Credit Crisis Interview: Richard Marston on Risk

Wharton finance professor Richard Marston discusses the markets’ perception of risk in this video interview. Marston is one of seven Wharton professors whom Knowledge@Wharton spoke with for this special report on the credit crisis.

An edited version of the transcript follows.

Knowledge@Wharton:  Looking back over the past few years, risk premiums have fluctuated dramatically, and most people don’t understand what this means. Can you explain it?

Marston:  Well, it’s natural, over time, for markets to change in terms of interest rates, in terms of the spreads of riskier assets over U.S. government bonds, to see the stock market fluctuate. In the case of bonds, though, it’s much easier to understand what’s going on in terms of being able to measure what’s happening, in that we have the spread of interest rates between riskier bonds and Treasury Bonds.

And if you watch the spread over time, you can get a good indication of what the market actually thinks is happening, in terms of risk. And recently, prior to the crisis, the spreads on high-yield bonds and emerging market bonds came down to much lower levels than normal.

Knowledge@Wharton:  So people thought the market was not that risky.

Marston:  That’s right. Look at the spreads winter a year ago, what you find is the spreads on the high-yield bonds had come down to 2.5%. The average spread in the long run is something like 5% or 6%. So the market was saying that high-yield bonds, the bonds of corporations with slightly lower credit standing, were simply looking less risky than they normally are.

Spreads on emerging market bonds had come down to 1.6%. And once again, what we’re seeing is the market saying that emerging market bonds are much less risky than they had been over the last 10 or 15 years.

Knowledge@Wharton:  Now the market was saying they were less risky. Were they really less risky, or was this just looking at the market with rose-colored glasses?

Marston:  You know, that’s how judgments differ in the market. I felt a winter ago that the spreads looked unattractive to me as an investor. IN fact, I was recommending to investors that they actually invest 0% in emerging market bonds and that the spreads had come down so far that there simply wasn’t enough reward for the risk.

On the other hand, if the market as a whole is pricing securities that way, that means that there’s an awful lot of people in the market that disagree with me. That’s what makes a market.

Knowledge@Wharton:  And what were we shown when the sub-prime crisis began?

Marston:  Well, what we found is that it was like a fire. We need a spark to set the fire, and the spark happened to be in sub-prime loans. If it hadn’t been there, it would have been in some other security.

Once you see the fire start, everyone starts to realize it’s going to spread. It’s going to spread to other types of securities that have nothing to do with mortgages. And what happens is, risk is reassessed by the market. And securities that would have had a spread of 4% just a few months ago suddenly have a spread of 7%.

And this happens normally. It happened back in 1998, when there was a financial crisis that actually began in Russian government bonds, of all things. Russian government bonds, what the Russians decided to do was fault on many of the government bonds. And as soon as that default occurred — of course the Russian bonds were not worth very much — but immediately the bonds of other emerging markets were suddenly reassessed. And people wouldn’t buy the bonds at the original prices; they insisted on much higher interest rates.

And soon thereafter, other securities were reassessed. High-yield bonds in the United States, Danish mortgage-backed bonds, of all things. And what we’re learning is that this financial market or ours is very interconnected. And when you see a reassessment of risk in one security, the market then very quickly reassess risks on other securities.

This time it was sub-prime loans, and what does that have to do with high-yield bonds and why were high-yield bonds then re-priced?

Knowledge@Wharton:  So there was just a general aversion to risk at the time that caused all of these bonds that were perceived as riskier fall in price and make their interest rates rise.

Marston:  That’s right. And what we had was a reassessment of risk, and it affected a lot of securities that had nothing to do with mortgages.

Knowledge@Wharton:  Now one of the things we’ve seen in the past few months or the past year, is that the prices of many debt securities have fallen tremendously even though there haven’t been that many defaults in many of these categories. And if the issuers of the bonds are still making the payments that they promised, it seems like these ought to be a good deal at these very low prices. And yet there seems to be this tremendous reluctance of investors to buy them, even at these deep discounts.

