With stock markets in freefall, U.S. Treasury Secretary Henry Paulson announced on Tuesday that the government’s effort to unlock credit markets would include direct investments of $250 billion in bank equities. He also warned bankers not to hoard the money, but to use it to make the loans that lubricate the nation’s economy. Similar moves announced by European governments over the weekend, along with anticipation that the U.S. would follow suit, sent global stock markets rocketing upward on Monday. But the moves signal significant changes in the financial landscape, moving leverage and power from Wall Street to Washington. In separate interviews, Wharton finance professors Richard Marston and Jeremy Siegel tell Knowledge at Wharton that while the investment is not without risk, it appears to be the best hope for restoring confidence in credit and stock markets — and reducing the severity of a recession that is all but certain to come.
Knowledge at Wharton: Why did the second part of the financial rescue plan — the government’s investment of $250 billion in bank equities — boost the market?
Marston: I think we have to realize that last week we saw that the market not only shrugged off the [first part of the] plan, but they were very upset about it. The market had one of its worst drops ever. There was — I think — the conviction on the part of the market that this plan, as formulated originally, wasn’t the right type of plan to get the banks to start lending again. I mean, in essence, the problem is that we’re going to have a serious credit crunch, and it’s going to have a major impact on the economy. And the sooner we get the banks and the financial sector in general in better shape, willing to lend, willing to take on credit risk, the better off the economy will be.
The initial plan was to buy up the debt. And the Treasury was going to take three or four weeks to get its act together, and to start buying the debt. The new plan focuses on equity. I think there’s a greater chance for success for two reasons. First of all, it focuses directly on injecting equity into the banks, rather than doing it indirectly through purchases of debt. And secondly, it’s a coordinated intervention. In that the British have already started buying equity in the banks, bolstering the banks. The European — your area has come up with a plan for doing the same thing. There’s an awful lot of effort on the part of the authorities in the industrial countries to try to get control over the situation as quickly as possible. And I think the prospects for success are just much greater than they were last week.
Knowledge at Wharton: How about from the taxpayer’s point of view? Are they better off now, because they’re getting an equity stake in the banks?
Marston: Ironically, with the Treasury taking a more aggressive stance, the chance that the taxpayers will come out whole in this are much greater. We will own, as taxpayers, pieces of these banks. And there’s going to be every incentive on the part of the banks to pay back the debt as quickly as possible. These are going to be preferred shares. And if the banks don’t start paying back after a period of the first few years, the rate of interest goes up on the debt. And so there’s going to be every incentive for the banks to use the equity to bolster their positions. Hopefully, to start lending again. But in the meantime, to try to get the government off their backs as quickly as possible.
Knowledge at Wharton: The whole plan moves government into a financial role that it’s never had before. And it would seem to shift a lot of power from Wall Street to Washington. What are the implications of that?
Marston: I think you’re exactly right, that this is almost unprecedented in the role of the federal government in taking active share of the risk in the financial sector. It’s unprecedented, except for the 1930s when we were in much worse shape than we are today. But I think it’s the nature of the financial crisis that unprecedented steps were needed. The financial sector — particularly the banks, investment banks. But also, as we saw with AIG insurance companies — have got themselves into securities, into risk positions, which require someone to come along to bail them out. And there are only so many Warren Buffetts in the world. And ultimately, it’s the federal government that’s going to have to step in there and make sure that this financial sector is righted. And that’s going to take a lot of imagination. And I think we’ve seen, so far, a lot of imagination on the part of the Federal Reserve, Bernanke, on the part of the Treasury, as well as the FDIC. They understand how serious this crisis is. And in a sense, they’re writing the rulebook from anew. Trying to do the right thing — to get the banks healthy again.
Knowledge at Wharton: We keep hearing that there’s going to be a lot more pain to come, even under the best circumstances. What is that pain likely to look like? Can we say with any certainty how many jobs are likely to be lost, or where home values will be going in the next 12 months?
Marston: I don’t think we can say with any certainty what’s going to happen to employment, except that if the bailout is a success in getting the banks to start lending again, we will have a much milder recession than we will have if we continue to see the credit crunch. And we’ve begun to see that in the last few months, and it’s a bit scary. To see companies with good credit standing unable to get the loans that they’re normally entitled to. To see households that rely upon credit, who have good credit ratings, which cannot get loans. And this is true all over the country. So far, it hasn’t reached the point where we’re going to have a serious recession. But I think the potential is there. And as a result, the federal authorities have had to take this crisis very seriously.
