00:00:00
[Music]
00:00:15
we're back and we've been joined by
00:00:17
Wharton Finance Professor Franklin Allen
00:00:19
welcome well uh since the fanny Freddy
00:00:22
story which was about a week ago we've
00:00:24
had all sorts of events AIG is in
00:00:26
trouble Leman is collapsed and
00:00:29
apparently going going out of existence
00:00:31
maril Lynch being taken over by Bank of
00:00:33
America
00:00:35
uh we don't know that all this would
00:00:38
have happened but is this a surprise and
00:00:40
is this the end do you think we're going
00:00:41
to see uh more and more of these
00:00:44
Financial companies going under or we
00:00:45
getting to the end of it so my answer to
00:00:48
that Jeff would be we're we're not going
00:00:52
to at the end of it yet we've got some
00:00:54
way to go what's driving this is the
00:00:56
fall in property prices and I'm not the
00:00:58
expert suan the expert on that but my my
00:01:02
view would be that's still got a a ways
00:01:04
to go and as long as that keeps
00:01:05
happening then we're going to have more
00:01:07
and more problems so I think we've got
00:01:09
some big problems coming up so AIG is
00:01:12
the next one that is in trouble and I
00:01:15
think uh it may well go under it may
00:01:18
survive but it may well go under let me
00:01:20
ask about AIG is is this a case unlike
00:01:23
Leman of a company that's too big to
00:01:25
fail where once again we're going to
00:01:27
have to see the government or somebody
00:01:29
do something to preserve this company
00:01:32
Susan well I think that Leman uh was
00:01:35
obviously not too big to fail and also
00:01:37
we need to have examples of companies
00:01:40
that are not too big to Veil because
00:01:41
otherwise moral hazard will be not only
00:01:44
with us for long time to come but right
00:01:46
now there are decisions being made right
00:01:49
now which um uh which will make things
00:01:52
harder if there's an assumption that the
00:01:53
government is just going to step in so
00:01:55
these are painful moments but we do need
00:01:57
to have the downside risk in order to
00:02:01
make decision making accountable uh is
00:02:04
is AIG too big well AJ has implications
00:02:08
internationally it's not just a US
00:02:10
company and um right now there are
00:02:14
discussions going on and I I don't know
00:02:16
that anybody knows how deep and
00:02:18
difficult a resolving AIG bankruptcy
00:02:21
will be than um I think Susan raises an
00:02:25
interesting point and that is um why was
00:02:30
it that Layman was not too big to fail
00:02:32
but Bear Sterns was because Bear Sterns
00:02:35
was a fraction of the size of layman and
00:02:39
uh one wonders exactly why the treatment
00:02:41
was
00:02:42
different um one can speculate that the
00:02:45
FED uh was taken by surprise with Bear
00:02:48
Sterns um looking back at credit default
00:02:51
swaps and the exposures and the The
00:02:54
Leverage of be Sterns one wonders why
00:02:57
they were so surprised but they were but
00:03:00
since the time of be Sterns they have
00:03:02
had teams of examiners in all of the
00:03:04
major investment Banks day by day and
00:03:08
one hopes they've done their homework to
00:03:10
know exactly where the spillovers are
00:03:12
likely to happen and that embolden them
00:03:16
to try an experiment with Layman which
00:03:18
is a substantially larger institution
00:03:20
than bear that they were unwilling to to
00:03:22
try with bear however Susan's moral
00:03:26
hazard point I think plays out even in
00:03:29
layman's difficulties because the
00:03:32
prospect that the treasury and the FED
00:03:36
would blink at the end led to a poker
00:03:39
game that was very very difficult for
00:03:41
Layman to find a partner people held out
00:03:44
until the very last moment they didn't
00:03:46
necessarily believe that banki and
00:03:49
Paulson would not bail out Layman and so
00:03:51
it really was until Sunday morning that
00:03:53
you saw the the two potential biders
00:03:56
withdraw and um that's one of the ca of
00:04:00
of the moral hazard that if the
00:04:02
government intervenes they set up
00:04:04
expectations they'll do it again just to
00:04:06
confirm just to say just i s interrupt
00:04:07
at AIG I think the same sort of thing is
00:04:09
happening just as we speak that AIG I
00:04:12
I'm not on the inside of this at all but
00:04:15
uh certainly rumors that there were some
00:04:17
who were coming to make offers and they
00:04:19
were turned away because the offers
00:04:21
weren't as good as maybe a bailout
00:04:23
situation might be so just now we have
00:04:26
it's almost a Russian Roulette situation
00:04:28
where some may be saved some may not
00:04:30
