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Although the subprime crisis seems to be
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showing some signs of easing, debate
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over what caused it, whether it could
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have been prevented, and how long it
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might last will continue for some time
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to come. Knowledge at Wharton asked
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Wharton finance professor Richard
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Marston for his perspective on the
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latest economic developments. Welcome,
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Professor Marston. Well, glad to be
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here. Looking back over the past few
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years, risk premiums have fluctuated
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dramatically and uh most people don't
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understand what this means. Can you
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explain it? Well, it's natural for over
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time for markets to uh change um in
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terms of interest rates, in terms of the
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spreads of riskier assets over uh US
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government bonds um to see the stock
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market fluctuate. Um, in the case of
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bonds though, it's um it's much easy to
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understand what's going on in terms of
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being able to measure what what is
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happening and in that we have the the
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spread of interest rates between uh
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riskier bonds and uh treasury bonds. And
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if you watch the spread over time, you
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can get a good indication of what the
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market is actually thinks is happening
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in terms of of of risk. And uh recently
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prior to the crisis uh the spreads on
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high yield bonds and emerging market
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bonds um came down to much lower levels
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than normal.
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So people thought the market is not that
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risky. That's right. If you look at the
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spreads uh winter uh a year ago what you
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find is that the spreads on high yield
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bonds had come all the way down to 2 and
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a.5%. Now the average spread in the long
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run is something like 5 to 6%. So the
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market was saying that uh high yield
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bonds, the bonds of corporations with
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lower credit standing were were simply
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looking much less risky than they
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normally are. Um the spreads on emerging
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market bonds had come down to
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1.6%. And once again, what we're seeing
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is the market saying that emerging
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market bonds are just much less risky
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than they have been over the last 10 or
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15 years. Now the market was saying that
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they were less risky. Were they really
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less risky or was this just uh looking
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at the market with rosecolored glasses?
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That's uh you know that's how judgments
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differ in the market. Um I felt a winter
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ago that uh the spreads looked uh very
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unattractive to me as an investor. Um in
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fact I was recommending to investors
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that they actually invest um 0% in
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emerging market bonds that the spreads
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have come down so far that there simply
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wasn't enough reward for the risk. On
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the other hand, if the market as a whole
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is pricing securities that way, that
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means there's an awful lot of the people
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in the market that disagree with me.
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That's what makes a market. And what
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were we shown when the subprime uh mark
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crisis began? Well, what we found is um
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is that uh it was like a um a fire. We
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need a spark to set the fire and uh the
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spark h happened to be in subprime
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loans. If it hadn't been there, it would
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have been some other security. But uh
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once the um once you see the the fire
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start uh everyone starts to realize it's
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going to spread. It's going to spread to
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other types of securities that have
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nothing to do with mortgages. And uh
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what happens is um risk is reassessed by
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the market and securities that would
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have had a spread of 4% just a few
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months ago suddenly have a spread of 7%.
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And uh this happens normally it it
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happened back in 1998 when there was a
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financial crisis that actually began in
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Russian government bonds of all things
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Russian government bonds. What the
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Russians decided to do is default on
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many of the government bonds. And as
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soon as that default occurred of course
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the Russian bonds were not worth very
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much but immediately the bonds of other
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emerging markets were suddenly
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reassessed and people wouldn't buy the
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bonds at the original prices. they
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insisted on much higher interest rates
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and then soon thereafter other
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securities were reassessed. High yield
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bonds in the United States um Danish
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mortgage back bonds of all things. Um
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and what we're learning is that this
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financial market of ours is very
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interconnected. And uh when you see a an
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reassessment of risk of one security,
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the market then very quickly reassesses
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risk on other securities. This time it
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was subprime loans. And what does that
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have to do with high yield bonds? And
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why why were high yield bonds then
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repriced? So there was just a general
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aversion to risk at the time that caused
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all of these bonds that were perceived
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as riskier to fall in price and make
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their interest rates. That's right. And
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what we had was a reassessment of risk
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and it affected a lot of securities that
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had nothing to do with mortgages. Now,
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one of the things we've seen uh in in
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the in the past few months or the past
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year is that the prices of of many uh
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debt securities have fallen tremendously
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even though there haven't been that many
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defaults in many of these categories.
