How the Credit Crisis Could Forge a New Financial OrderPublished: October 15, 2008 in Knowledge@Wharton
In the middle of a battle, it's hard to know what the landscape will look like after the smoke clears. But as the government wrestles with the credit crisis, economists and finance experts are starting to make some predictions.
Individuals and businesses will have a harder time getting loans in coming years, but also may be less eager to take on debt. There will be "more" financial regulation or "better" regulation, but definitely not less regulation. There will be intense efforts to see what is going on inside previously opaque areas like hedge funds, derivative markets and subsidiaries set up to evade restrictions. Instruments like credit default swaps, which helped bring down AIG and other big financial institutions, are likely to become more standardized, allowing them to be traded on centralized exchanges so that values will be easier to fix.
"We have to design a system where participants cannot threaten the safety of the American economy," says Wharton finance professor Richard Marston. "I think this crisis is bad enough that it has rung some alarm bells, and there's a better chance of doing something right ... than there has been for decades."
The most obvious change in the financial markets is the government's new role as a major owner of the nation's banks, announced October 13 and modeled on a British plan being adopted in much of Europe. While such partial nationalization is meant to be temporary, even its proponents are uneasy about excess government power in business.
Wharton finance professor Franklin Allen also worries that the program will encourage risky behavior in the future by shoring up the banks to the benefit of current shareholders. When the government took over Fannie Mae and Freddie Mac, the shareholders were all but wiped out. "It sets bad precedents for the future," he says, warning that taxpayers could take a hit if the program does not work as well as advertised.
But several Wharton faculty members say the plan, calling for a $250 billion investment in newly created bank stocks, has a better chance of success than the earlier plan to buy up mortgage-backed securities and other bad assets. That remains in force but probably will entail about $100 billion in purchases instead of $700 billion.
"I think we can call this Plan B, and Plan B is substantially better than Plan A," Marston says, adding that Paulson was clever in calling in executives of the nation's nine largest banks and essentially ordering them to participate so that smaller banks will not fear that taking part will signal failure.
The new plan can provide money much more quickly than the asset-purchase plan, which might take months, even years, Marston notes. Also, it provides more bang for the buck because it harnesses the power of leverage. Buying $1 worth of assets can give a bank $1 to lend, but buying $1 in stock can allow the bank to lend many dollars, since a bank could have an asset-to-equity ratio of 10 to one.
Taxpayers can profit under the initial plan if the government eventually sells assets it buys for more than it pays. But that might not happen because banks typically are more likely to sell their worst assets, such as securities backed by mortgages plagued by defaults and foreclosures, according to Marston.
In the new plan, if a bank's share price rises, taxpayers can recover their investments and even earn a profit. In addition, the government will earn a 5% dividend on its investment for the first five years and 9% afterward, and it will have the right to buy more shares. "A lot of economists are in favor of it because they think there is more upside for the government," Marston says. But, he adds, the new plan does have risks. "What bothers me about this is what I think bothered Henry Paulson from the beginning. It is to what extent the government is going to be in the business of picking and choosing which banks are going to survive."
And although the program aims to rekindle the lending from one bank to another, it will resolve the crisis only if that leads to more lending to companies and other non-bank borrowers, says Wharton finance professor Jeremy J. Siegel, adding that even with plenty of money on hand, banks may keep the lending spigot closed for fear borrowers will not be able to pay back loans if the world tumbles into a deep recession.
On October 14, a day after announcing his plan, Paulson warned that banks receiving government investment will be expected to lend the money, not to "hoard" it. But the program might work better if the government offered guarantees to banks that lend to businesses, Siegel says. "The injection of capital.... I don't regard that as an instant cure-all."
Assuming the cash infusion does get banks lending again, what happens next? Kent Smetters, Wharton professor of insurance and risk management, cautions that Congress or other governmental bodies could use the public stake to advance social goals, pressuring banks to make risky loans to favored groups, for example.
To minimize such influence, Paulson said shares acquired by the government will not have voting rights. But risk could be reduced further with rules requiring the people overseeing the program to run it for the benefit of bank shareholders -- the taxpayer and others -- as is commonly done with investment trusts, Smetters notes. The program, he adds, should not be used "to try to conduct policy that should be conducted by the rest of the government," such as providing inexpensive mortgages to people with shaky credit. That kind of pressure from Congress contributed to the troubles at Fannie and Freddie.
Money Will Remain Tight
Even with the program in force, borrowers will find money harder to come by than it was in the easy-money years leading to the crisis. Already, home buyers must come up with 10% or 20% down payments and prove they have sound incomes. Loans allowing borrowers to decide how much they want to pay back each month have all but disappeared, and people with tarnished credit are finding it much more difficult to borrow.
Businesses, too, find money harder to get, as lenders worry more about their ability to repay. The commercial paper market, used by businesses to obtain low-cost, short-term loans, has been frozen, and parts of the new bank-investment plan are designed to get it moving again.
Use of commercial paper has mushroomed in the past two decades, largely because the growth of money market funds furnishes a huge source of cash for these loans. Investors benefit because money markets pay higher interest than bank savings.
