
fed's balance sheet notice that it's
01:15:50
almost doubled and it's still going up
01:15:53
because just today they announced they
01:15:54
were going to have a new facility for
01:15:56
money market mutual funds um more
01:15:59
broadly the problem has been excessive
01:16:01
leverage and it's been mainly centered
01:16:04
in the household sector and um in the
01:16:08
financial sector which and where it's
01:16:09
really
01:16:10
quadrupled um with a Year's inventory of
01:16:14
unsold homes it's inevitable that we're
01:16:17
going to have larger losses and uh more
01:16:21
deleveraging um deleveraging has had all
01:16:24
sorts of financial institutions even
01:16:26
hedge funds where you can see the green
01:16:27
line going down precipitately um it has
01:16:31
even hit Main Street um where uh uh what
01:16:34
used to be the Friendly Loan company has
01:16:36
become the go to Hill loan company and
01:16:40
sadly as we all know it's hit the
01:16:42
financial sector really really hard uh
01:16:46
and it's not just the financial sector
01:16:47
it's it's others as well um the problem
01:16:52
of course is that the treasury insisted
01:16:54
on
01:16:55
uh interpreting this as a liquidity
01:16:57
problem as recently as the tarp fund
01:16:59
with this bizarre $700 billion program
01:17:02
to buy taxic toxic asset or toxic um
01:17:06
assets um uh there's another cartoon
01:17:08
that I skipped that showed them bearing
01:17:10
them and it was a bizarre political
01:17:13
gesture uh for some reason they seem to
01:17:16
think it would be easier to sell as
01:17:18
buying toxic assets from the people who
01:17:21
owned them and had created them than to
01:17:23
talk about actually doing something for
01:17:25
homeowners or for um uh rebuilding the
01:17:29
institutions um Congress originally
01:17:31
rejected it but when Ben banki told them
01:17:34
that we wouldn't have an economy if they
01:17:35
didn't pass it they came up with
01:17:37
something uh in addition to production
01:17:40
for makers of wooden arrows and rum and
01:17:43
and a monthly subsidy for bicyclists um
01:17:46
they actually came up with some pretty
01:17:47
good programs um and one of them is the
01:17:51
treasury that can now invest 250 billion
01:17:53
in Bank preferred sh shares uh 125 of it
01:17:57
has already been allocated uh the
01:17:58
remaining
01:17:59
125 has to be applied for by the middle
01:18:02
of next fund next uh month uh the FED
01:18:06
can purchase a commercial paper now uh
01:18:08
starting October 27th which is a market
01:18:11
you could seriously start about making
01:18:13
you could seriously think about making
01:18:15
more liquid there's no way to revive the
01:18:17
market for Junk Securities and so that
01:18:19
was misguided from the start the F FDIC
01:18:23
has also been hyperactive
01:18:25
they've raised Insurance to
01:18:28
250,000 on um uh regular deposits from
01:18:32
100,000 with with utterly no discussion
01:18:34
about it they've offered unlimited
01:18:36
deposit uh Insurance on non-interest
01:18:39
bearing accounts that businesses hold
01:18:41
and they're also going to start
01:18:43
guaranteeing subordinated debt for three
01:18:45
years so if there was ever any hope of
01:18:47
having Market discipline in the system
01:18:49
it's pretty much gone um and um the
01:18:53
European hm this has cut pretty badly
01:18:56
but should say the uee the European
01:18:58
Union has uh acted with surprising speed
01:19:01
and deceptive unanimity um and you can
01:19:04
see the kinds of bailouts they've been
01:19:06
doing it looks the same but it's it's
01:19:08
not quite the same um this is um sort of
01:19:12
led to worldwide round of of coordinated
01:19:15
government guarantees and subsidies that
01:19:17
have have made moral hazard really
01:19:19
rampant and have really I think made it
01:19:22
very difficult to see where we go from
01:19:24
here um punchline here is now we just
01:19:26
have to sit back and wait for the FED to
01:19:28
Veil us out well where are all these ad
01:19:30
hoc measures taking us um deep
01:19:33
government involvement um in the banking
01:19:36
system and it's not and there's really
01:19:38
no sense of how they're going to exit or
01:19:40
any vision of where they should be going
01:19:42
you have quasi ownership um of banks
01:19:45
with very few protections for taxpayers
01:19:48
the US is pouring in perverted stock but
01:19:50
with no cost to existing shareholders um
01:19:53
and uh no push to write down or actually
01:19:56
reveal the Bad Assets uh which the
01:19:59
Europeans at least have done we're
01:20:01
ending up with a tiered banking system
01:20:03
where the nine favored banks are like
01:20:06
gsse with all of the problems that we
01:20:08
faced with the gses and and very few of
01:20:10
the controls um and the liquidity
01:20:13
programs have basically been nothing but
01:20:15
for barrance they've been putting off
01:20:16
problems that have been growing not
01:20:19
shrinking um Housing Finance is is an
01:20:21
open question nobody knows how we're
01:20:23
going to do it in the future but it's
01:20:25
very clear that the government's playing
01:20:26
a bigger and bigger role um and it is
01:20:29
going to be a bigger and bigger
01:20:31
liability on the B on the government's
01:20:33