nobody knows which is which is that
00:04:32
right well you can that's the way
00:04:35
Central Bankers would like you to feel
00:04:37
about it they call it constructive
00:04:38
ambiguity I think it's quite destructive
00:04:41
because I think it's quite easy to
00:04:42
figure out which institutions in general
00:04:45
they're going to to deal with AIG is a
00:04:49
very interesting case because the
00:04:51
subsidiaries are perfectly solvent it's
00:04:53
the holding company that's having
00:04:55
difficulty and because of the peculiar
00:04:58
way in which life insur which insurance
00:05:00
is regulated in the United States
00:05:02
there's no regulator with overall
00:05:04
oversight of the company there's in fact
00:05:06
nobody who has an overall oversight but
00:05:09
you have individual
00:05:10
subsidiaries that are regulated in each
00:05:13
of the 50 states and in each of the
00:05:15
countries in which they work now what is
00:05:17
the duty of those supervisors well first
00:05:20
and foremost it is to protect the assets
00:05:23
of that subsidiary for the benefit of
00:05:26
the policy holders in that domain
00:05:30
and so there's an enormous reluctance to
00:05:32
let the
00:05:33
excess Assets in those subsidiaries be
00:05:37
Upstream to the holding company to meet
00:05:39
this uh uh kind of demand um there are
00:05:44
lots of solutions for potentially for
00:05:49
AIG that that um I think were more
00:05:52
difficult for the others they have more
00:05:55
things that are easy to Value um you
00:05:58
have Warren Buffett sitting out out
00:05:59
there who'd be happy I think to take
00:06:01
them over who does this kind of business
00:06:03
anyhow and has pockets deep enough to
00:06:06
actually Supply the funds um you have uh
00:06:10
private Equity concerns that for
00:06:13
regulatory reasons can't take over US
00:06:16
Banks but could in fact take over an
00:06:19
insurance company with no problem at all
00:06:21
or parts of an insurance company what I
00:06:24
think we're going to see happening is
00:06:26
that uh the parts of AIG that are easy
00:06:29
to sell are going to get sold pretty
00:06:31
quickly it's going to be a smaller
00:06:33
company um but um uh one hopes it
00:06:36
survives apart from the holding company
00:06:39
the subs are not subject to the same
00:06:42
kinds of pressures that investment Banks
00:06:44
and Commercial banks are subject to they
00:06:46
in general have liabilities that are
00:06:49
long-term they're not subject to runs in
00:06:52
the way that we've seen Layman and beer
00:06:55
Sterns and and Banks
00:06:57
classically um and so they usually have
00:07:00
more time to deal with it liquidity is
00:07:02
not usually going to bring them down
00:07:05
except that the holding company got
00:07:06
deeply involved in ensuring credit
00:07:09
default swaps and in the mortgage Market
00:07:13
um and that is um a source of liquidity
00:07:18
pressure the fact that they were
00:07:20
downgraded last night I guess it was two
00:07:22
notches some people feared it would be
00:07:23
three set off Clauses that permitted
00:07:26
counterparties to demand more collateral
00:07:29
and that's the source of of their urgent
00:07:32
demand need for more cash um and as in
00:07:36
all of these cases in the end it's it's
00:07:38
a fierce bargain between those who've
00:07:40
got cash including the government and uh
00:07:44
those who need it and um having some
00:07:47
clarity about whether the government
00:07:49
will step in or not I think would make
00:07:52
the whole thing resolve a lot more
00:07:53
quickly what's the systemic risk that
00:07:56
dick from allowing them to go down well
00:07:59
they are the insurer of um a lot of
00:08:03
credit default swaps that's is but
00:08:05
that's also true of layman brothers and
00:08:08
um the um answer is that you know it
00:08:12
won't be a total loss it would probably
00:08:14
mark down the value of those swaps maybe
00:08:17
20 cents and in the end the yeah so in
00:08:20
other words if they can't make good on
00:08:22
the insurance then somebody else loses
00:08:24
money some other and many banks and
00:08:26
these will be European banking
00:08:27
institutions are
00:08:29
but speaking of European banking
00:08:31
institutions and following up on
00:08:32
Franklin's theme that we're not through
00:08:34
this yet if you look at where the
00:08:36
subprime is held almost half of it is in
00:08:39
Europe in fact most of the losses are in
00:08:41
Europe not and the difference in
00:08:43
reporting between the United States and
00:08:46
Europe has made us institutions
00:08:49
recognize those losses more rapidly uh
00:08:52
they're considerably more
00:08:54
