“There was a machine being developed which created just a fantastic amount of … junk,” says Wharton finance professor Marshall Blume. “At some point, that all had to explode.” Blume is one of seven Wharton professors interviewed by Knowledge at Wharton for this special report on the credit crisis.
An edited transcript of the conversation follows.
Knowledge at Wharton: It seems odd, I think, to a lot of people that a problem that originated with just a slice of the housing market has evolved this way to encompass not only many types of mortgages, but other types of debt securities, and it seems to be spilling over and affecting the financial markets and other countries as well. How does this happen? How does it evolve to be so big?
Blume: You have to go back a little bit. We actually had a liquidity bubble. Anybody could obtain funds at very cheap prices. As a matter of fact, it was a savings glut and it was going to be punctured. The question was how it was going to be punctured. There were whole factors, a perfect storm actually of factors that came together that created the problems in the subprime market. It was the most fragile.
There were a lot of government policies, global events that created that situation. You used to have to borrow — on a mortgage you had to pay something down. Now, you don’t have to do that. As a matter of fact, some of the mortgages were over the appraised value of the houses. This was actually a government policy. The House and the Senate, Republicans and Democrats think home ownership in the United States is a good thing.
On top of that, you had a tax program for corporations, which encouraged them to issue debt. They issued lots of debt. As they issued the debt, some of it became of lower and lower quality. There are also some institutions that require high quality. But for regulation or for just that they always had it, like insurance companies. So, what did all this amount to? Well, the brokerage firms figured out a way of taking this excess debt, subprime mortgages, and repackaging it, making a lot of money in the process and selling it to insurance companies and the like.
So there was a machine being developed, which created just a fantastic amount of … junk and it was being repackaged as high-quality. At some point, that all had to explode.
Knowledge at Wharton: Now, one of the things in the description of the “perfect storm” that I’ve heard fairly often is: “The problem is we had three events occur that don’t usually occur together.” That is, these securities were predicated on the belief that interest rates would stay very low, that housing prices would continue to rise and that people’s incomes would rise enough so that they could cover the higher payments when these adjustable rate loans reset down the road.
But it doesn’t seem all that unlikely for these events, these conditions to change because interest rates were exceptionally low. They just went back to normal. Housing prices were clearly in a bubble and they just fell back to normal. Was this implosion something that the people who were involved in this market should have foreseen?
Blume: They might have foreseen it. I’m sure that some foresaw it. But again, you [could] make money, get rid of the risk yourself and make a lot of money in doing that. Firms like Countrywide made money by selling mortgages and then they would get rid of them. The same thing would be true with the investment banking firms, although they were stuck with low inventory at the end. It’s like the Ponzi Scheme.
Knowledge at Wharton: One of the things that seems curious to me about that is that if many of the participants knew that these were risky things, but they saw a chance to make a great deal of money, they must have anticipated that it would fall apart later. It seems to me that there had to have been a great financial incentive to make it quickly, make the money quickly, and the future would just take care of itself. Is there something skewed in the compensation system, in all of these lines of business that contributed to this?
Blume: Well, you always have to pay people to do things. But, you have to ultimately have a buyer of the tranches … with alphabetical soup — SPVs, et cetera.
Knowledge at Wharton: Right.
Blume: You have to have somebody who wants to buy them. Well, now when all the credit agencies come in, and they say these are AAA — well, they are AAA and that’s good. So people buy them. They could even get a higher yield than on other AAAs. That should have told them something, but they still bought them.
Knowledge at Wharton: If it’s too good to believe, you shouldn’t believe it, right?
Blume: That’s correct.
Knowledge at Wharton: You have done a lot of work on the evolution of the financial markets, the exchanges themselves.
Knowledge at Wharton: In recent years there has been a dramatic change in both the lines of business the various exchanges are in, which used to be separated even geographically or with the types of securities they traded or in some other way. Now they are all, it seems to me, blending into one another’s business. We have mergers that are even taking place across oceans. Has this blending of markets contributed in any way to the kinds of aftershocks we are seeing and the enlarged effects that we are seeing from this subprime mess?
Blume: Well, I think there is. What is happening is the regulatory framework has not caught up. In this country, we regulate futures differently from stocks. But I can package, as a financial engineer, a derivative that looks or behaves just like a stock, a stock that behaves just like a derivative. So there has been a melding of these instruments, which has created a lot of liquidity in the economy. But it is not being regulated as well as it should — because the regulation hasn’t caught up with the technology.
Knowledge at Wharton: Just to explore that a little further, for example, you have a stock that is going to behave in a certain way. Historically, that is predictable. Certain factors will affect it. And then you have a derivative that will behave somewhat differently, but is based on what the stock does. They may be traded by entirely different groups of people, or they may be overlapping groups of people. But the point is that what happens to one of them will feed back into the other. Is that correct?
Blume: Well, certainly we used to think that there was a primary security, like a stock in all the derivatives. But the derivatives actually are more liquid today, so they may be driving the stock prices. But I can also create a derivative whose returns are exactly the same as the stock and it’s called a derivative.
Knowledge at Wharton: What will be the purpose of that? If you have the stock, why bother?
Blume: It’s cheaper to trade; it’s liquidity. We have very high volume in all these markets. The reason is it’s cheap to trade, and if you have an inkling that something is mispriced by a mil or a penny, you go and you can trade it now.
Knowledge at Wharton: And you get to make a little profit on the difference.