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And and uh I if if the the issuers of
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the bonds are still making the payments
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they originally promised, it seems like
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uh these ought to be a good deal at
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these very low prices. And yet there
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seems to be this tremendous reluctance
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of investors to buy them even at these
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deep discounts. What has caused this
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when there haven't been so many
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defaults? What we worry about is um is
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the future. What we worry about is um
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how well the securities are going to do
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in the future and that's what the price
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is supposed to be indicating. That's
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what this the spread of the interest
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rate over treasuries supposed to be
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indicating. And if if we see the economy
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slowing down, and we're certainly seeing
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that at this point, um, and we see the
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risk of further turmoil in the financial
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markets, which we certainly were seeing
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in last fall, we were seeing in uh
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during the winter, we were seeing it
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into March. We were seeing the
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possibility that the that the
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deteriorating fixed income market could
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get even worse. And as a result, people
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were were not taking chances. They were
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bidding up the spreads of high yield
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bonds. Uh they were bidding up the
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spreads of of emerging market bonds. Um
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it wasn't just mortgage back securities
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and that's a natural development. Um and
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then of course there was the rescue of
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Bear Sterns and that turned the tables.
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Yes, the Federal Reserve has gotten
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involved and and the rescue of Beer
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Sterns was the most obvious example or
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the most prominent in the news. It's
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also done a lot of other things like uh
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lending to securities firms, US
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treasuries, and taking riskier mortgage
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back securities in trade as collateral,
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things it doesn't normally do. Uh are
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these a good idea, a bad idea? Are they
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working or not? Well, let's let's start
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off with what a bank normally does and
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has been doing for um in the case of the
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Bank of England for over 20 or 30 years.
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And that is to uh butress the banking
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system whenever there's a danger within
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the banking system. And what the bank of
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England learned they had to do in the
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19th century and what the Fed has has
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been doing since it was founded is
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stepping in whenever there's a liquidity
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crisis, when banks are running short of
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of funding and they need some additional
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funding from the central bank. That's
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traditional banking function and you
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could see that very dramatically in
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August. This is before the Federal
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Reserve started lowering interest rates.
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The Federal Reserve and the European
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Central Bank in concert
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uh moved into the market and started to
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flood the banks with sec with with
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liquidity and that's very important
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because what was happening at the time
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is the interbank rate in the Liebore
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market the London interbank market um
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those interest rates were going very
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high. Traditionally, liebore rates have
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an average uh spread over treasuries of
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about 50 basis points, half a percent.
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But in August of last year, the spread
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went up to 2 and a half%. And that
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that's basically sending off alarm bells
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saying that the banks are in distress.
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They don't trust each other. Um the the
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system needs more liquidity. So the Fed
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stepped in and provided liquidity. That
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was a very traditional banking function.
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Of course, that wasn't enough because
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later in the fall, what we found was um
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that um the banks and the investment
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banks were were having some difficulty
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with um funding their positions and the
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Fed expanded its role, not as
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dramatically as it did it this spring,
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but basically expanded its role to
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taking in securities that they normally
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wouldn't have taken in in trade. Uh once
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again, rather traditional banking
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function, uh trying to buttress the
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banking system. and um that kind of
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thing would have worked and solved the
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problem 20 years ago.
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What's changed? What's changed is that
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in the meantime we've uh we've um had a
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revolution in securization and what has
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happened is the uh banking institutions
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including investment banks have learned
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about ways to fund investments, fund uh
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securities uh ways that were really not
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tried in the in the early 1980s. And
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this has allowed the um for example in
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the mortgage market, it's allowed the
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mortgage market to expand much more
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dramatically than it could have
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otherwise. So what uh mortgage brokers
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do is they originate the securities,
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package them together, the banks package
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them together and then sell them to uh
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to pension plants and so on. Um this has
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opened up tremendous possibilities for
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the financial markets. Uh but it's also
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changed the role of the central bank in
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terms of what they have to do in a
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crisis. Now the first time we saw this
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was in uh 1998 again. In 1998 we had the
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Russians default on their government
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bonds and soon uh bond markets for a lot
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of securities having nothing to do with
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Russian government bonds froze up. Soon
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thereafter we saw that major hedge fund
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in New York um long-term capital
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management ran into trouble. So why
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would we care whether or not a hedge
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fund runs into trouble? Well, it turns
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out that the hedge fund highly leveraged
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positions has many of the same
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securities that the banks are holding
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and many of the same securities that the
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investment banks are holding. So, um, in
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some sense, securization has made the
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system much more interconnected than it
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was before. So, the Fed could have stuck
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to its normal role and said, "Oh, we're
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only responsible for commercial banks."