What has caused this, when there haven’t been many defaults?

Marston:  What we worry about is the future. What we worry about is how well the securities are going to do in the future. And that’s what the price is supposed to be indicating, that’s what the spread of the interest rate of return was supposed to be indicating.

And if we see the economy slowing down, and we’re certainly seeing that at this point, and we see the risk of further turmoil in the financial markets, which we were certainly seeing last fall. We were seeing it during the winter. We were seeing it into March. We were seeing the possibility that the deteriorating fixed income market could get even worse.

And this result, people were not taking chances. They were bidding the spreads of high-yield bonds, they were bidding up the spreads of emerging market bonds. It was just mortgage-backed securities. And that’s a natural development. And then, of course, there was the rescue of Bear Stearns, and that turned the tables.

Knowledge@Wharton:  Yes. The Federal Reserve has gotten involved, and the rescue of Bear Stearns was the most obvious example, or the most prominent in the news. It’s also done a lot of other things, like lending to securities firms, U.S. Treasuries, and taking riskier mortgage-based securities in trade as collateral. Things it doesn’t normally do.

Are these a good idea, a bad idea? Are they working or not?

Marston:  Let’s start out with what a bank normally does, and has been doing for — in the case of the Bank of England, for over 130 years. And that is to buttress the banking system whenever there’s a danger in the banking system. And what the Bank of England learned in the 19th century, and what the Fed has been doing since it was founded, is stepping in whenever there’s a liquidity crisis, when banks are running short of funding and they need some additional funding from the central bank.

That’s traditional banking function. And you could see that very dramatically in August. This was before the Federal Reserve started lowering interest rates. The Federal Reserve and the European Central Bank, in concert, moved into the market and started to flood the banks with liquidity.

And that’s very important, because what was happening at the times was the interbank rates in the LIBOR market — the London Interbank Market — those interest rates were going very high. Traditional LIBOR rates have an average spread over treasuries of about 50 basis point, 0.5%. But in August of last year, the spread went up to about 2.5%.

And that’s basically setting off alarm bells, saying that the banks are in distress, they don’t trust each other. The system needs more liquidity. So the Fed stepped in to provide liquidity. That was a very traditional banking function.

Of course, that wasn’t enough. Because later in the fall what we found was that the banks and the investment banks were having some difficulty with funding the positions. And the Fed expanded its roll — not as dramatically as it did this spring — but basically expanded its roll to taking in securities that they normally wouldn’t have taken in as trade.

Once again, a rather traditional banking function, trying to buttress the banking system. And that kind of thing would have worked and solved the problem 20 years ago. What’s changed? What’s changed is that in the mean time we’ve had a revolution in securitization. And what that means is that the banking institutions, including investment banks, have learned about ways to fund investment, fund securities, ways were really not tried in the early 1980s.

And this had allowed — for example, in the mortgage market — it’s allowed the mortgage market to expand much more dramatically than it could have otherwise. So what mortgage brokers do is they originate the securities, the banks package them together, and then sell them to pension plans and so on.

This has opened up tremendous possibilities for the financial markets. But it’s also changed the role of the central bank in terms of what they have to do in a crisis.

The first time we saw this was in 1998, again. In 1998, we had the Russians default on their government bonds, and soon the bond markets for a lot of securities having nothing to do with government bonds froze up. Soon thereafter, we saw the major hedge fund in New York, Long Term Capital Management, ran into trouble.

So why would we care whether or not a hedge fund runs into trouble? Well, it turns out that the hedge fund’s highly leveraged positions has many of the same securities that the banks are holding, and many of the same securities that the investment banks are holding.

So in some sense securitization has made the system much more interconnected than it was before. So the Fed could have stuck to its normal role and said, “Oh, we’re only responsible for commercial banks,” and it would have been interesting to see what would have happened. It wouldn’t have been pretty.