transparent the Europeans are also held
00:08:57
to a fair value standard but because
00:08:59
they have sort of principles based
00:09:00
accounting rather than the bright line
00:09:03
rules the CFO has a lot of judgment
00:09:06
about what standards he uses for
00:09:08
valuation and when he actually talks
00:09:11
about when the loss was suffered so um
00:09:15
we know there are lots of shoes to drop
00:09:17
and they may be Europe a lot of those
00:09:19
are in how about Asia very little of it
00:09:22
was sold in Asia that the only the the
00:09:25
surprising link to Asia quite frankly
00:09:27
was the loans to Layman Brothers yes it
00:09:30
was big time especially Korea South
00:09:31
Korea's Market down substantially today
00:09:34
and and we we uh read so much about uh
00:09:36
the the interlocking of the economies
00:09:39
and the financial markets in between
00:09:41
China and the US and India and the us
00:09:43
and we all we're all connected in
00:09:45
different ways are are they going to
00:09:47
suffer from what we're doing China and
00:09:48
the US came into this in a very
00:09:50
interesting way because one of the very
00:09:52
largest holders of Fanny and Freddy debt
00:09:56
is China and one of the tough questions
00:09:59
that Paulson is facing I assume this
00:10:01
afternoon because I think they hearings
00:10:02
on it is why did he protect Chinese debt
00:10:08
holders while letting small and
00:10:11
medium-sized US Banks suffer who were
00:10:14
holding preferred shares and thought
00:10:16
they were equally safe because the
00:10:17
government was telling them that they
00:10:19
they had the same sort of capital charge
00:10:22
there was really the run on Fanny and
00:10:24
Freddy were was in some ways started in
00:10:27
China and the the selling of the debt
00:10:30
there which should normally trade very
00:10:32
close to treasury that those spreads
00:10:34
were widening and China was selling and
00:10:37
that really provoked uh the necessity of
00:10:40
stepping in but I agree this is going to
00:10:41
be a difficult uh set of questions that
00:10:43
he's facing today and how about India
00:10:46
they're a big player in the
00:10:47
international economy are they involved
00:10:49
I mean if we we all go into deep
00:10:51
recessions they're not going to be too
00:10:53
happy so I think it it depends a lot how
00:10:55
bad things get but I think in a way it
00:10:58
it sets back back the case for financial
00:11:01
reform in India which they desperately
00:11:02
need in a major way because now they can
00:11:05
point to the rest where the US in
00:11:07
particular and say look what a terrible
00:11:09
mess they've made with their Innovations
00:11:11
and liberalized standards uh our direct
00:11:14
controls have kept us out of this
00:11:17
Whirlwind of financial chaos and um
00:11:22
India has a real problem in allocating
00:11:24
Capital efficiently because it's
00:11:27
controlled by state own banks that have
00:11:31
multiple objectives but it isn't
00:11:33
necessarily who can use the money most
00:11:36
efficiently and they do have
00:11:37
subsidiaries AIG subsidiaries in India
00:11:40
will be under pressure so they'll have
00:11:42
some real job losses real impact they'll
00:11:44
be able to point to it and turn to it in
00:11:46
terms of these questions of Reform which
00:11:47
I absolutely agree with dick Herring on
00:11:50
these are this is throughout the world
00:11:52
people are asking reform to what and
00:11:55
these this move to reform Financial
00:11:58
systems that were stated
00:11:59
are are now being called into question
00:12:01
don't you think it's a valid point
00:12:03
though it is true that we are going
00:12:05
through this terrible crisis and who
00:12:07
knows where it will lead but it could
00:12:09
well get a lot worse and one may wonder
00:12:12
what exactly went wrong and maybe we
00:12:14
have some problems with the way we
00:12:16
regulate or deal with makes kind of hard
00:12:17
for hard for us to scold the rest of the
00:12:19
world about the way they behave doesn't
00:12:21
it well Franklin when you and I talk
00:12:22
about this uh months ago back in the
00:12:25
spring you felt that the subprime
00:12:27
mortgage crisis was reminiscent of some
00:12:29
of the things that happened in Japan a
00:12:31
while back uh and I wonder if you still
00:12:33
felt that way with all that's happened
00:12:34
since yes I think it's it's very
00:12:37
reminiscent of that they had a property
00:12:39
bubble and a stock price bubble and
00:12:41
we've had a stock price bubble and when
00:12:44
they tried to save the reaction to that
00:12:45
we had a property price bubble and now
00:12:48
it's burst it's caused similar kinds of