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And um, that would have been interesting
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to see what would have happened. It
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wouldn't have been pretty. But the Fed
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had an ingenious solution. Then what
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they did is they organized a meeting
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down at the Federal Reserve Bank in New
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York and lower Manhattan and invited the
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CEOs of virtually every major bank in
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the United States and many of the banks
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in Europe. Called them to meeting and
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said, uh, basically as as we understand
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it, um, wouldn't it be a good idea for
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all of us if you were to fund a rescue
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of this hedge fund that is about to go
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under? Wouldn't it be a great idea if
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you Maril Lynch and you City Bank and uh
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you Smith Barney would have put up $300
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million each and of course everyone
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around the room with a few exceptions
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including the head of Bear Star said uh
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gee that would be a wonderful idea
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because this would be in our interest be
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in the interest of our shareholders. And
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so the Fed in a sense finessed the
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problem of um of a crisis being so large
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that it was no longer enough to be a
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traditional central bank. They finessed
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that problem by organizing a rescue
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which didn't involve any Federal Reserve
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money. One of the concerns back in the
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long-term capital management crisis was
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that uh the the hedge fund owned so many
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bonds of different types that if it went
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under and ended dumping them on the
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market at fire sale prices, it would
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cause prices of other banks holdings to
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collapse. and there would be kind of a
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domino effect. That's the concern. And
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that's the reason why the CEOs of these
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major firms, what they said to
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themselves is, is it in the interest of
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our shareholders and our management to
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provide $300 million each? And almost to
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the last person around the table, they
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came up with the money. And um in a
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sense, the Fed finessed the problem that
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time and very brilliantly. By the way, I
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was always a fan of that rescue. This
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time, it's different. Now this time as
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it it's uh it's sort of built on that it
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seems to me it's a little more
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extensive. How how so? Well um once
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again what we had was a institution
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getting into trouble much bigger
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institution. We're talking about Bear
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Sterns one of the major investment
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banks. Um but a lot of the um a lot of
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the situation was very similar in the in
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the sense that Bear Sterns was holding
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securities in a highly leveraged
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portfolio which were also being held
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by Croup, by Meil Lynch, by Goldman
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Sachs, by UBS, by many of banks of the
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world and investment banks. And so, uh,
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what the Fed could do, the Treasury
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could have done was to say, "Well, Bear
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Sterns, it's not the biggest investment
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bank in the world. Um, let's let the
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market work here." And, um, the great
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thing is that the head of the Federal
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Reserve, Ben Bernani, has actually done
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a study of what happened the last time
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the federal government let the banking
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system go down in a domino effect. And
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his study of the of the depression was,
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of course, one of the major studies of
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that period. And um I think that
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informed him a great deal about what to
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do in this crisis because the worry is
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that if you allow Bear Sterns to go
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under, you allow them to dump all their
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securities in the market, remember this
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is a very highly levered firm, uh what
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happens is an awful lot of other
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firms in the United States as well as in
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Europe and elsewhere in the world are at
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risk. And subsequent to the Bear Stern's
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uh uh rescue, there have been other
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things that they've done and some of
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them preceded that which was making
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basically making money available to keep
00:14:10
liquidity in the market. Uh are are
00:14:13
these things that we're going to need on
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a continuing basis or do you see this
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crisis abating and going back to the
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sort of the practices that preceded it?
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Well, let me uh put my neck out on the
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line and say this episode we've probably
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seen the worst and we probably do not
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have I may regret these words, but we
00:14:34
probably do not have another bear sterns
00:14:36
lurking during this crisis. But that
00:14:39
doesn't tell us that we don't have a
00:14:41
problem in the future because when you
00:14:43
think of it, um we're going to continue
00:14:45
to have securization. In fact, we might
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have increased leverage in the future.