balance sheet which could in fact uh
01:20:36
ultimately affect its ratings um one of
01:20:39
the key questions is how far house
01:20:40
prices will fall uh the average um we
01:20:45
have uh some reason to believe that
01:20:48
there's a third wave of defaults on
01:20:50
Equity loans and Prime loans and then
01:20:53
the real economy effects are just
01:20:54
sitting in luckily we're sitting on a
01:20:57
market that's not nearly as bad as most
01:20:59
people think uh actually 25 million
01:21:02
people have have paid off their houses
01:21:04
and um 55 million have mortgages that uh
01:21:07
and of those 51 are paying on time it's
01:21:10
really only 4 million that are um behind
01:21:14
and uh only 2% of those are in
01:21:16
foreclosure as opposed to 50% in the
01:21:18
Great Depression um I think one of the
01:21:21
key questions is how you um U restore
01:21:24
faith in securitization because private
01:21:27
securitization amounts to almost 12
01:21:29
trillion and there's just not enough
01:21:31
capital in the world to put that back on
01:21:34
institutions balance sheets so we have
01:21:36
to think of some way to uh make it more
01:21:39
transparent and more possible um and as
01:21:42
you can see new issues of private
01:21:44
securitizations have virtually
01:21:46
disappeared um the key policy challenge
01:21:49
I think that really nobody has discussed
01:21:52
and Marty will be glad to hear these uh
01:21:54
long awaited words in conclusion I think
01:21:57
the really really tough problem facing
01:21:59
us all is trying to figure out how um we
01:22:03
can make the world safe for even the
01:22:05
largest most uh uh the failure of even
01:22:08
the largest most interconnected
01:22:10
institutions it's not Beyond possibility
01:22:13
but nobody seems to be working on
01:22:15
it in terms of remedying the economic
01:22:18
situation yesterday uh chairman Ben
01:22:22
banki uh came out uh in favor of
01:22:26
additional fiscal stimulus do you think
01:22:28
that's appropriate at this juncture U
01:22:30
and uh it it Unleashed a rather harsh
01:22:33
response by Wall Street Journal today
01:22:35
actually saying that uh this this was
01:22:39
akin to his endorsement of Obama that he
01:22:41
should have in their words begged off of
01:22:43
any pronouncement on the fiscal side in
01:22:46
fact even stating that in past prior to
01:22:49
past elections fed Federal Reserve
01:22:50
chairman would even beg off of even
01:22:53
exercising monetary policy so should he
01:22:55
have begged off and uh and and what
01:22:58
should in your view uh be done in the
01:22:59
area of either fiscal or monetary
01:23:04
policy well let me comment
01:23:08
that um I think he could be right uh I
01:23:12
think fourth quarter looks horrendous
01:23:14
the one we're in U
01:23:18
um the estimates for GDP growth are now
01:23:21
minus 2 to minus three for the this
01:23:24
quarter that's one of the sharpest
01:23:26
declines I think since uh Carter put
01:23:30
credit card controls on um maybe it's
01:23:33
too late to get uh a tax refund to boost
01:23:38
holiday spending um that's what you'd
01:23:41
really uh like to do um uh it did seem
01:23:45
to work in the um uh second quarter and
01:23:49
we had a fairly decent growth on GDP uh
01:23:53
but I don't know whether we could get it
01:23:55
in the hands of consumers fast enough uh
01:23:59
anyway that's my
01:24:01
opinion I actually agree with uh Jeremy
01:24:04
uh but let me say that I I don't think
01:24:06
the Fed chair should talk about fiscal
01:24:08
policy I think Greenspan was wrong to
01:24:10
talk about endorse the Bush tax cuts
01:24:14
didn't quite endorse them but he
01:24:15
certainly encouraged them and I think
01:24:17
banki should focus on monetary policy
01:24:19
the central bank really has to keep
01:24:21
credibility with respect to bank
01:24:23
regulation and monetary policy and there
01:24:26
are enough other people who can talk
01:24:28
about the need for for uh a stimulus
01:24:31
package but I agree entirely with Jeremy
01:24:33
that um we need a stimulus package
01:24:36
sooner rather than later uh how it's
01:24:38
designed will be a different issue um
01:24:40
but I expect that as soon as the
01:24:42
election is over uh the Congress will be
01:24:45
back in session and we'll have something
01:24:47
on the president's desk uh very soon uh
01:24:50
president may not like it so it's a
01:24:51
question of compromise to see what they
01:24:54
actually do in terms of what to
01:24:55
stimulate just just sending people
01:24:58
$1,000 um an awful lot that doesn't get
01:25:01
spent so perhaps we can do it a little
01:25:03
more imaginatively this time but I I
01:25:05
think there'll definitely be a stimulus
01:25:08
package yeah I don't think you need to
01:25:10
count on the uh chairman of the FED for
01:25:13
encouragement to Congress to spend more
01:25:15
money um and I I really do take Dick's
01:25:18
Point very seriously I I think the fed's
01:25:21
credibility is enormously important and
01:25:23
I think they're really in danger of
01:25:25
losing it um a lot of the reform
01:25:28
packages have talked about giving them
01:25:30
oversight of the entire Financial system
01:25:33
and de facto they've more or less
01:25:35
assumed it but the regulatory record is
01:25:38
spotty at best uh it's certainly uneven
