In a roundtable discussion on the fallout from a week of turmoil on Wall Street, Wharton professors Richard Herring, Susan Wachter and Franklin Allen discuss the ripple effect of the crisis across U.S. and global markets. They also speculated on the AIG bailout, which was announced shortly after this video was recorded on September 16.
Knowledge at Wharton: We are back and we have been joined by Wharton finance professor Franklin Allen. Welcome. Since the Fannie Freddie story, which was about a week ago, we have had all sorts of events: AIG is in trouble, Lehman has collapsed and apparently is going out of existence, Merrill Lynch has been taken over by Bank of America. Is this a surprise and is it the end? Do you think we are going to see more and more of these financial companies going under or are we getting to the end of it?
Allen: My answer to that is we are not at the end of it yet. What’s driving this is the falling property prices. I am not the expert — Susan is the expert on that — but my view would be that we still have a ways to go; and as long as that keeps happening, then we are going to have more and more problems. AIG is the next one that is in trouble, and I think it may well go under.
Knowledge at Wharton: Let me ask about AIG. Is this a case, unlike Lehman, of a company that is too big to fail where once again we are going to have to see the government or somebody do something to preserve this company?
Wachter: I think that Lehman was obviously not too big to fail. Also we need to have examples of companies that are not too big to fail, because otherwise moral hazard will be not only with us for a long time to come, but right now, there are decisions being made which will make things harder if there is an assumption that the government is going to step in. These are painful moments, but we do need to have the downside risk in order to make decision making accountable.
Is AIG too big? Well, AIG has implications internationally. It is not just a US company. And right now, there are discussions going on. I don’t know that anybody knows how deep and difficult the resolving of AIG’s bankruptcy will be.
Herring: Susan raises an interesting point and that is, why was it that Lehman was not too big to fail, but Bear Stearns was? Because Bear Stearns was a fraction of the size of Lehman. And one wonders exactly why the treatment was different. One can speculate that the Fed was taken by surprise with Bear Stearns. Looking back at credit default swaps and the exposures and the leverage of Bear Stearns, one wonders why they were so surprised, but they were.
But since the time of Bear Stearns, they have had teams of examiners in all of the major investment banks day by day. One hopes they have done their homework to know exactly where the spillovers are likely to happen. That emboldened them to try and experiment with Lehman, which is a substantially larger institution than Bear.
However, Susan’s moral hazard point, I think, plays out even in Lehman’s difficulties, because the prospect that the Treasury and the Fed would blink at the end led to a poker game that was very, very difficult for Lehman to find a partner. People held out until the very last moment. They didn’t necessarily believe that Bernanke and Paulson would not bail out Lehman. And so, it really wasn’t until Sunday morning that you saw the two potential bidders withdraw. That’s one of the causes of the moral hazard — that if the government intervenes, they set up expectations they will do it again.
Wachter: I think the same sort of things is happening, just as we speak, at AIG. I am not on the inside of this at all, but certainly rumors that there were some who were coming to make offers and they were turned away because the offers weren’t as good as maybe a bail out situation might be.
Knowledge at Wharton: It is almost a Russian roulette situation where some may be saved, some may not, nobody knows which is which. Is that right?
Herring: Well, that’s the way central bankers would like you to feel about it. They call it constructive ambiguity. I think it is quite destructive because I think it is quite easy to figure out which institutions in general they are going to deal with. AIG is a very interesting case because the subsidiaries are perfectly solvent. It is the holding company that is having difficulty.
And because of the peculiar way in which insurance is regulated in the United States, there is no regulator with overall oversight of the company. There is in fact nobody who has an overall oversight, but you have individual subsidiaries that are regulated in each of the 50 states and in each of the countries in which they work.
Now, what does it do to those supervisors? Well, first and foremost, it is to protect the assets of that subsidiary for the benefit of the policy holders in that domain. And so, there is an enormous reluctance to let the excess assets in those subsidiaries be upstreamed to the holding company to meet this kind of demand.
There are lots of solutions potentially, for AIG that were more difficult for the others. They have more things that are easy to value. You have Warren Buffett sitting out there who would be happy to take them over, who does this kind of business anyhow and has pockets deep enough to actually supply the funds. You have private equity concerns that for regulatory reasons can’t take over US banks, but could in fact take over an insurance company with no problem at all – or parts of an insurance company.
What I think we are going to see happening is that the parts of AIG that are easy to sell are going to get sold pretty quickly. It is going to be a smaller company, but one hopes it survives. Apart from the holding company, the subs are not subject to the same kinds of pressures that investment banks and commercial banks are subject to. They in general have liabilities that are long term. They are not subject to runs in the way that we have seen Lehman and Bear Stearns and banks classically. And so, they usually have more time to deal with it. Liquidity is not usually going to bring them down except that the holding company got deeply involved in insuring credit default swaps and in the mortgage market. And that is a source of liquidity pressure. The fact that they were downgraded last night — I guess it was two notches, some people feared it would be three — set off clauses that permitted counter parties to demand more collateral, and that is a source of their urgent need for more cash.