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And we haven't solved the problem of um
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how does a system that has been set up
00:14:54
of system of regulation to to watch over
00:14:57
commercial banks and leave hedge funds
00:15:00
and leave investment banks relatively
00:15:03
unregulated. How is that system going to
00:15:05
withstand the next crisis? Now, the next
00:15:07
crisis might be 10 years from now. It
00:15:09
might be a totally different um
00:15:11
administration. Of course, it will be a
00:15:13
new administration. um it'll be a
00:15:15
different set of actors. A lot of the
00:15:17
regulators would have retired. We'll
00:15:18
have a new new breed. Um but the same
00:15:21
issues will occur again. And the
00:15:23
question is in a um highly integrated
00:15:27
financial sector with uh a tremendous
00:15:30
amount of securization, high leverage,
00:15:32
more leverage outside the commercial
00:15:34
banking system than inside it. Um is it
00:15:36
possible to have another bear sterns?
00:15:38
And the obvious answer is of course. And
00:15:40
the question is then how would we handle
00:15:42
it the next time? Would it be a bigger
00:15:45
problem next time? So we're faced with
00:15:47
an issue of whether or not the old
00:15:50
system of regulation is going to
00:15:52
continue to work in the future and
00:15:54
that's that's the number of the problem.
00:15:55
Uh the the sort of extreme view on on
00:15:58
one end of the scale is that well uh
00:16:01
many of these big institutions suffered
00:16:02
enormous losses and uh chief executives
00:16:06
lost their jobs and there's there's been
00:16:07
a lot of bloodletting and that alone
00:16:10
should be less than enough to not not
00:16:13
get out on this limb in the future. But
00:16:15
you think that's probably not enough
00:16:17
just leaving the market to sort it out.
00:16:19
You have you have to remember that u the
00:16:21
people who have learned this lesson will
00:16:23
no longer be in leadership positions 5
00:16:25
10 years from now. We'll have a new uh a
00:16:28
new group of people. There's a lot of
00:16:29
turnover in the financial services
00:16:31
industry. The careers are relatively
00:16:33
short. And so what we'll have are are
00:16:35
people who are traders today will be
00:16:37
running the firms 10 years from now or
00:16:39
so on. Uh the question is what what do
00:16:41
we learn from history from the LTCM uh
00:16:44
episode? Did did hedge funds learn that
00:16:47
they had to be much more careful? Well,
00:16:49
the next couple years, yes, they
00:16:50
probably learned. But do current hedge
00:16:53
funds uh behave um differently than they
00:16:56
did in the late '9s because of LTCM? The
00:16:59
answer is probably not. Probably not.
00:17:01
There's um there's a short memory in the
00:17:03
financial markets, particularly if the
00:17:05
rewards are tremendously large, and they
00:17:07
are for the individual players as well
00:17:09
as for the shareholders, but
00:17:10
particularly for the individual players.
00:17:12
if you take some chances and let's we
00:17:15
let's look at the uh previous five
00:17:17
years. Suppose you were one of those
00:17:19
people that were very riskaverse and you
00:17:22
were in charge of fixed income at one of
00:17:24
the major houses. You saw the spreads
00:17:27
come down and down and down and you
00:17:29
pulled back and you said well this
00:17:32
institution I'd like to maintain a more
00:17:34
conservative position. What would have
00:17:36
happened to you within the industry? The
00:17:38
answer is you probably would have had a
00:17:39
fairly short career. And I could name
00:17:41
some names of people who whose careers
00:17:44
were shortened during this five-year
00:17:46
period um because they were a little
00:17:48
more conservative than than their peers.
00:17:50
Whereas on the other hand, if you take
00:17:52
your chances and if you make your money
00:17:55
and over the 5-year period there's some
00:17:57
very large bonuses to be had um and then
00:18:01
the system blows
00:18:03
up, you're still much better off, aren't
00:18:05
you? Well, it certainly seems an
00:18:06
individual actor. Certainly many of the
00:18:08
CEOs who who left in shame left with a
00:18:11
lot of money in shame and uh uh they're
00:18:13
they're not out selling pencils. Um now
00:18:16
as you mentioned the regulatory system
00:18:18
is well it seems to be kind of a
00:18:20
patchwork that's been built over the
00:18:22
decades. parts of it originating back in
00:18:24
the
00:18:25
1930s. And now we have with the repeal
00:18:28
of GlassSteagall some years ago uh and
00:18:31
and and other changes, we have different
00:18:34
kinds of firms getting into lines of
00:18:36
business that at other times they were
00:18:38
barred from and uh the result is
00:18:41
apparently a lack of regulation in some
00:18:44
of these areas. Do you see that there
00:18:45
needs to be some change in the
00:18:47
regulatory structure? I think the answer
00:18:50
um should be obvious to everyone, but
00:18:53
I'm not sure that it will be obvious to
00:18:55
Congress and the new administration is
00:18:58
the following. That um in this episode,
00:19:00
what we found was that the Fed had to
00:19:03
stre to stretch its uh mandate in order
00:19:08
to rescue the system. Um the Fed had to
00:19:12
go in and provide funding to an
00:19:15
investment bank which traditionally has
00:19:17
been outside of the purview of the Fed.