00:12:51
problems I think we had a much more
00:12:54
dramatic effect for some of the reasons
00:12:56
that dick was mentioning a few minutes
00:12:58
ago ago about our accounting system
00:13:01
requiring people to keep much
00:13:04
more should I say honest or much closer
00:13:07
tabs onto what's actually happening
00:13:09
whereas in Japan they were able to
00:13:12
essentially ignore those problems use
00:13:14
tax losses and things to keep the banks
00:13:17
solvent in some sense and we aren't and
00:13:20
we what we're seeing is a lot of
00:13:22
problems because of that in Japan that
00:13:24
spilled into the real economy and they
00:13:26
had the last decade and the big question
00:13:29
in the US is whether the same thing's
00:13:31
going to happen is whether this is going
00:13:32
what do you think we should sort of take
00:13:34
away from the Japanese experience about
00:13:37
what needs to be done to handle this
00:13:38
kind of Crisis so it's well the first
00:13:40
thing we should take away is that we
00:13:42
shouldn't have got here in the first
00:13:43
place and we should have looked much
00:13:45
more closely at this fact that if you
00:13:47
have bubbles it causes big problems when
00:13:50
they burst and I think we had that
00:13:52
debate back in 2000 2001 in the US the
00:13:56
FED decided that it was a problem and we
00:13:59
shouldn't worry about it and this is the
00:14:02
Buble the bubble burst there was a
00:14:04
question of should they have raised
00:14:05
interest rate earlier to burst it their
00:14:08
conclusion was it's difficult to know
00:14:09
whether you're in a bubble or not we
00:14:10
didn't worry about it then we had the
00:14:13
property bubble because they kept
00:14:14
interest rates low and now we're having
00:14:16
the Fallout from that so that would be
00:14:18
the first thing we have to revisit that
00:14:20
issue very urgently and then given that
00:14:23
we're in it what does the Japanese
00:14:24
experience tell us about getting out
00:14:27
it's very difficult and it's not clear
00:14:29
to me that there are any easy solutions
00:14:32
to that so quite what we do as we go
00:14:36
forward it's very difficult to say
00:14:38
whether we should pump Capital into the
00:14:40
financial institutions whether we should
00:14:42
save them to to to prevent to meltdown
00:14:45
like in Scandinavia for example these
00:14:48
things take a long time and they're very
00:14:50
painful once you get there there are no
00:14:52
no easy solutions I I would disagree in
00:14:55
one respect I think one of the um
00:14:58
although I think Franklin's analysis of
00:15:01
Japan is right on um I think one of the
00:15:04
things we've learned from restructuring
00:15:06
banking systems is that delay is very
00:15:10
costly to the real economy that the
00:15:13
sooner you recognize losses allocate
00:15:16
them reallocate resources and move on
00:15:20
the more likely you are to recover it's
00:15:22
a lesson from the Asian
00:15:24
crisis um and it's actually something
00:15:27
that we in the US are pretty good at
00:15:28
once we set our minds to it it's also a
00:15:30
lesson from the Scandinavian crisis um
00:15:34
the swedes were very quick to take uh
00:15:36
the dead debt and sell it off as quickly
00:15:39
as they could to people who were willing
00:15:42
to take that kind of risk for presumably
00:15:44
High returns uh clean up the banks and
00:15:48
um uh let them move forward and as a
00:15:51
result uh they didn't lose a Whole
00:15:53
Decade of growth as the Japanese did who
00:15:56
basically ran an insolvent banking
00:15:58
system for an entire decade on the other
00:16:01
hand in Japan it didn't spill over into
00:16:03
the real economy in a negative way it in
00:16:07
the sense that there wasn't huge
00:16:09
contractions so you didn't have a very
00:16:11
large contraction in GDP so unemployment
00:16:15
didn't go up dramatically the ordinary
00:16:18
people didn't really very suffer very
00:16:20
much compared to the sced incomes for a
00:16:23
Whole Decade are something the US
00:16:25
couldn't would have trouble tolerating
00:16:28
that's true but the 19 in the 1930s we
00:16:31
had 25% unemployed for years on end
00:16:35
which is much much worse in my view
00:16:37
absolutely but that was not a result of
00:16:39
allocating losses quickly and and moving
00:16:41
on that was a result of financial system
00:16:43
collapsing know so I think that I mean
00:16:45
that there are there are advantag as
00:16:47
what Japan did in my view they actually
00:16:49
came through it quite well because
00:16:51
Ordinary People didn't really suffer
00:16:53
other than that their income didn't grow
00:16:55