Knowledge at Wharton: Now, of course, this is going to deepen the deficit, along with the impact on federal revenues from just a recession. At what point — or is there a point — at which we need to become as concerned or more concerned about that than we are about the immediate financial crisis?
Marston: Well, I think you have to realize that over the last four or five years, the economy has been expanding, and the Treasury’s revenues have grown. As a result, last year, the federal deficit was only 1.2% of GDP. That’s relatively low. This bailout, as well as the recession — and you’re right to point out that in a recession, tax revenues really do decline. And government expenditures increase. During the recession itself, what we will find is a serious deterioration of the deficit. On top of that, we will have whatever cost there is of this bailout. Now, a lot of people have said, “We’re spending $750 billion on a bailout.” Actually, that is money that is being invested in the banking system. And we will see later on how much of that is actual cost for the taxpayer. But there’s no question that there will be an increase in the deficit. But the deficit we should worry about as taxpayers is the longer-term deficit — the deficit that has to do with the growing cost of Medicare, the growing cost of Social Security, the growing cost of having an aging population. That is the time bomb, as far as the deficit is concerned. And if the Congress, and if public opinion-makers pay too much attention to the short-term deficit, they will miss the big picture. Which is, what are we going to do with the longer-term fiscal health of this country? Right now, we have an excellent credit rating across the world. In the longer term, unless we do something about the longer term problems with the deficit, we will have problems with our credit rating.
Knowledge at Wharton: And how would you rate the performance of Treasury Secretary Paulson and Fed Chairman Bernanke in all of this?
Marston: Let me start off with the easy case, which is the Fed Chairman. Bernanke spent his academic career making sense of the mistakes that were made during the Depression. And I don’t think there’s anyone who could be better-prepared to understand t important role the banking sector plays in the economy. And the importance of making sure that the financial sector as a whole is protected from the worst excesses of the mistakes made in the past. As far as Paulson is concerned — he certainly was named to the Treasury in time for this overwhelming crisis. In a crisis, what you need are people — particularly in a crisis like this, which involves so many sophisticated instruments. You need someone who is thoroughly versed in Wall Street. Who understands financial institutions, understands financial instruments. We need expertise. And while in the past we’ve had corporate executives heading up the Treasury who are not versed in finance, Paulson was named just in time, as far as I’m concerned. And it’s very important to have someone with his expertise to deal with this crisis.
Knowledge at Wharton: Well, we see that the market reacted very positively yesterday, Monday. Today was a little less certain, in terms of what their reaction was. But are we likely — do you think that this represents a possible true rally in the market? Or are the fundamentals still standing in the way of something more significant?
Marston: I think it’s very difficult to know whether or not a particular day or even a week of market movements represent — what they represent in terms of the market view. Clearly there are two things going on as far as the market is concerned. First of all, is the direct impact on the financial sector. The marking down of financial sector shares. And with that, any companies that could be directly affected by it. But in addition, I think that the market is recognizing during this period that we are entering a recession. That at this point, we don’t know for sure how serious it would be. But normally what we see is a downturn in the market in anticipation of the recession. And then later on, we find an upturn in the market, in anticipation of the rising earnings of companies during the recovery. In fact, I did a study of the last nine recessions. And in every recession recovery period, what we find — and this is going back to 1950 — what we find is that in the first 12 months of the market recovery, the market rises at least 30%. I’m talking about the S&P. Very sharp rise. And so at some point during the recession, normally, we see the anticipation of the recovery. And then there’s a sharp rise in the equity market.
There is another pattern that’s very interesting. Which is, in these nine recessions, in all but one recovery, the recovery itself of the stock market began before the end of the recession. The exception is the last recession, when we had to wait until after the recession ended before the market finally turned around. So there’s a natural tendency for the market to react first of all to the signs of the recession, to the downturn in business activity. And then later on, often times during the recession itself, to the rising — rise in earnings that will occur once the recovery begins.