01:25:41
it's unpredictable they've not done a
01:25:43
good job of explaining what they're
01:25:45
trying to do and if they really were the
01:25:48
Architects as one has heard of the tarp
01:25:52
plan to um buy
01:25:54
that uh toxic debt from the people who
01:25:57
created it um I think there they real
01:26:00
questions about uh whether they don't
01:26:02
have enough on their plate already to uh
01:26:05
uh you think did you think the Fed was
01:26:08
the architect and not Paulson I had
01:26:10
heard that was the case sounds like a
01:26:13
pulson plan to me well I think they both
01:26:15
have to agree before they go out but I
01:26:17
have been to seminars at the FED where
01:26:19
people go through exercises where they
01:26:22
believe that they can actually price the
01:26:25
stuff and um the assumptions you can if
01:26:29
you make if you're willing to make
01:26:30
assumptions about future cash flows and
01:26:33
the appropriate discount rate but the
01:26:34
range of those assumptions can be huge
01:26:37
um and uh I think that if they did not
01:26:41
actually set out the plan they certainly
01:26:44
gave him encouraging encouragement by uh
01:26:46
indicating that now we know it's the
01:26:48
Paulson plan because he clearly didn't
01:26:50
know how to price this stuff he's
01:26:52
Outsourcing it he's Outsourcing and he
01:26:55
has friends who tell that for a lot of
01:26:58
money I guess I would just make two
01:27:00
quick points I think the role issue that
01:27:02
we have to face as a long-term economy
01:27:05
is that we are in dire need of
01:27:07
fundamental tax reform and the problem
01:27:09
with doing a little rebates here a
01:27:11
little rebates there is it postpones the
01:27:14
big discussion we have some of the
01:27:15
highest effective tax rates on capital
01:27:17
income in the world um we need
01:27:19
fundamental tax reform and we use up our
01:27:22
black powder we just sent up debate
01:27:24
checks I think we need to have a serious
01:27:26
discussion go beyond the simple short
01:27:28
run let me push back on the panelist on
01:27:30
1 point2 and that is this idea of
01:27:32
credibility of the FED it's not obvious
01:27:35
to me that that's so important and I
01:27:37
realize that I'm saying something that's
01:27:40
completely the opposite but one way you
01:27:42
could think about you know credibility
01:27:44
it's predictability and that
01:27:45
predictability can sometimes lead to
01:27:47
moral hazard I think sometimes this idea
01:27:49
of a mixed strategy where the government
01:27:51
is less predictable about who it's going
01:27:53
to bail out and how
01:27:54
can actually have some feedbacks on
01:27:56
dealing with moral hazard and so I think
01:27:58
we the fact that it let some banks sink
01:28:01
and some banks survive people are
01:28:03
criticized and saying well that's a
01:28:04
terrible thing it was inconsistent not
01:28:06
obvious on an ongoing basis that's
01:28:08
really the the bad strategy because now
01:28:11
when I'm a bank and I can do stupid
01:28:13
stuff it's not obvious where the if I'm
01:28:15
going to be the one bailing out getting
01:28:17
getting bailed out or not oh I
01:28:19
absolutely agree and that's why I think
01:28:21
the policy of uh constructive ambiguity
01:28:24
it is is fundamentally unworkable
01:28:26
because we usually can predict and we in
01:28:29
fact have a very rigorous system for
01:28:31
figuring out which banks we should bail
01:28:34
out and which we shouldn't and what's
01:28:35
distressing about the way all of this
01:28:37
has happened is that if we had made the
01:28:39
list of the nine biggest Banks two
01:28:41
months before we did it would have
01:28:43
included Washington Mutual and wacovia
01:28:45
and we have no reason to believe that
01:28:48
the nine on the list now are
01:28:49
fundamentally that much stronger in fact
01:28:52
if you want to see how just how
01:28:56
unreliable public information about
01:28:58
these institutions is think of the fact
01:29:01
that just two weeks before viovia became
01:29:04
insolvent Morgan Stanley one of the uh
01:29:07
firms with the reputation for being able
01:29:09
to Value anything was willing to sell
01:29:12
itself to a firm that became bankrupt
01:29:14
two two months later the the disclosure
01:29:17
that we have is simply completely
01:29:19
inadequate for the kind of business
01:29:22
these banks are doing is there a
01:29:24
question over on this
01:29:26
side uh what changes would you
01:29:28
anticipate in the hedge fund industry
01:29:30
both in terms of Regulation as well as
01:29:32
trading strategies of profitability I
01:29:34
guess I'll I'll tackle that um I think
01:29:36
that's the big unknown in terms of
01:29:38
whether or not uh the new regulations
01:29:40
will be extended to hedge funds um they
01:29:44
um on there there's some real
01:29:46
difficulties in conceiving exactly how
01:29:48
they would be regulated um it's an
01:29:51
international market um so I think we
01:29:55
we'll we'll really have to wait and see
01:29:56
what happens with the respect to
01:29:58
regulation um it's uh there's going to
01:30:01
be a lot of discussion of to to what
01:30:04
extent should the traditional banking
01:30:06
regulation be extended to other types of
01:30:08