00:19:19
Um this is not like uh trying to rescue
00:19:22
a commercial bank in 1980 because
00:19:24
they're having funding problems. This is
00:19:26
very different. It's going in because
00:19:28
you know that the portfolio of
00:19:30
securities of this investment bank uh is
00:19:32
being held by commercial banks as well
00:19:34
as by other investment banks and the
00:19:37
financial sector as a whole is in
00:19:39
danger. That's expanding the Fed Fed's
00:19:41
role and if you're going to expand their
00:19:45
responsibility, I think you have to
00:19:47
expand their ability to oversee these
00:19:50
institutions and I think it has to be
00:19:52
done wisely and you have to think very
00:19:54
carefully about what kind of regulation
00:19:57
would be necessary and clearly um many
00:20:00
of us believe that the less regulation
00:20:03
the better. But once you have the
00:20:05
Federal Reserve committing potentially
00:20:07
committing taxpayers money, um you then
00:20:10
have to say, well, does the Federal
00:20:12
Reserve have to play more of a role in
00:20:14
regulation? And this would mean reg
00:20:16
regulation of investment banks. That's
00:20:18
right. Regulation in terms of thinking
00:20:20
through what kind of capital
00:20:22
requirements are needed um if you're an
00:20:25
investment bank as opposed to a
00:20:27
commercial bank. I noticed uh uh one
00:20:30
assessment said that Beer Sterns had a
00:20:32
leverage of something like 33 to1. So
00:20:34
for every $33 it had at risk, it really
00:20:37
only had $1 uh uh in in real capital. Uh
00:20:41
is that too much? Is that something
00:20:43
needs to be overseen? That's something
00:20:44
that um that's for the details of the
00:20:47
regulation, but clearly commercial banks
00:20:49
would not be able to get away with that
00:20:51
kind of leverage. Commercial banks
00:20:52
definitely have a lot of leverage but
00:20:54
they wouldn't be able to get away with
00:20:56
that much leverage without having I mean
00:20:58
we have a whole set of rules
00:20:59
international rules uh for banks on how
00:21:02
much capital they have to hold behind
00:21:04
each type of asset. We also have to
00:21:07
reconsider the um oversight of
00:21:10
offbalance sheet entities on the part of
00:21:12
the commercial banks as well as the
00:21:14
investment banks. Um, can we sit sit
00:21:18
back and say, "Oh, it's all right for a
00:21:20
commercial bank to set up an off uh
00:21:23
balance sheet entity as long as they
00:21:25
don't formally commit to rescuing those
00:21:27
entities." Well, this episode's taught
00:21:29
us some things. Uh, when push came to
00:21:31
shove, the banks, many of them, stepped
00:21:34
in and took over the entire book of
00:21:38
these offbalance sheet entities, pulling
00:21:40
them into their own balance sheets. That
00:21:42
means that um in a sense they're now
00:21:44
under the purview of the Federal Reserve
00:21:47
and I think we have to rethink that. The
00:21:49
the banks really had to do that or
00:21:50
nobody would do business with them in
00:21:52
the future. Yes, I'm certainly not
00:21:53
criticizing the banks for trying to
00:21:55
protect their their good reputation by
00:21:56
using the offbalance sheet entities.
00:21:58
They were carrying in fact liabilities
00:22:02
that they didn't show. So people looking
00:22:04
at the banks didn't really have a clear
00:22:06
picture of the risk there. So
00:22:08
transparency is always one of the early
00:22:10
things you want to do in a crisis to
00:22:12
make sure people understand risks even
00:22:14
if you're going to let them take them.