As in all of these cases, in the end, it is a fierce bargain between those who got cash, including the government and those who need it. Having some clarity about whether the government will step in or not, would make the whole thing resolve a lot more quickly.
Wachter: Well, is it systemic risk, Dick, from allowing them to go down?
Herring: Well, they are the insurer of a lot of credit default swaps, but that is also true of Lehman Brothers. And the answer is that it won’t be a total loss, it will probably mark down the value of those swaps maybe $0.20 and in the end….
Knowledge at Wharton: From the dollar?
Herring: Yes.
Knowledge at Wharton: So, in other words, if they can’t make good on the insurance, then somebody else loses money?
Wachter: And many banks — and these will be European banking institutions — are exposed.
Herring: Speaking of European banking institutions and following up on Franklin’s comment that we are not through this yet, if you look at where the subprime is held, almost half of it is in Europe.
Wachter: In fact, most of the losses are in Europe …
Herring: And the difference in reporting between the United States and Europe has made US institutions recognize those losses more rapidly. They are considerably more transparent. The Europeans are also held to a fair value standard, but because they have a set of principles based accounting rather than the bright line rules, the CFO has a lot of judgment about what standards he uses for evaluation and when he actually talks about when the loss was suffered. So, we know there are lots of shoes to drop …
Knowledge at Wharton: We read so much about the interlocking of the economies and the financial markets between China and the US, and India and the US, and that we are all connected in different ways. Are they going to suffer from what we are doing?
Herring: China and the US came into this in a very interesting way because one of the very largest holders of Fannie and Freddie debt is China. And one of the tough questions that Paulson is facing this afternoon, because I think their hearing is on it, is why did he protect Chinese debt holders while letting small- and medium-sized US banks suffer who were holding preferred shares and thought they were equally safe, because the government was telling them that they had the same sort of capital charge.
Wachter: The run on Fannie and Freddie was in some ways started in China and the selling of the debt there, which should normally trade very close to Treasury. Those spreads were widening and China was selling. That really provoked the necessity of stepping in. But, I agree, this is going to be difficult set of questions that he is facing today.
Knowledge at Wharton: And how about India — a big player in the international economy. Are they involved?
Allen: If we all go into deep recessions, they are not going to be too happy. So, I think, it depends a lot on how bad things get.
Herring: In a way, it sets back to the case for financial reform in India, which they desperately need in a major way because now they can point to the US in particular and say, “Look, what a terrible mess they have made with their innovations and liberalized standards. Our direct controls have kept us out of this whirlwind of financial chaos.” India has a real problem in allocating capital efficiently because it is controlled by state owned banks that have multiple objectives, but it isn’t necessarily who can use the money most efficiently.
Wachter: They do have subsidiaries. AIG’s subsidiaries in India will be under pressure, so that will have some [consequences] … Real job losses will [result]…
Allen: We are going through this terrible crisis and who knows where it will lead, but it could well get a lot worse. One may wonder what exactly went wrong and maybe we have some problems with the way we regulate or deal with….
Knowledge at Wharton: It is a little hard for us to scold the rest of the world about the way they behave, isn’t it? Franklin, when you and I talked about this months ago, back in the spring, you felt that the subprime mortgage crisis was reminiscent of some of the things that happened in Japan a while back. I wonder if you still feel that way with all that has happened since?
Allen: Yes, I think, it is very reminiscent of that. They had a property bubble and a stock price bubble. And we have had a stock price bubble and … a property price bubble, and now it has burst and has caused similar kinds of problems. We have had a much more dramatic effect for similar reasons that Dick was mentioning a few minutes ago, about our accounting system requiring people to keep much more, shall I say, honest or much closer tabs on what’s actually happening, whereas in Japan, they were able to essentially ignore those problems, using tax losses and things to keep the banks solvent in some sense.
What we are seeing is a lot of problems because of that. In Japan, that has spilled into the real economy and they had the lost decade. The big question in the US is whether the same thing is going to happen.
Knowledge at Wharton: And what do you think we should take away from the Japanese experience about what needs to be done to handle this kind of crisis?
Allen: Well, the first thing we should take away is that we shouldn’t have got here in the first place and we should have looked much more closely at this fact that if you have bubbles, it causes big problems when they burst. And I think, we had that debate back in 2000, 2001 in the US. The Fed decided that it wasn’t a problem and we shouldn’t worry about it.
Herring: This was the dot-com.