financial institutions I really
01:30:10
personally doubt whether or not it will
01:30:12
be extended to hedge funds um let me be
01:30:15
a little
01:30:15
cynical uh who are some of the biggest
01:30:18
contributors to the incoming
01:30:20
Administration the real test of the
01:30:23
administration in with respect to hedge
01:30:24
funds which is going to be very
01:30:26
interesting as far as I'm concerned is
01:30:29
is it going to be
01:30:30
possible to actually impose income taxes
01:30:35
on the income earned by hedge funds and
01:30:37
private
01:30:38
Equity Partners under the current law
01:30:42
what happens is the income not the
01:30:46
capital at risk but the income the
01:30:48
carried interest is taxed at
01:30:51
15% rather than at the ordinary 35% 5%
01:30:54
income tax rate an interesting question
01:30:56
will be in the new Administration will
01:30:59
they actually decide to tax the people
01:31:02
who have donated so much money to them
01:31:05
that's going to be interesting that's
01:31:06
going to be a test litness test of
01:31:08
whether or not they're serious about
01:31:10
changing the income distribution in the
01:31:11
United States my guess is they won't
01:31:14
touch that thing but we'll see we'll see
01:31:16
next year and the following year will
01:31:18
the new Administration tax carried
01:31:20
interest at ordinary income tax rates I
01:31:24
would add uh one point or I guess three
01:31:26
points to that one I think that
01:31:28
leveraged strategies are um pretty much
01:31:33
doomed for this the short to medium term
01:31:37
um Prime Brokers are much much tighter
01:31:40
than they used to be it's very very hard
01:31:42
to leverage up in the way that that
01:31:44
hedge funds once did so those that were
01:31:46
relying heavily on Leverage I think are
01:31:48
going to be in a lot of trouble on the
01:31:50
other hand I think hedge funds that
01:31:52
specialize in distressed debt have just
01:31:54
incredible opportunities before them and
01:31:57
probably will do remarkably well I guess
01:32:00
I'm a little more optimistic that they
01:32:02
won't be regulated um and I think the
01:32:05
very fact that investment Banks now are
01:32:08
all nestled in more heavily regulated
01:32:10
Banks means that a lot of the top talent
01:32:13
are probably going to leave for hedge
01:32:14
funds and hedge funds are going to end
01:32:17
up being something like the new
01:32:18
investment Banks um not with the scale
01:32:22
but but with much of the innovation and
01:32:24
much of the uh um uh kind of uh uh
01:32:28
interesting business that was once done
01:32:31
by investment Banks I I think uh what's
01:32:34
interesting is that you know a year ago
01:32:37
people said what's going to explode if
01:32:39
there is going to be an explosion uh you
01:32:41
know it was the hedge funds they're you
01:32:43
know totally unregulated $2 trillion of
01:32:47
assets at their Peak uh and and the
01:32:50
interesting thing is they didn't I mean
01:32:52
yes a few of them G G down of course um
01:32:56
uh but in general um now the aggregate
01:32:59
returns a year to date are down about
01:33:02
half the S&P which means their beta is
01:33:05
about 1/ half it's which is a little bit
01:33:06
higher than what they sometimes
01:33:08
advertise themselves out but if you take
01:33:09
a blended average that's not all you
01:33:12
know that's not all that bad and and
01:33:14
really um you know there hasn't been
01:33:17
that much finger pointing as one might
01:33:19
expect at the hedge funds causing any of
01:33:21
this because they didn't uh they did
01:33:23
short things faster which should go down
01:33:26
and did go down to some extent but uh
01:33:30
outside of that um you know they they've
01:33:33
actually stayed pretty clean in this
01:33:35
mess uh I think which interestingly the
01:33:38
the G7 meeting that preceded the one
01:33:41
that took place just this last fall um
01:33:45
had labeled that as the main threat to
01:33:47
the financial system and if you looked
01:33:50
at their involvement in this market they
01:33:52
were actually big bu ERS of the CDO
01:33:55
Equity tranches so they were holding the
01:33:57
riskiest pieces of these things but they
01:34:00
tended to do much better with them than
01:34:02
the people who actually originated them
01:34:05
and the reason is that the hedge funds
01:34:07
did their homework they they priced them
01:34:10
appropriately they knew when to hedge
01:34:11
them they um moved them quickly and um
01:34:15
you found other institutions were just
01:34:17
really sitting on it okay yeah uh
01:34:19
question in the
01:34:21
middle yeah um sorry light of the
01:34:24
current crisis and also the entitlement
01:34:26
problems that Professor sm's touched
01:34:28
upon um what is the chance that the
01:34:31
riskiness of t- bills will be changing
01:34:33
in the future that the the riskiness of
01:34:35
t- bills that the treasury bills will be
01:34:40
changing what do you mean by the
01:34:42
risk there there is never any risk on
01:34:45
the T bills r that they won't be risk-
01:34:46
free anymore in the future but they only
01:34:49
promis to pay Federal Reserve notes and
01:34:50
there's an unlimited supply of Federal
01:34:52
Reserve notes from the that so there
01:34:54
cannot be any risk I I guess the
