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Executive Education for more information
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[Music]
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although the subprime crisis seems to be
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showing some signs of easing debate over
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what caused it whether it could have
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been prevented and how long it might
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last will continue for some time to come
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knowledge at Wharton asked Wharton
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Finance Professor Marshall Bloom for his
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perspective on the latest economic
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developments welcome Professor Bloom
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thank you it seems odd I think to a lot
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of people that a problem that originated
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with a just a slice of the housing
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market uh has evolved this way to
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Encompass not only many any types of
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mortgages but other types of debt
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Securities that seems to be spilling
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over and affecting the the uh financial
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markets and and other countries as well
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uh how does this happen how does it
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evolve uh to be so big well you have to
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go back a little bit we actually had a
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liquidity bubble uh anybody could obtain
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uh funds at very cheap prices as a
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matter of fact it was a savings clut and
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in the it was going to be punctured the
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question is how it was going to be
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punctured and there were whole factors a
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perfect storm actually of factors that
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came together that created the problems
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in the subprime market and it was the
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most fragile um the uh there were a lot
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of government
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policies um Global events that uh
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created that uh situation uh you you
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used to have to borrow uh on a mortgage
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you had to pay uh something down now you
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don't have to do that as a matter of
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fact uh some of the mortgages were uh
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over were over the appraised value of
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the houses
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um this was actually a government policy
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both the house and the Senate
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Republicans and Democrats think
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homeownership in the United States is a
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good
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thing uh on top of that you had
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a a tax program for corporations which
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encourag them to issue debt they issued
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lots of debt some of that debt as as
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issued uh the debt it became lower and
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lower quality there are also some
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institutions that require high quality
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but for regulation or uh for U just that
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they always had it like insurance
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companies so what what did all this um
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amount to well brokerage firms figured
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out a way of taking this uh uh excess
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debt uh subprime mortgages and
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repackaging it making a lot of money in
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the process and selling it to to um
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insurance companies and the like um so
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that there was a a machine being uh
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developed which created just a fantastic
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amount of this uh really junk uh and it
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was being repackaged as high quality and
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at some point that had to explode now
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one of the things in the description of
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the perfect storm that I've heard fairly
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often is that people say well the
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problem is we had three events occur
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that don't usually occur together and
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that is that uh these Securities were
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predicated on the belief that uh
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interest rates would stay very low uh
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that housing prices would continue to
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rise and that people's incomes would
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rise enough so that they could cover the
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higher payments when these adjustable
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rate loans reset down the road but it
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doesn't seem all that unlikely for these
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events these conditions to change
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because interest rates were
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exceptionally low and they just went
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back to normal housing prices were
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clearly in a bubble and they just fell
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back to normal I mean was was this
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implosion something that the people who
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are involved in this market should have
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foreseen uh they might have foreseen I'm
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sure that some foresaw it but again if
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you can make money get rid of the risk
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yourself uh you make a lot of money in
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doing that I uh firms like
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Countrywide uh made money by uh selling
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uh
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mortgages and then they would get rid of
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them now you and the same thing would be
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true at the investment banking firms
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although they were stuck with little
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inventory at the end it's like a Ponzi
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scheme what one of the things that that
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seems curious to me about that is that
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if if many of the participants knew that
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these were risky things but but they saw
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a chance to make a great deal of money
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uh they must have anticipated that it
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would fall apart later and there there
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it seems to me that uh there had to have
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been a great financial incentive to make
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it quickly make the money quick quickly
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and the future would just take care of
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itself is is there something skewed in
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the compensation system in all of these
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lines of business that contributed to
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this well you always have to uh pay
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people to do things but you have to
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ultimately have a buyer of these
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tranches of these uh uh with
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alphabetical soup uh sivs
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Etc no SP special per SP special purpose
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entities uh you have to have uh somebody
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who wants to buy them well now the
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Credit Agencies come in and they say
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these are
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AAA well you know they're AAA that's