But the Fed had an ingenious solution. What they did was they organized a meeting down at the Federal Reserve Bank in New York, in lower Manhattan, and invited the CEOs of virtually every major bank in the United States and many of the banks in Europe. Called them to a meeting and said basically, as we understand it, “Wouldn’t it be a good idea for all of us if you were to fund a rescue of this hedge fund that is about to go under? Wouldn’t it be a great idea if you, Merrill-Lynch, and you, Citibank, and you, Smith Barney, put up $300 million each?”

And of course, everyone around the room — with a few exceptions, including Bear Stearns — said, “Gee, that would be a wonderful idea, because this would be in our interests, be in the interests of our shareholders.”

So the Fed, in a sense, finessed the problem of a crisis being so large that it was no longer enough to be a traditional central bank. They finessed that problem by organizing a rescue that didn’t involve any Federal Reserve money, and that was a wonderful thing.

Knowledge@Wharton:  One of the concerns back in the Long Term Capital Management crisis, was that the hedge fund owned so many bonds of different financial types that if it went under and ended up dumping them on the market at fire sale prices, it would cause prices of other banks holdings to collapse and there would be a kind of a domino effect. That’s the concern.

Marston:  That’s exactly right. Yes. And that’s the reason why these CEOs of the major firms, they said to themselves, “Is it in the interests of our shareholders and our management to provide $300 million each?” And almost to the last person, around the table, they came up with the money.

And in a sense, the Fed finessed the problem that time. And very brilliantly, by the way. I was always a fan of that rescue. This time it’s different.

Knowledge@Wharton:  This time, it’s sort of built on that, it seems to me. It’s a little more extensive. How so?

Marston:  Once again, what we had was an institution getting into trouble. A much bigger institution, we’re talking about Bear Stearns, one of the major investment banks. A lot of the situation was very similar in the sense that Bear Stearns was holding securities in a highly leveraged portfolio, which were also being held by Citigroup, by Merrill-Lynch, by Goldman Sachs, by UBS, by many banks of the world. Investment banks.

And so what the Fed could do, the Treasury could have done, was to say, “Well, Bear Stearns, it’s not the biggest investment bank in the world, let’s let the market work here.” And the great thing is that the head of the Federal Reserve, Ben Bernanke, has actually done a study of what happened the last time the federal government let the banking system go down in a domino effect.

And his study of the Depression was, of course, one of the major studies of that period. And I think that informed him a great deal about what to do in this crisis. Because the worry is that if you allow Bear Stearns go under, you allow them to dump all their securities on the market — remember this is a very highly leveraged firm — what happens is an awful lot of other firms in the United States as well as in Europe and elsewhere in the world, are at risk.

Knowledge@Wharton:  And subsequent to the Bear Stearns rescue there have been other things that they’ve done, and some of them preceded that, which was making money available to keep liquidity in the market. Are these things that we’re going to need on a continuing basis, or do you see this crisis abating and going back to sort of the practices that preceded it?

Marston:  Let me put my neck out on the line and say, this episode, we’ve probably seen the worst. And we probably do not have — I may regret these words — but we probably do not have another Bear Stearns lurking during this crisis.

But that doesn’t tell us we don’t have a problem in future, because when you think of it, we’re going to continue to have securitization. In fact, we’re going to be having increased leverage in the future. And we haven’t solved the problem of how does a system that has been set up, a system of regulation to watch over commercial banks and leave hedge funds and leave investment banks relatively unregulated, how is that system going to withstand the next crisis?

Now the next crisis might be 10 years from now, it might be a totally different administration. Of course, it will be a new administration. It’ll be a different set of actors. A lot of the regulators will have retired; we’ll have a new breed. But the same issues will occur again. And the question is, in a highly integrated financial sector, with a tremendous amount of securitization, high leverage, more leverage outside the commercial banking system than inside it, is it possible to have another have another Bear Stearns? And the obvious answer is: of course.