01:34:57
question me Bills he means bonds he
01:34:59
means the longer term it doesn't matter
01:35:01
CA any risk on that in nominal terms
01:35:03
either well nominal terms yeah sure then
01:35:06
you're talking about risk of inflation
01:35:08
okay yeah yeah I mean that's the real
01:35:10
but then that's the question I mean
01:35:11
sorry I guess the question is about the
01:35:13
default of the US government in the most
01:35:17
you're talking about a hyperinflation or
01:35:18
a massive inflation of some sort or
01:35:21
explicit theault
01:35:24
well both can
01:35:28
happen I mean there's no what there's no
01:35:30
way they're going to default on the
01:35:32
nominal debt they might they might
01:35:34
default on the on the tips inflation
01:35:36
indexed bonds that's that's a
01:35:39
theoretical possibility which actually
01:35:42
got raised as the tips yields went up to
01:35:44
3% and people were wondering my God can
01:35:46
the government really pay these things
01:35:48
off or not um but I think I think the
01:35:51
question was what's say is this all this
01:35:53
debt going to lead to inflation and I
01:35:55
think especially all this liquidity as
01:35:57
as Professor Herring you know showed the
01:35:59
balance sheet has doubled even more than
01:36:01
doubled I think it's absolutely
01:36:04
essential I I think that's a good thing
01:36:06
you there's a liquidity crisis everyone
01:36:08
wants liquid safe assets the central
01:36:11
bank is there to provide them but as
01:36:13
soon as confidence returns they have to
01:36:15
withdraw this liquidity um there's ABS
01:36:18
absolutely no question the good thing
01:36:20
that happened yesterday is that the the
01:36:22
90-day t- rate went above 1% for the
01:36:25
first time since the Leman bankruptcy
01:36:27
which means there isn't like a panic
01:36:29
into bills uh which is a good sign
01:36:32
actually uh that that there's an
01:36:34
alleviation of of some of that uh
01:36:38
anxiety uh that we have uh uh in the
01:36:42
system but if they don't withdraw
01:36:44
liquidity then you're going to have a
01:36:45
lot of liquidity laying around that will
01:36:48
find its way into prices later on but we
01:36:50
have to trust that the FED is going to
01:36:51
do the right thing uh which is withdraw
01:36:54
that liquidity as trust is restored in
01:36:57
the markets incidentally I uh wanted to
01:36:59
offer my alternative uh interpretation
01:37:02
of the Ted spread or the the spread
01:37:05
between the liore and the the treasury
01:37:08
bill rate um with all of the uh array of
01:37:14
of special facilities that nearly all
01:37:16
the central banks have to take in almost
01:37:19
any kind of collateral that is remotely
01:37:22
good um it's quite possible that what
01:37:25
you're seeing in in the liore market is
01:37:27
only those banks that don't have good
01:37:30
collateral to deal more cheaply at the
01:37:32
fed and so it doesn't mean what it used
01:37:35
to mean it may simply be a reflection of
01:37:38
unease about counterparty risk which is
01:37:40
well warranted in this world where we
01:37:42
well the liar is unsecured that's true
01:37:45
it's uncollateralized but it it's the
01:37:47
fear that these big Banks could go on I
01:37:49
you know if if you know Morgan Stanley
01:37:52
WAMU and all these others can suddenly
01:37:54
go under AIG you begin to is any Bank
01:37:57
completely safe you know if there's only
01:37:59
a 1 2 3% probability that they're going
01:38:02
to go under uh all of a sudden that gets
01:38:05
added to the uh but the good quality
01:38:08
banks are not going there for but if but
01:38:09
you can look at the bankers Association
01:38:11
and look at the at the the rate quote
01:38:14
from all the banks and they were all
01:38:16
about the same the American Banks the
01:38:18
three Americans were a little lower
01:38:20
because probably they did have fed funds
01:38:22
access with some of these Europeans
01:38:24
didn't have but they were all high there
01:38:26
wasn't a big
01:38:28
difference in in the rat they were
01:38:30
borrowing at it though well I I don't
01:38:33
know and that was how but that that
01:38:36
means it's even it it should be
01:38:38
discarded I mean you should you should
01:38:40
price off a Fed funds Target yeah that I
01:38:42
wouldn't disagree yeah because it means
01:38:44
something different than it used to be
01:38:45
yeah absolutely okay question now over
01:38:47
on this side yeah I was just wondering I
01:38:50
mean how much of this I mean the crisis
01:38:52
is an accounting fiction I mean if banks
01:38:54
are able to migrate their asset back
01:38:56
Securities from trading books to I guess
01:38:59
hold to Value um how much of this would
01:39:01
have been avoided and how much of this
01:39:03
going forward um would be
01:39:05
mitigated in my opinion none of it I
01:39:08
mean it it it it Market to Market is not
01:39:12
the cause of this
01:39:14
crisis um this crisis is because Banks
01:39:18
overloaded and leveraged and and
01:39:20
insurance companies in AIG and insured
01:39:23
risky mortgage and housing related debt
01:39:27
that they thought or hoped was not
01:39:31
risky um and and the way you know it
01:39:34
isn't Mark to Market accounting is
01:39:36
because when the FED shopped these firms
01:39:39