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good uh so people buy them and they
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could even get a higher yield than on
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other aaa's that should have told them
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something but they still bought them
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right if it's too good to to believe you
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shouldn't believe it right correct
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sounds too good to be true um you've
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done a lot of of work on on the
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evolution of of the financial markets
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the exchanges themselves uh and in
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recent years there's been dramatic
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change in uh both the lines of business
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that various exchanges are in which used
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to be separated either geographically or
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with the types of Securities they traded
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or in some other way now they're all
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sort of it seems to me blending into one
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another's business we have mergers that
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are even taking a place across oceans uh
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has this blending of these Mar markets
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contributed in any way to the kinds of
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uh aftershocks we're seeing and the the
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enlarged effects we're seeing from this
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subprime mess well I think there's
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um the what was happening is the
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regulatory uh framework has not caught
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up uh we in this country we regulate
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Futures differently from stocks but I
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can uh package as a financial engineer
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uh a derivative that looks just a
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derivative which behaves just like a
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stock a stock that behaves like a
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derivative uh so there's been a melding
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of these instruments um which has
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created a lot of liquidity uh in the uh
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economy but uh it's not being regulated
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as well as it should because the
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regulation hasn't caught up with the uh
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technology and and just to explore that
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a little further uh for example you have
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a stock that's going to behave in a
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certain way and historically that's
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that's predictable uh certain factors
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will affect it and then you have a
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derivative that will behave somewhat
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differently but is based on what the
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stock does and and they may be traded by
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entirely different groups of people or
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there may be overlapping groups of
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people but the point is that what
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happens to one of them will feed back
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into the other is that correct well
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certainly uh we used to think that there
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was a primary of security like a stock
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and all the derivatives but the
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derivatives actually are more liquid
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today so they may be driving the stock
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prices uh but I can also create a
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derivative whose returns are exactly the
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same as a stock and it's called a
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derivative mhm and what would be the
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purpose of that if you have the stock
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why bother it's cheaper to trade it's
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liquidity see I mean uh you don't we
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have very high volumes in all these
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markets uh the reason is it's cheap to
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trade and if you have a an inkling that
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something is mispriced by a mill of or
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Penny you go and you can trade it now
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and you can make a profit on the
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difference yeah you pick up the nickels
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and the dimes and the pennies and when
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you do it in hundreds of millions of
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dollars or billions So eventually it's
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real money yeah so you know you pick up
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a 20 up nickel you got a dollar and so
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on now you talked about uh and I think a
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lot of people have been looking at the
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question of whether the regulatory
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system which has roots going back 60
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years and has been put together peace
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meal over time is really up to the task
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today and are there gaps in it and what
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do you think need to be uh done to fill
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them if there are we have uh first of
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all gaps in uh or differences in
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regulation in this country is between
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Futures and stocks and the the sec's
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uh uh dictate is to protect the small
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investor well the small investor isn't
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here anymore but they still try to
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protect them uh the uh future regulation
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is more designed for sophisticated
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invest ERS so you have a gap there
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people can take advantage of it and then
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you've got differences between Europe uh
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Asia and the United States regulation
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they don't always talk to each other so
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much they're a big gaps one of the
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arguments that comes up a lot when when
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you hear people talking about new
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regulation for the US markets is well
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they're not doing it overseas we'll lose
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all our business companies will list
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their stocks overseas instead of in New
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York and that sort of thing is that a
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legitimate worry or is that just an
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excuse to avoid regulation it's
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a one it's a worry it's a not a worry uh
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some people would argue that our better
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regulation in this country presumably
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better regulation encourages companies
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to list here because they have a cheaper
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cost of money than if they listed just
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in a foreign country now that is some
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what debatable but it might be the case
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so you can say good regulation is
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actually good for uh uh companies now it
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is true that we may be overregulation in
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Silly Ways in this country and what are
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those uh sarban Oxley uh
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requires a a lot of
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paperwork and some of that paperwork may
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not be
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valuable but uh corporations have to do
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it boards have to do it and that was a