Blume: Yes. You pick up the nickels and dimes and the pennies.
Knowledge at Wharton: And if you do it in hundreds of millions of dollars or billions, eventually it is real money.
Blume: Yes — so you pick up 20 nickels, you have got a dollar and so on.
Knowledge at Wharton: A lot of people have been looking at the question of whether the regulatory system, which has roots going back 60 years and has been put together piecemeal over time, is really up to the task today. Are there gaps in it, and what do you think needs to be done to fill them if there are?
Blume: Well, we have first of all gaps in or differences in regulation in this country between futures and stocks. The SEC’s dictate is to protect the small investor. Well, the small investor isn’t here anymore. But they still try to protect them. The future regulation is more designed for sophisticated investors. So you have a gap there. People will take advantage of it. And then you have got differences between Europe, Asia and the United States regulation and they don’t have always talk to each other so much. There are big gaps.
Knowledge at Wharton: One of the arguments that comes up a lot when you hear people talk about new regulation for the US markets is, well they are not doing it overseas, we will lose all our business. Companies will list their stocks overseas instead of in New York and that sort of thing. Is that a legitimate worry, or is that just an excuse to avoid regulation?
Blume: One, it is a worry, and then it’s not a worry. Some people would argue that a better regulation in this country, presumably better regulation, encourages companies to list here because they have cheaper cost of money than if they list it just in a foreign country. Now that is somewhat debatable, but it might be the case. So you can say good regulation is actually good for companies. Now it is true that we may be over-regulated in silly ways in this country.
Knowledge at Wharton: And what are those?
Blume: Sarbanes-Oxley requires a lot of paper work and some of that paper work may not be valuable, but corporations have to do it and boards have to do it.
Knowledge at Wharton: And that was a result of the Enron period ….
Blume: Yes, that was passed quickly and it wasn’t a well vetted bill. There are certain features of it that are very good and some that are not.
Knowledge at Wharton: One of the effects of this sort of globalization and mixing of all of these financial markets and institutions is that it is much easier for people around the world to trade securities from places half a world away. Do international investors have a good enough idea of what it is they are buying and selling when they deal with some security that was created 6000 or 8000 or 10,000 miles away?
Blume: I think they have as good a knowledge as our people in this country, which the evidence shows some people have gotten hurt in both countries, here and there.
Knowledge at Wharton: So a lot of people thought they were taking less risk than they were in the United States?
Blume: Well, a lot of that had to do with the rating agencies. That was an example of systemic effects. The rating agencies consistently underrated the risk of some of these derivatives.
Knowledge at Wharton: And was this because they didn’t understand them, or there are conflicts of interest in their relationship with the firms whose securities they are rating, or what?
Blume: Well, certainly there wasn’t, I don’t think, fraud. This was an instrument that did not have a lot of history; therefore, they didn’t really understand the risk, so they made some assumptions and those assumptions turned out to be optimistic.
Knowledge at Wharton: And do you think that this is something that they will remedy on their own — they obviously got a black eye over this — or does some agency need to step in and say, you will do this from now on?
Blume: No, investors are very smart; they only get burned once, and they got burned.
Knowledge at Wharton: Other ways [of getting burned] are always waiting around the corner.
Blume: Oh no, they will be burned again; you know we had the S&L disaster a long time ago; you don’t have any problem there any more.
Knowledge at Wharton: At the other end of the spectrum, we talked about the sort of the big companies and the big players, the investors. But at the other end there are homeowners. And there are various proposals floating around in Washington now for helping them in some way. And they range from things like helping them to refinance, to fixed rate loans at lower rates, to postponing the resets that will cause their monthly payments to rise, to buying the securities from their owners and rewriting them, and all sorts of exotic things. Do you think that some sort of — I hate to use the word “bailout” — but bailout is necessary for homeowners?
Blume: A bailout of homeowners is a bailout of the lenders. Whenever people say they are going to bailout the homeowners, they are bailing out the lenders and that creates a horrible precedent. Now, many of these homeowners didn’t put much down, so they are not going to be losing very much of the homes that are in default, but the lenders will, and that is probably where it should be. Now having said that, there were certainly cases of fraud and there should be remedies for that type of situation.
Knowledge at Wharton: Finally, what is your assessment of the Federal Reserve’s response to all of this?
Blume: The Federal Reserve has opened up new avenues — which we are going to have to see how they work out. I mean if I were now lending to a brokerage firm or an investment bank in a subordinated debt, I would say: “I don’t really have to worry about doing too much research because if the thing goes down, they will bail me out just like they did with Bear Stearns.”
Knowledge at Wharton: And you are including in this not just the Bear Stearns situation, but they have been doing things like lending out treasury bonds and taking mortgage obligations as collateral and that sort of thing. A lot of people are in favor of that. They think this has restored liquidity and prevented a domino effect that would have been worse, but I take it you don’t agree with that.
Blume: No, this is a problem. In the short run, it has certainly helped. We don’t know the counter factual — what would have happened had they not done it. There was a lot of risk about what might happen if they had not done it. But, by doing what they did, they reduced that risk. Now whether this, in the long run will hurt the economy or hurt the functioning of the financial markets, I am not sure.
Knowledge at Wharton: So the real test will be in the future to see whether financial institutions take advantage of this, to do something excessive again?
Blume: I wouldn’t say that [laughs].
Knowledge at Wharton: All right, well thank you very much professor.