around no one wanted them I mean forget
01:39:41
about what you can apply any counting
01:39:42
you wanted to here's the assets here's
01:39:45
liabilities no one would take
01:39:47
them doesn't you know use whatever
01:39:50
counting you think is right but it is
01:39:53
true that nearly every CEO who's gone
01:39:55
down with one of these firms has blamed
01:39:58
two things marketto Market accounting
01:40:00
short yeah and uh I think you're quite
01:40:03
right that neither one of them has had
01:40:05
anything at all to do with the problem
01:40:07
no very good uh sir question yes stand
01:40:10
here first I would like to thank the
01:40:12
panel for the insights provided my
01:40:14
question is are the steps being uh taken
01:40:18
by the fed and government in the last 6
01:40:20
weeks addressing the root cause of the
01:40:22
problem that is the lowering property
01:40:24
prices unless somebody addresses the
01:40:27
lowering property prices the housing
01:40:29
cycle nothing would actually happen
01:40:32
Jeremy actually mentioned the same thing
01:40:34
we are actually facing a liquidity
01:40:36
problem but once liquidity is provided
01:40:39
the problem that comes into the scene is
01:40:42
fear of solvency unless housing cycle is
01:40:46
uh put on its space nothing else nothing
01:40:50
would actually
01:40:51
happen that's my VI
01:40:55
the the the problem is there's a lot of
01:40:58
fixes of proposals out there it's too
01:41:01
slow right now it it it it cannot
01:41:05
they're so complex they cannot be done
01:41:06
with a stroke of a pen we're all going
01:41:08
to Value these at 80 or 70 and the
01:41:10
government will take the remainder or
01:41:11
whatever um and and and to actually
01:41:15
raise housing prices I mean Gody would
01:41:18
need inflation and and all sorts of
01:41:20
subsidies to housing and that's you
01:41:22
don't I don't know know if you want that
01:41:25
and remember that that house prices are
01:41:27
really in some sense an
01:41:28
intergenerational transfer there are
01:41:30
lots of people who are now buying houses
01:41:32
who could not previously afford them or
01:41:34
who were too prudent to overextend
01:41:36
themselves to buy them yes my point on
01:41:38
that is can the government actually sell
01:41:41
these foreclosed houses at maybe 50
01:41:43
cents a dollar to people meaning people
01:41:46
I mean here are people with good cred
01:41:49
score by giving some sort of confidence
01:41:52
this would actually liquidate the Banks
01:41:53
directly by the people's money not by
01:41:56
the government's money and the
01:41:57
government would actually be helping the
01:41:59
people not the big
01:42:02
companies that's what but that's what's
01:42:04
happening in private negotiations
01:42:05
between Banks and and and the Borrowers
01:42:08
is that there is tens of thousands of
01:42:10
short sales going on right now where
01:42:12
someone underwater in their mortgage is
01:42:15
getting permission from the bank to sell
01:42:16
it uh underwater to a new borrower um
01:42:20
that's that's already happening now
01:42:22
whether there should be some overall
01:42:25
structure the government to help people
01:42:27
get a framework for it because it's sort
01:42:28
of an ad hoc basis right now is is
01:42:31
probably a good question but that's
01:42:33
what's happening taking that just a bit
01:42:36
further I think the way the government
01:42:38
usually does this is part of the problem
01:42:42
they usually do it by encouraging people
01:42:44
to over leverage so if you have an FHA
01:42:48
mortgage or if you have uh something for
01:42:50
Fanny or Freddy what they basically do
01:42:52
is allow you to take a more leverage
01:42:55
loan than than you actually should if
01:42:57
they really want to help people own
01:43:00
homes and keep them they really should
01:43:02
be subsidizing their Equity stake in the
01:43:05
home and uh so far Congress hasn't
01:43:08
wanted to face up to that because that
01:43:09
would mean allocating the funds and
01:43:11
actually having to uh pay for it on the
01:43:13
out of taxes but uh if we really wanted
01:43:16
to do it right I think that's what we
01:43:18
should do and have a much more stable
01:43:20
system I should point out that um um
01:43:23
there's an additional problem that
01:43:25
Jeremy and I have talked about um
01:43:27
directly which is the mortgages which
01:43:29
have been securitized which is a large
01:43:31
proportion of the mortgages in that case
01:43:34
um there's no one that you can negotiate
01:43:36
with because the mortgages are are split
01:43:39
up in so many tches and they're owned by
01:43:41
so many different people technically
01:43:43
it's a very difficult thing for the even
01:43:46
if we had a government program that said
01:43:48
let's go in and buy these mortgages uh
01:43:51
what exactly how do how do we actually
01:43:52
do this yet um if we have one bank we
01:43:55
can go to the bank and say Let's Make a
01:43:57
Deal Let's Make a Deal uh we're going to
01:44:00
have the owner pay something for the
01:44:01
house and you won't have an abandoned
01:44:04
house that's something that's feasible
01:44:07
but uh when they're securitized you you
01:44:10
have to realize how much securitization
01:44:12
has changed even this simple problem of