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result of the Enron period that sarban
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oxid came yes that was passed quickly uh
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and it wasn't a well vetted Bill and
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there's some certain features of it are
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very good and some are not now one of
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the effects of this sort of
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globalization and mixing of all of these
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financial markets and institutions is
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that it's much easier for people around
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the world to trade Securities from
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places half a world away do do do
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International investors have a good
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enough idea of what it is they're buying
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and selling uh when they deal with some
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security that was created 6 or eight or
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10,000 miles
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away well I think they have as good a
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knowledge as our people in this country
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which uh which the evidence shows uh
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some people have got hurt in both
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countries here and there so so a lot of
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people thought they were taking less
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risk than they were in well a lot of
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that had to do with the rating agencies
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I mean the that was a an example of
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systemic uh uh effects uh the mar the
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the rating agencies consistently
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underrated the risk of some of these
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derivatives and was this because they
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didn't understand them or their
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conflicts of interests in their
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relationship with the firms whose
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Securities they're rating or what oh I'm
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not sure they UND misund well certainly
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there wasn't I don't think
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fraud uh there was
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a uh this was an instrument that did not
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have a lot of
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history uh therefore they didn't really
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understand the risks so they made some
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assumptions and those assumptions turned
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out to be uh uh optimistic and do you
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think that this is something that they
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will remedy on their own they obviously
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got a black eye over this or does some
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agency need to step in and say you will
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do this from now on no I you know
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investors are very smart they only get
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burned once and uh they got burnt burned
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once in each way I take right other ways
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are always waiting around the corner oh
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no they'll be burned again but but I
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mean we you know we had the uh SNL uh
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disaster a long time ago um you don't
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have any problem there anymore now at at
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the other end of the spectrum we've
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talked about the the sort of the big
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companies the big players and and
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investors but at the other end there are
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homeowners and there are various
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proposals floating around in in
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Washington now for helping them in some
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way and they they range from things like
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uh uh helping them to refinance to fixed
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rate loans at lower rates to postponing
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the sets that will cause their monthly
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payments to rise to buying the
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Securities from their owners and
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rewriting them and all sorts of exotic
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things do you think that that that some
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sort of I hate to use the word bailout
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but bailout is necessary for
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homeowners
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um I do a bailout of homeowners is a
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bailout of the lenders whenever people
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say they're going to bail out the
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homeowners they're bailing out the
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lenders and that creates a horrible
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president now many of these uh
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homeowners uh didn't put much down so
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they're not going to be losing very much
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of the homes are in default of the
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lender's will and that's probably where
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where it should be now having said that
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there were certainly cases of fraud uh
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and uh there should be remedies for that
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type of U
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situation now finally what is your
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assessment of the federal reserve's
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response to all of
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this uh the Federal Reserve had has uh
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opened up new
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avenues uh which we're going to have to
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see how they work out I mean if I were
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now lending to a brokerage firm or an
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investment Bank in a subordinated debt I
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would say I don't really have to worry
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about doing too much research because if
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thing goes down they'll bail me out just
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like they do with beer
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Sterns and uh and you're including in
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this uh not just the baale stern
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situation but they they've been doing
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things like uh lending out treasury
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bonds and taking mortgage obligations as
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collateral and that sort of thing A lot
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of people are in favor of that they
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think this has restored liquidity and
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presented a do prevented a domino effect
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that would have been worse but I take it
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you don't agree with that no this is the
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problem uh in the short run is certainly
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uh helped um we don't know the
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counterfactual what would have happened
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had they not done it there was a lot of
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risk about what might happen if they had
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not done it
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by doing what they did they reduced that
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risk now whether they in the long run it
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will hurt the economy I'm not sure or
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hurt theii functioning of the financial
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markets I'm not sure so the real test
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will be in the future to see whether
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financial institutions sort of take
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advantage of this to do something
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excessive again uh I wouldn't say
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that all right well thank you very much
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profor very good