And the question is then: how would we handle it the next time? Would it be a bigger problem next time? So we’re faced with an issue of whether or not the old system of regulation is going to continue to work in the future. And that’s the nut of the problem.

Knowledge@Wharton:  The sort of extreme view on one end of the scale is sort of that, well, many of these big institutions suffered enormous losses, and chief executives lost their jobs, and there’s been a lot of blood-letting, and that alone should be lesson enough to not get out on this limb in the future. But you think that’s probably not enough, just leaving the market to sort it out by itself?

Marston:  You have to remember that the people who have learned this lesson will no longer be in leadership positions 5-10 years from now. We’ll have a new group of people; there’s a lot of turnover in the financial services industry. The careers are relatively short.

And so what we’ll have is people who are traders today will be running the firms 10 years from now and so on.

The question is, what have we learned from history, from the LTCM episode? Did hedge funds learn that they had to be much more careful? Well, the next couple of years, yes, they probably learned. But do current hedge funds behave differently than they did in the late ’90s because of LTCM? The answer is probably not.

There’s a short memory in the financial markets, particularly if the rewards are tremendously large. And they are for the individual players as well as well as for the shareholders, but particularly for the individual players.

If you take some chances — and let’s look at the previous five years. Suppose you were one of those people that were very risk-averse, and you were in charge of fixed income at one of the major houses. You saw the spreads come down and down and down. And you pulled back and you said, “This institution, I’d like to maintain a more conservative position.” What would have happened to you within the industry?

The answer is, you probably would have had a fairly short career, and I can name some people whose careers were shortened during this five-year period because they were a little more conservative than their peers.

Whereas on the other hand, if you take your chances and if you make your money, and over the five-year period there’s some very large bonuses to be had — and then the system blows up. You’re still much better off, aren’t you? As an individual actor.

Knowledge@Wharton:  Well it certainly seems many of the CEOs who left in shame, left with a lot of money in shame. They’re not out selling pencils.

Now, as you mentioned, the regulatory system is, it seems to me, kind of a patchwork that’s been built over the decades, parts of it originating back in the 1930s. And now we have, with the repeal of Glass-Siegel some years ago and other changes, we have different kinds of firms getting into lines of business that at other times they were barred from.

And the result is, apparently, a lack of regulation in some of these areas. Do you see that there needs to be some change in the regulatory structure?

Marston:  I think the answer should be obvious to everyone, but I’m not sure it will be obvious to Congress and the new administration. It is that in this episode what we found was the Fed had to stretch its mandate in order to rescue the system. The Fed had to go in and provide funding to an investment bank, which has traditionally been outside the purview of the Fed.

This is not like trying to rescue a commercial bank in 1980, because they’re having funding problem. This is very different. It’s going in because you know that the portfolio of securities of this investment bank is being held by commercial banks as well as by other investment banks, and the financial sector as a whole is in danger. That’s expanding the Fed’s role.

And if you’re going to expand the responsibility, I think you have to expand their ability to oversee these institutions. And I think it has to be done wisely. You have to think very carefully about what kind of regulation would be necessary. And clearly, many of us believe that the less regulation the better.

But once you have the Federal Reserve potentially committing taxpayer’s money, you then have to say, “Does the Federal Reserve have to play more of a role in regulation?”

Knowledge@Wharton:  And this would mean regulation of investment banks.

Marston:  That’s right. Regulation in terms of thinking through what kind of capital requirements are needed if you’re an investment bank as opposed to a commercial bank.

Knowledge@Wharton:  I noticed one assessment said that Bear Stearns had a leverage of something like 33 to 1. So for every $33 it had at risk, it really only had $1 in real capital. Is that too much? Is that something that needs to be overseen?

Marston:  That’s something that — that’s for the details of the regulation. But clearly, commercial banks would not be able to get away with that kind of leverage. Commercial banks definitely have a lot of leverage, but they wouldn’t be able to get away with that much leverage without having — I mean, we have a set of rules, international rules, for banks on how much capital they have to hold behind each type of asset.