00:22:15
Is that right? That's exactly right. And
00:22:17
that's what we want to uh guard against
00:22:18
in the future. Making sure that there's
00:22:20
much more transparency. You would have
00:22:22
thought we would have learned from uh
00:22:24
Enron that uh offbalance sheet entities
00:22:27
can be dangerous particularly if we're
00:22:29
talking about the major commercial banks
00:22:31
of this country. And yet we don't seem
00:22:33
to have learned enough lessons from from
00:22:36
Enron. Now there's also been some talk
00:22:38
about the way the mortgage business has
00:22:40
evolved and uh we have companies that
00:22:42
are uh initiating lo mortgages and
00:22:46
others that are bundling them up into
00:22:48
securities and uh mortgage brokers and
00:22:51
many of these are are sort of
00:22:52
unregulated or at least there's no
00:22:54
central regulation at the federal level.
00:22:56
Should there be? I think uh the mortgage
00:22:59
industry has changed so much and we
00:23:01
definitely used to have government
00:23:03
federal government regulation of the
00:23:05
provision of mortgages through the SNLs.
00:23:08
Uh now we have mortgage brokers who are
00:23:11
subject um as far as I can tell to uh a
00:23:14
minimal amount of regulation um and
00:23:17
oversight and uh we've heard about some
00:23:20
pretty bad practices in the mortgage
00:23:21
brokerage industry by a minority of of
00:23:24
participants but nonetheless um
00:23:26
upsetting to us because we know that
00:23:28
ultimately the spark that set off this
00:23:31
blaze was in the subprime mortgage
00:23:33
market and the mortgage market in
00:23:34
general. So clearly we're going to have
00:23:36
to look at mortgage originations. Uh how
00:23:39
much oversight there should be. Um we
00:23:41
also have to worry about whether or not
00:23:44
if a bank is going to package together a
00:23:46
mortgage um would it be a good idea for
00:23:48
the bank to be required to hold on to
00:23:51
some of the mortgages in a sense to as
00:23:54
we say um keep some skin in the game to
00:23:57
make sure if they implode the bank will
00:23:59
lose some money and it's not just passed
00:24:01
on to somebody in Abu Dhabi or some
00:24:03
place. That's right. That's exactly
00:24:04
right. to try to get the banks to think
00:24:06
of themselves. I mean, it's a wonderful
00:24:08
thing that we've uh developed the
00:24:10
financial market so we don't have an SNL
00:24:13
um in uh Philadelphia that goes under
00:24:16
because it's uh funding 30-year
00:24:19
mortgages with uh short-term deposits. I
00:24:22
mean, that was an absolute crazy system.
00:24:24
Um now we have the ability to uh bundle
00:24:28
together some mortgages um diversify
00:24:30
them and then sell them to institutional
00:24:33
investors. What a wonderful thing.
00:24:34
Securization is such a sensible idea.
00:24:36
But somehow we have to make sure that um
00:24:40
that there's oversight first of all of
00:24:42
the origination of the mortgages and
00:24:44
then that the packages of the mortgages,
00:24:48
whether they're commercial banks or
00:24:49
investment banks, um somehow pay a
00:24:52
little more attention to the quality of
00:24:54
the securities that they're developing.
00:24:56
Um, and one way to do that would be to
00:24:58
require that they have some capital
00:25:00
invested in those same securities so
00:25:01
they'll share the losses. But these are
00:25:03
the kinds of things that I think we have
00:25:05
to think about. We have a change in in
00:25:08
the administration coming up. We have an
00:25:10
election, changes in Congress. Um, after
00:25:13
the election, I think people are going
00:25:14
to have to sit down in Washington and
00:25:16
really think through what would be the
00:25:18
minimum minimal amount of regulation
00:25:21
which would make this system of ours
00:25:23
safer. uh which would make the mortgage
00:25:27
um system fairer to Americans and more
00:25:30
sensible from the point of view of the
00:25:32
stability of the financial system. But
00:25:34
more generally, what what is the minimum
00:25:36
amount of regulation which will make uh
00:25:39
the financial sector as a whole safer?
00:25:42
Well, this story is going to be running
00:25:44
for quite some time we can tell. Uh
00:25:46
thank you very much, Professor Marston.
00:25:47
Thank you for inviting me.
00:25:49
[Music]
00:25:52
For more information, please visit
00:25:54
knowledge.warton.upen.edu.
00:25:59
[Music]