as much as it might have done other
00:16:57
higher taxes than they would other
00:16:58
otherwise well that's not true yet
00:17:00
because it's all in the
00:17:02
Deb it may be inflated away or whatever
00:17:05
one of the things we've all sort of
00:17:06
grown up with is a belief in the in the
00:17:08
free markets and they should be allowed
00:17:10
to uh move back and forth and and solve
00:17:13
problems on their own on the other hand
00:17:15
there are those who are arguing that
00:17:16
this whole crisis was a result of the
00:17:18
free markets going haywire I'm just
00:17:21
wondering whether looking forward all of
00:17:24
this uh suggests a need for a new round
00:17:26
of Regulation a reorganization ation of
00:17:29
the uh the the the institutions in the
00:17:32
in the government that regulate or in
00:17:34
the states or what needs to be done to
00:17:38
prevent a recurrence of this kind of
00:17:39
thing in the future Franklin I think
00:17:42
it's it's very difficult to say how
00:17:44
we're going to stop it because these
00:17:45
things happen every 10 years or so we
00:17:49
could do what they did after the 1930s
00:17:52
which is put in such stringent
00:17:54
regulation that Banks and other
00:17:56
financial institutions can't take risks
00:17:59
but then we get in the problem that we
00:18:00
don't grow in the long run and so it's a
00:18:04
very difficult trade-off I think we have
00:18:06
to try and figure out what happened this
00:18:08
time I think there's a lot of De debate
00:18:11
and a lot of differences as to whether
00:18:13
it was just that people in the property
00:18:14
markets screwed up completely and the
00:18:17
the the uh rating agencies did a bad job
00:18:21
the incentives all went apart or whether
00:18:24
as I would argue what happened was that
00:18:26
the financial system itself in terms of
00:18:28
pricing the assets that pricing
00:18:31
mechanism failed and that's why it came
00:18:33
as such a surprise to people well I
00:18:36
would agree I think the pricing system
00:18:37
did fail
00:18:40
uh we we easily have bubbles in in real
00:18:43
estate and housing uh and there are
00:18:47
expectations that um feed on themselves
00:18:50
both on the upside and the downside so
00:18:53
there are frenzies that kind of occur
00:18:55
but then there's always the question of
00:18:57
uh who's lending the money for for
00:18:58
people to actually buy and in this
00:19:01
episode we had lending standards erode
00:19:04
and we actually had risk premium erode
00:19:06
so there clearly was a r a race to the
00:19:10
bottom uh that was not we we did not
00:19:14
have lending
00:19:15
controls uh they were off the table we
00:19:18
were we were underwriting any risk and
00:19:20
we weren't underwriting very well so
00:19:23
that has to change two ways of changing
00:19:25
it and I don't think we know which way
00:19:26
to go or combination
00:19:28
one is to have Regulators who are on the
00:19:31
job two is and that's you know say it
00:19:35
quickly but there are all sorts of
00:19:36
issues about that two is to have a
00:19:38
market based discipline where we have
00:19:41
actually Market instruments which can be
00:19:44
traded to um expose uh risk of buyer and
00:19:50
selling in this case we had many of
00:19:52
these instruments um in primature AAA uh
00:19:56
very complex never traded put into
00:19:59
portfolios and there wasn't the ability
00:20:02
to trade against them with market
00:20:03
knowledge now there were a few indexes
00:20:05
out there that got created towards the
00:20:07
end but they were very small percentage
00:20:09
of the market Just One Last point
00:20:11
because following up on some work that
00:20:13
Susan and I did these sorts of things
00:20:15
and and the oecd and the IMF have done
00:20:17
as well these sorts of things happen
00:20:20
every 10 to 20 years and they happen in
00:20:23
all kinds of systems it isn't special to
00:20:26
systems that have securitization it
00:20:28
isn't special to systems that have
00:20:30
private Banks it isn't special to
00:20:32
systems that have only thrifts it isn't
00:20:35
special to systems that have only
00:20:37
nationalized banks it happens in all of
00:20:39
them there are fundamental Dynamics in
00:20:42
housing and property markets that lead
00:20:44
to speculative Bubbles and inevitably
00:20:47
bring some Financial systems down with
00:20:49
them because Financial systems are
00:20:51
heavily involved in in uh mortgage
00:20:53
lending well uh thank you I'm sure we'll
00:20:56
be back talking about it again Professor
00:20:58
Herring Professor wer Professor Allen
00:21:00
thank you very much thank you and thank
00:21:03
you for joining
00:21:07
[Music]
00:21:13
us