We also have to reconsider the oversight of off-balance-sheet entities, on the commercial banks as well as the investment banks. Can we sit back and say, “Oh, it’s all right for a commercial bank to set up an off-balance-sheet entity, as long as they don’t formally commit to rescuing those entities?”

Well, this episode’s taught us some things. When push came to shove, the banks — many of them — stepped in and took over the entire book of these off-balance-sheet entities, pulling them into their own balance sheets. That means that, in a sense, they’re now under the purview of the Federal Reserve. I think we need to rethink that.

Knowledge@Wharton:  The banks really had to do that, or nobody would do business with them in the future, right?

Marston: Yes. I’m certainly no criticizing the banks for trying to protect their good reputations.

Knowledge@Wharton:  But by using the off-balance-sheet entities, they were carrying in fact liabilities that they didn’t show.

Marston:  That’s exactly right.

Knowledge@Wharton:  So people looking at the banks didn’t really have a clear picture of the risk there. So transparency is always one of the early thing you want to do in a crisis, to make sure people understand risks even if you’re going to let them take them, is that right?

Marston:  That’s exactly right. And that’s what we want to guard against in the future, making sure that there’s much more transparency. You would have thought that we would have learned more from Enron, that off-balance-sheet entities can be dangerous, particularly if we’re talking about the major commercial banks of this country. And yet we don’t seem to have learned enough lessons from Enron.

Knowledge@Wharton:  There’s also been some talk about the way the mortgage business has evolved, and we have companies that are initiating mortgages and other that are bundling them up into securities, and mortgage brokers, and many of these are sort of unregulated, or at least there’s no central regulation at the federal level. Should there be?

Marston:  I think the mortgage industry has changed so much, and we definitely used to have federal government regulation of the provision of mortgages through the S&Ls. Now we have mortgage brokers who are subject, as far as I can tell, to a minimal amount of regulation and oversight.

And we’ve heard about some pretty bad practices in the mortgage industry, by a minority of participant, but nonetheless upsetting to us. Because we know that ultimately the spark that set of this blaze was in the sub-prime mortgage market and the mortgage market in general.

So clearly, we’re going to have to look at mortgage originations, how much oversight there should be. We also have to worry about whether or not, if a bank is going to package together a mortgage, would it be a good idea for the bank to be required to hold onto some of the mortgages. In a sense to, as we say, keep some skin in the game.

Knowledge@Wharton:  So if they implode, the bank will lose some money and it’s not just passed on to somebody in Abu Dhabi or someplace.

Marston:  That’s right. That’s exactly right. To try to get the banks to think of themselves. I mean, it’s a wonderful thing that we’ve developed the financial markets to we don’t have an S&L in Philadelphia that goes under because it’s funding 30-year mortgages with short-term deposits. I mean, that was an absolutely crazy system.

Now we have the ability to bundle together some mortgages, diversify them, and then sell them to individual investors. What a wonderful thing; securitization is such a sensible idea. But somehow we have to make sure that there’s oversight, first of all at the origination of mortgages, and then that the packagers of the mortgages — whether they’re commercial banks or investment banks — somehow pay a little more attention to the quality of the securities that they’re developing.

And one way to do that would be to require that they have some capital invested in those same securities.

Knowledge@Wharton:  So they’ll share the losses.

Marston:  But these are the kinds of things that I think that we have to think about. We have change in the administration coming up. We have an election; changes in Congress. After the election I think people are going to have sit down in Washington and really think through, what would be the minimal amount of regulation which would make this system of our safer, which would make the mortgage system fairer to Americans and more sensible from the point of view of the stability of the financial system.

But more generally, what is the minimal amount of regulation that will make the financial sector as a whole safer.

Knowledge@Wharton:  Well, this story is going to be running for quite some time, we can tell. Thank you very much, Professor Marston.

Marston:  Thank you for inviting me.

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