01:44:15
subsidizing mortgages there was a
01:44:17
serious attempt in Congress uh to
01:44:20
broaden the scope for um the um agents
01:44:25
that were servicing these mortgages to
01:44:27
renegotiate them and it was pretty much
01:44:29
stopped dead in its tracks by uh a
01:44:32
number of investors who said look if you
01:44:34
tamper with this again we're never again
01:44:37
investing in securitized mortgages that
01:44:40
you'll change the payment priorities
01:44:42
that we were counting on you're
01:44:44
expropriating what were our property
01:44:46
rights and um so it didn't really get
01:44:49
very
01:44:50
far think we have time for one or two
01:44:52
more more questions if they're quick
01:44:54
questions and responses is there a has
01:44:56
microphone been given to anybody in the
01:44:58
middle okay hi uh thanks for your
01:45:00
thoughts um given given sort of the real
01:45:02
erosion in in wealth particularly in the
01:45:04
part of the American Consumer um and
01:45:07
starting to think about you know the
01:45:08
next steps of this thing which is sort
01:45:09
of a a consumer Le recession globally um
01:45:13
what steps from uh a perspective Pro
01:45:17
prescriptive or restorative standpoint
01:45:19
can the government take to step in I
01:45:21
guess um act as that sort of you know I
01:45:24
guess buyer of Last Resort for lack of a
01:45:26
better
01:45:29
term and this is a really difficult
01:45:31
question I mean you're a big question
01:45:33
people are asking um you know is the
01:45:36
savings rate going to suddenly rise now
01:45:39
because with with you know the days of
01:45:41
easy borrowing and lending are over the
01:45:44
consequences of over leverage are are
01:45:46
are now very
01:45:48
apparent um you know what happens if the
01:45:50
household in the US suddenly goes to a
01:45:52
two for 6% savings rate like we had in
01:45:55
the 90s or even higher as we had even
01:45:58
before um that that's a big
01:46:01
downward shock uh to aggregate
01:46:05
demand um and I mean and and it's I mean
01:46:11
the only thing that I can see and not
01:46:13
that I like it but you're going to have
01:46:14
to use you know
01:46:17
tax uh tax policy or fiscal policy of
01:46:20
some sort to to try to offset some of
01:46:22
that
01:46:23
shock I mean it's interesting to look at
01:46:26
what happened in Japan and uh because
01:46:28
they tried to do that with you know some
01:46:32
success but um we would end up with even
01:46:35
a bigger debt at the end but maybe we'
01:46:37
keep the economy moving a little bit
01:46:39
further I would like to know what other
01:46:40
panelists think about that if if they've
01:46:43
thought about that
01:46:47
issue well in fact we have a huge amount
01:46:50
of empirical evidence this is um not a
01:46:53
unique problem we've had housing created
01:46:56
financial disasters uh in at least 100
01:46:59
countries around the world and the world
01:47:01
bank has actually done a lot of pretty
01:47:03
serious research on what works and what
01:47:06
doesn't and what seems to work best is
01:47:09
to um take your write Downs early on to
01:47:12
try to um uh separate the good assets
01:47:15
from the Bad Assets to sell off the Bad
01:47:17
Assets even if they're at very low
01:47:19
prices and get them back into the
01:47:21
economy and um you have sort of it's in
01:47:25
a sense a sort of shock treatment but it
01:47:28
seems to um lead to Greater speed in
01:47:32
recovery um and uh less of a a fall in
01:47:36
per capita income over
01:47:38
time okay uh is one more question is the
01:47:42
microphone over here yes uh hi we have a
01:47:46
very large uh fiscal deficit right now
01:47:49
and I was wondering what role like we're
01:47:52
Bor borrowing so much from China what
01:47:54
role does that play if any in the um or
01:47:59
what role will it play um in the current
01:48:03
economic crisis well I think it's just
01:48:05
natural um in a recession that the
01:48:08
fiscal deficit deteriorates quite
01:48:10
marketly last year's fiscal deficit
01:48:12
strangely enough was not very large uh
01:48:15
it had been coming down during most of
01:48:17
the years the Bush Administration after
01:48:18
initially Rising sharply with the tax
01:48:20
cuts uh last year
01:48:23
the uh deficit fiscal deficit Federal
01:48:26
fiscal deficit as a percentage GDP was
01:48:28
only
01:48:29
1.2% uh this year it's going to balloon
01:48:31
like crazy it's going to be even worse
01:48:33
next year and that's a cyclical movement
01:48:36
that always happens during recession and
01:48:38
what happens after the recession is
01:48:40
revenues tax revenues start to rise
01:48:42
government
01:48:43
expenditures uh involved with the
01:48:45
recession start to decline and the
01:48:48
fiscal situation improves there's a
01:48:50
longer run deficit problem which is the
01:48:52
only what I worry about I don't worry
01:48:54
about the the cycal deficit what's the
01:48:56
big deal we have a a very substantial
01:48:58
lent uh borrowing capacity in the
01:49:00
federal government what I worry about is
01:49:02
the longer term and that's due to the
01:49:04
entitlements and the Aging population
01:49:07
and we all know that that's very serious
01:49:09
problem if I were advising the new
01:49:11
president what I would say is focus on