The commercial paper market is likely to revive, but the recent experience probably will make businesses more conservative about using it, according to Allen. Many companies have relied on it for long-term needs, repeatedly paying off each month's loans with new borrowing. That left many without a ready source of cash when the flow stopped in the recent crisis. "I think the commercial paper market may shrink significantly," Allen says. "People are nervous about funding long-term assets with short-term paper." In the future, he adds, long-term needs are more likely to be funded with new stock or bond issues.
Another reason lending will tighten: Big investment banks have been sold to or converted to commercial banks, which have tougher capital requirements. While some investment banks gambled $30 for every $1 they had, the ratio for commercial banks is more like 10 to 1.
Most experts believe the current crisis is an extraordinary situation rather than an exaggerated plunge in the normal business cycle. Many of the causes need further study, but the consensus seems to be that the next president and Congress will need to reform the regulatory system, a patchwork built over the past seven decades. No one has a master plan now, but some themes are emerging.
To assess risks building up in the system, regulators are sure to demand more transparency. That will include a clearer look at how leverage is used and by whom, and which institutions are accumulating big positions in volatile derivatives like credit default swaps. "What we need to know is how much macro risk is taken by various organizations and pools of funds that could, in a crisis, turn out to harm the economy," Siegel says. "We need to bring transparency to the credit default swaps market and the derivatives market. That's got to happen, and it will happen."
Smetters notes that while transparency is valuable, it is hard to get it just right. Casting too much light into a firm's affairs can undermine its competitive advantage, discouraging innovation and risk-taking. But requiring firms to make only generalized disclosures can give outsiders a distorted view. Reports on total derivatives holdings might make a firm look very risky, while some holdings actually may offset risks of others, he says. "I don't think anybody has figured this one out."
Back on the Balance Sheet
Marston suggests that regulators also must wrestle again with the use of off-balance-sheet entities -- subsidiaries set up to skirt regulations affecting the parent company. While there was an effort to rein these in after the Enron debacle early in the decade, the recent crisis shows they had continued to be used to amass and conceal risky, highly leveraged positions. "If activity X is prohibited among banks, what they do is set up a non-bank financial institution that can get into that activity," Marston says. Since businesses will always look for ways to get around the rules, "we've got to have a regulatory system that is just as imaginative."
Oversight of different types of securities needs to be more consistent, adds Wharton finance professor Marshall E. Blume, noting that bets on individual stocks can now be made in various ways -- by purchasing the stocks themselves, or through futures, options or swaps contracts based on those stocks. The Securities and Exchange Commission oversees the stock market and the Commodity Futures Trading Commission regulates the futures and options market, but the swaps market, often involving individually tailored contracts, has virtually no regulation.
All securities that rise or fall according to the health of an underlying company should be treated the same, Blume says. "If it has payouts the same as an equity but we call it a swap, it's probably an equity. I always think of derivatives as something like very sharp knives," he adds. "They are very good at parsing risk. Used properly, they are very valuable, and there shouldn't be anything to prohibit that parsing of risk." In the current markets, however, "the regulations have not kept up with these new tools."
The poster child of the current crisis is the credit default swap, a kind of insurance policy. Like auto insurance, the buyer makes regular payments to the seller, which pays a claim if a given event occurs, like a specific company defaults on its debt payments or goes bankrupt. A buyer that has lent the company money, or a business awaiting payment from that company, can use a credit default swap to buy coverage in case the company fails to meet its obligations.
But these instruments can also be used by speculators to bet on companies' rising and falling credit worthiness. As the mortgage crisis deepened over the past two years, many firms' credit worthiness fell, leaving firms like AIG and Bear Stearns with huge obligations to pay swaps owners' claims. While insurance companies are required to keep enough money on hand to pay expected claims, swaps issuers are not.
"You probably do want some capital requirements," Siegel says, noting that even if there is no regulatory requirement, investors may demand this. Adds Allen: "There should be a capital requirement and [credit default swaps] should be regulated."
Another problem: Credit default swaps and many mortgage-backed securities are so highly customized it is hard to assess their value from day to day. As the housing bubble burst -- and homeowners fell behind on payments -- swaps and mortgage securities tied to these payments lost value, but it was unclear by how much. Lenders, worried about unknown liabilities on borrower's books, became reluctant to lend, causing the credit crisis.
Marston suggests the market needs better transparency and a better way to establish values as conditions change. That may be accomplished if the current over-the-counter trading system were replaced with a centralized exchange and a greater standardization among these products. "The problem is we have no idea how large the [swap] market is, and there's no oversight of it," says Marston. "Would it be so terrible to have these instruments traded through organized exchanges? That's the question the new president is going to have to ask."
While there is some talk of doing this, it is not clear whether the marketplace will do it on its own or needs to be prodded by regulators. "When things become commoditized they tend to gravitate towards a central trading place," Blume says, "and credit derivatives are becoming commodities. If the government facilitates that [move to exchange-based trading], great."
Either way, it's likely these instruments will not continue to create the hazards that they have recently, because investors and issuers who were burned will be more careful. Indeed, the business world and financial markets are likely to become considerably more conservative and cautious. "I daresay that for the next few years, we are not going to have excesses in the financial markets," Blume says. "I don't think the markets are going to repeat the same follies that we have had in the last few years."