Knowledge at Wharton: We’ve heard a lot that the financial crisis, the global crisis, would have a very deleterious effect on some of these emerging economies, and emerging markets. Particularly places like India and China. What’s their position now? Are they still in harm’s way here?
Marston: I think there was a notion in the market that some people believed in just a few months ago, that there was a genuine decoupling of the emerging markets from the industrial countries. Now we have the potential for a recession in Europe. In fact, I believe we’ve already started a recession in Europe. Some of the European countries like Germany and France. And we probably have a recession in Japan. And we probably have a recession already started in the United States. And what we’ve found is that the concept of decoupling is total nonsense. There’s a substantial impact on emerging market stock markets, and there’s an impact on their economies, as well. Now, it’s true that China is still growing rapidly. But the growth is being generated by infrastructure projects, rather than by exports. And eventually, I believe that even China will slow down significantly. Decoupling — maybe in the future we’ll be able to see it. But we certainly don’t see it now.
Knowledge at Wharton: And one final question. Is it likely that a legacy of this crisis could be a thriftier America? Thriftier consumers, a thriftier government, and more risk-averse banks?
Marston: I think it’s just undoubtedly true that the household is going to be thriftier in the future. I think just by the very nature of the bubbles that we went through. First of all, the housing, and then the real estate bubble. We’ve ended up with a lot of households that, from a traditional definition of saving, were not saving at all. What’s the traditional definition of savings? What you do is, you say, “How much have you earned this year? How much have you spent this year?” And for many households, that’s a negative number. I think with the end of the rising house prices, rising stock prices, there’s going to be increased attention on saving in this country. And that’s going to be a good thing. I think it’s also going to be the case that a lot of state and local governments are going to be much more careful in the future. This credit crisis is — as you said at the beginning — unprecedented. And I think it’s going to alter behavior. And I’m an optimist. I’m an optimist in the sense that I believe that households, as well as companies, as well as government organizations, are going to be alternative more careful in the future. Because when push comes to shove, in this crisis, they have been unable to rely upon financial institutions to provide them with the credit that they’re normally accustomed to.
Knowledge at Wharton: Thank you very much.
Marston: Thank you.
Knowledge at Wharton: We’re joined by Wharton Finance Professor Jeremy Siegel, who will try to help sort out the impact on global markets of the new chapter in the rescue plan. Welcome, Professor Siegel. The rally ahead of investments — is that likely to continue, or are the fundamentals still standing in the way of a bull market?
Siegel: There’s going to be a lot of ups and downs. You get a lot of volatility at the bottom of a bear market. It rallies strongly, and then it falls back. Usually after a month or two, it will tend to fall back traditions the initial low point of the sell-off, but not quite that low. And then starts upward. And then we get a nice movement upward in the market. Now, that could be a one-month, two months. It can sometimes be four, five months between that. So my feeling is, is we’re in the bottoming phase of this bear market. I mean, I’ve done all sorts of trend lines now, looking at earnings, looking at prices. And this sell-off that we’ve had in the last week, two weeks, has brought us, like, three or four standard deviations below the mean of the last 40 years. I mean, that is how extreme the selling has gone. And — you know, that means that a long term investor clearly is going to have a — my feeling is, is going to experience good gains in the market.
Knowledge at Wharton: And what about overseas markets? Especially in emerging markets, like India and China? Are they going to be taking a continuing hit because of the crisis, do you think?
Siegel: Well, it’s a worldwide crisis, and there’s going to be a worldwide recession. There’s not going to be a depression, because all governments are coming to rescue the banks. We’re not going to have failures of banks. We’re not going to have lost depositors, such as we had in the 1930’s. And that’s very comforting. And that is definitely going to ease any hit. But we are going to go in a worldwide recession. Some of those emerging markets — and particularly China, as we talked about for many months — was way overblown. And it is coming down to reality. I now see Shanghai at 15 times earnings. That’s amazing. This was a market that was 50 times earnings just a year, a year and a half ago. Right now, I’m looking around the world. I’m looking at earnings, and I’m even looking at reduced earnings as a result of the recession. And what I see is valuations that are about the lowest that I’ve seen since the 1970s. And that was a very bad decade for stocks, that set off the greatest bull market in the ’80s and ’90s that we ever experienced.