01:49:13
that ignore the short-term fiscal
01:49:15
problems but try to do something with
01:49:17
entitlement reform the last few
01:49:19
presidents have ignored it um and are
01:49:22
future fiscal situation is going to be
01:49:25
very serious sometime later in the next
01:49:28
decade uh Social Security revenues fall
01:49:30
short of Social Security expenditures
01:49:33
and the medical medical sit situation in
01:49:35
this country is is horrendous the
01:49:38
government expenditures on medical care
01:49:39
they're going to grow as my generation
01:49:42
retires um is going to get more and more
01:49:44
serious we have the baby boom population
01:49:46
getting close to retirement um it's
01:49:49
going to get worse and worse and worse
01:49:50
this is worse in other industrial
01:49:52
countries but you know only but
01:49:54
comparison um that's the fiscal deficit
01:49:57
problem we have it's not the current
01:49:59
cyclical deficit problem that'll go away
01:50:01
with the recovery what about the current
01:50:03
deficit current account deficit current
01:50:05
account deficit is an absolutely
01:50:07
different question and and I I I refrain
01:50:09
from answering the question about
01:50:11
savings because I'm actually in favor of
01:50:13
a substantially higher savings rate in
01:50:15
this country that's the one thing that
01:50:17
could have a substantial impact on the
01:50:19
current account deficit and um I don't
01:50:21
know whether I'll believe it will come
01:50:23
but at some point the American Consumer
01:50:25
is going to have to save more uh and
01:50:27
that's really going to turn around the
01:50:28
current account deficit nothing like a
01:50:30
credit crunch to do that that's right
01:50:33
hopefully it will do it we'll see I mean
01:50:35
I certainly hear you know a lot of
01:50:37
rhetoric during the last few years about
01:50:39
the Chinese buying our debt I mean keep
01:50:42
in mind that's a good thing I mean a
01:50:43
couple years ago when everybody's
01:50:45
worried about the fixed exchange rate
01:50:47
when I was in China talking to their
01:50:49
equivalent of SEC treasury secretary I
01:50:51
personally thank them for buying our our
01:50:54
debt at inflated prices it's a it's a
01:50:56
nice little transfer to the US Treasury
01:50:58
I mean what would you rather have not
01:51:01
high demand for our debt I mean that
01:51:03
would have mean higher interest rates
01:51:05
that we' have to pay so this is this is
01:51:07
a good thing in terms of the entitlement
01:51:09
problem I I think we all in agreement
01:51:11
that's the big train wreck I mean and
01:51:13
that's something that we have to deal
01:51:15
with the one thing I guess um I I would
01:51:18
in terms of the previous question that
01:51:20
dealt with that that really I think
01:51:23
still answered is what could potentially
01:51:26
happen I think it's quite possible we
01:51:29
could have very high inflation rates we
01:51:32
could have um a default in real terms
01:51:35
through inflation monetization of of our
01:51:38
debt I think it's inevitable that
01:51:40
Congress typically will wait till the
01:51:42
crisis is eminent in this case however
01:51:45
it that will be simply way too late uh
01:51:48
every year I mean if they if we talk
01:51:51
about accounting and accounting
01:51:52
standards the US accounting Federal
01:51:55
accounting uh budget it um is is
01:51:59
completely fraudulent accounting system
01:52:02
I mean it's it basically makes Enron
01:52:04
accounting look at pristine I I remember
01:52:07
mentioned that in Congressional
01:52:08
testimony both Republicans and Democrats
01:52:10
no one followed up because you know
01:52:12
Democrats want to spend more money
01:52:14
Republicans want to do tax cuts
01:52:15
everybody is an agreement with a fraud
01:52:17
on accounting scheme in Washington I
01:52:19
mean if you measured the deficit
01:52:21
correctly it wouldn't be $400 billion or
01:52:24
$5500 billion would be about $2.5
01:52:26
trillion if you did it right and the the
01:52:28
fact of the matter is we this is this is
01:52:30
the serious problem and the one or two
01:52:33
trillion dollars that we spend on this
01:52:35
uh subprime mess it's it's in the
01:52:37
tracking era of any estimat um
01:52:39
associated with the with the entitlement
01:52:41
shortfalls i i i sometime point out the
01:52:44
only time anyone is going to worry about
01:52:46
the deficit is if interest rates start
01:52:48
Rising as long as there's an appetite
01:52:50
for the debt you'll never get any action
01:52:55
ever okay well final word Yeah final
01:52:58
word you got
01:52:59
it well uh one of the true benefits of
01:53:02
being at the University of
01:53:04
Pennsylvania's Wharton School is that we
01:53:05
have faculty like the four here uh the
01:53:07
representative of the kinds of
01:53:09
colleagues I interact with and you take
01:53:10
courses from uh it's a it's a real
01:53:12
privilege to have you share your wisdom
01:53:14
and knowledge and expertise on uh
01:53:17
economic and financial matters that are
01:53:19
the most critical of our time so thank
01:53:20
you very much for your time and
01:53:21
generosity
01:53:23
[Applause]
01:53:26
for more information please visit
01:53:28
knowledge. won. up.edu
01:53:31
[Music]