Knowledge at Wharton: Is this a bargain buying opportunity for investors?
Siegel: Well, as I said, on trend lines, what happened last week was just several standard deviations below any trend. From 1970, it was further below than any other sell-off we’ve had. I went even back to 1945. And it’s about the same as the lowest point it was after the terrible 1974 sell-off, which was accompanied by double-digit inflations, interest rates of 15, 20%, and unemployment that in the early ’80s actually reached 10.8%. So we were in really much worse shape in the ’70s than we are today. But here is the fear of the financial situation. It’s not a fear of runaway inflation, as we had there — which is actually harder to control. We finally did it. But it’s harder to control than to get the lending function going again.
Knowledge at Wharton: Do you think that the decision to invest directly in bank equities and actually give taxpayers a share of these banks, other than just buying up the toxic paper — is that a good move for taxpayers?
Siegel: Definitely. I mean, we can’t give support to an institution and not get some of the upside. And it was mandatory that we do take some of the upside in this. And I think they did, in terms of designing these preferred shares with warrants. I think it’s very well-designed. The only thing that I’m concerned about is — again, giving them capital is not the same thing as getting them to lend more. It’s not equivalent. We’ve got risk premiums on the LIBOR, which is the inter-bank rate upon which trillions of dollars of loans are based, at extraordinarily high levels compared to Fed funds. These extraordinary borrowing rates must be brought down. And I hope that the Federal Reserve takes further action to bring these rates down, and to encourage the lending process. Not just infusion of capital. But also, we must keep the lending process going.
Knowledge at Wharton: Secretary Paulson sort of wagged his finger at the banking industry the other day when he announced this program, saying that, “I don’t want you to hoard this money. You need to go out and use it to grease the skids of the economy.” Do you think that’s going to happen? Or do we need —
Siegel: We need to do something more? Well, it’s a nice thing to say it. But what is going to make that happen? And as I say, it might require the government to back up more loans, and say, “Listen. You keep on lending, and we’ll back you up. And if you lend at a more reasonable rate than LIBOR,” which is really European banks, not American banks, with borrowing much lower — you know, we’ll back it up even more. So Paulson said the right thing. But there were no teeth in any of that program that said, “This money is now to go out and be lent out.”
Knowledge at Wharton: In this whole crisis, how would you rate the performance of Treasury Secretary Paulson and Fed Chairman Bernanke?
Siegel: Unfortunately, my opinion of Paulson went way down, particularly because of the way he marketed the plan. The way it was called a bailout plan. He didn’t stop anyone from calling it that, even though that was not the official — this idea, “Give me $700 billion and I know what to do with it.” No Congressional oversight. That was ridiculous. And he got — you know, pushed back tremendously. It got delayed. Then it got more expensive. Then he caved in on all the points, being somewhat embarrassed at sparking and whipping up the anti-Wall Street sentiment that he did, and he’s responsible for. Unfortunately, it was a terrible failure. It shows you how obtuse he is to political realities, more than anything else.
Bernanke’s been doing a very good job. But he has to come ahead and continue. There’s got to be more going on. As I said, back-up with some interbank lending. I would like to see LIBOR being rebased on the basis of the US rates, which are Fed funds, and not the European rates right now. There’s a lot of moves that still can be done, and I’m hoping that Bernanke — who’s been very innovative in the past — will continue to move forward and be so in the future.
Knowledge at Wharton: So, you wrote the book on investing for the long haul. Are you still standing by that philosophy?
Siegel: Oh, yes. I mean, I think — you know, at the bottom of bear markets, I keep on getting asked that. And I say, “I’m standing by it.” And then people thank me a year or two later on. It’s really painful to go through it. And I do know the decade of the last ten years have not been good, probably because we were at the top of the biggest bubble in history, in 2000. So when you measure it from there, stock returns haven’t been good. But if you go back 20 years or 30 years or 40 years again, if you’re not investing at the top, you’ve got great stock returns. And I don’t think anyone will argue that anyone puts money in the stock market today is not investing at the top of the market, at a very significant discount to the market. Forty%. And from those levels, returns to investors have been very good.
Knowledge at Wharton: Well, thank you very much for joining us today, Professor Siegel.
Siegel: Thanks for having me.