Allen: The dot-com bubble burst. There was a question of should they have raised the interest rate earlier to burst it? Their conclusion was, it’s difficult to know whether you’re in a bubble or not; we needn’t worry about it. And we had the property bubble because they kept interest rates low, and now we’re having a fallout from that. So, that would be the first thing. We have to revisit that issue very urgently.
Knowledge at Wharton: And then, given that we’re in it, what does the Japanese experience tell us about getting out?
Allen: It’s very difficult. And it’s not clear to me that there are any easy solutions to that. So, as we go forward, it’s very difficult to say whether we should pump capital into the financial institutions, whether we should save them to prevent a meltdown like in Scandinavia, for example. These things take a long time, and they’re very painful once you get there. There are no easy solutions.
Herring: I would disagree in one respect. Although I think Franklin’s analysis of Japan is right on, I think one of the things we’ve learned from restructuring banking systems is that delay is very costly to the real economy, that the sooner you recognize losses, allocate them, reallocate resources, and move on, the more likely you are to recover. It’s a lesson from the Asian crises, and it’s actually something that we in the U.S. are pretty good at once we set our minds to it.
It’s also a lesson from the Scandinavian crisis. The Swedes were very quick to take the dead debt and sell it off as quickly as they could to people who were willing to take that kind of risk for presumably high returns, clean up the banks, and let them move forward. As a result, they didn’t lose a whole decade of growth as the Japanese did, who basically ran an insolvent banking system for an entire decade.
Allen: On the other hand, in Japan, it didn’t spill over into the real economy in a negative way in the sense that there wasn’t a huge contraction. You didn’t have very large contraction in GDP, so unemployment didn’t go up dramatically. The ordinary people didn’t really suffer very much compared to the Scandinavian crisis.
Herring: Stagnant incomes for a whole decade are something the U.S. would have trouble tolerating…. And the rest of the world, too.
Allen: In the 1930s, we had 25% unemployment for years, which is much, much worse in my view.
Herring: Absolutely, but that was not a result of allocating losses quickly and moving on.
Allen: That was a result of financial system collapse.
Herring: Yes.
Allen: So, I think that there are advantages to what Japan did. In my view, they actually came through it quite well because ordinary people didn’t really suffer other than that their income didn’t grow as much as it might have done otherwise.
Herring: And they pay higher taxes than they would otherwise.
Allen: Well, that’s not true yet, because it’s all in the debt.
Knowledge at Wharton: One of the things that we’ve all grown up with is a belief in the free markets that they should be allowed to move back and forth and solve problems on their own. On the other hand, there are those who are arguing that this whole crisis was a result of the free markets going haywire. I’m just wondering whether, looking forward, all of this suggests a need for a new round of regulation, a reorganization of the institutions in the government that regulate, or in the states. What needs to be done to prevent the recurrence of this kind of thing in the future.
Allen: I think it’s very difficult to say how we’re going to stop it, because these things happen every 10 years or so. We could do what they did after the 1930s, which is put in such stringent regulation that banks and other financial institutions can’t take risks, but then we get into the problem that we don’t grow in the long run. It’s a very difficult trade off.
We have to try and figure out what happened this time. There’s a lot of debate and a lot of differences as to whether it was just that people in the property markets screwed up completely, and the rating agencies did a bad job, the incentives all went apart. Or whether, as I would argue, what happened was that the financial system itself, in terms of pricing assets, that pricing mechanism failed, and that’s why it came as such a surprise to people.
Wachter: I would agree. I think the pricing system did fail. We easily have bubbles in real estate and housing, and there are expectations that feed on themselves, both on the upside and the downside, so there are frenzies that occur.
But then, there’s always the question of who’s lending the money for people to actually buy, and in this episode, we had lending standards erode, and we actually had risk premium erode. There clearly was a race to the bottom … and we did not have lending controls. They were off the table. We were underwriting any risk and we weren’t underwriting very well.
So, that has to change. There are two ways of changing it — and I don’t think we know which way to go or [whether it should be] a combination. One is to have regulators who are on the job, but there are all sorts of issues about that. Two is to have a market based discipline where we have actually market instruments, which can be traded to expose risk of buyer and selling.
In this case, we had many of these instruments, Imprimatur, AAA, very complex, never traded, put into portfolios, and there wasn’t the ability to trade against them with market knowledge. There were a few indexes out there that got created towards the end, but they were a very small percentage of the market.
Herring: Just one last point, following up on some work that Susan and I did, and the OACD and the IMF have done as well. These sorts of things happen every 10 to 20 years. And they happen in all kinds of systems. It isn’t special to systems that have securitization, it isn’t special to systems that have private banks, it isn’t special to systems that have only thrifts, it isn’t special to systems that have only nationalized banks. It happens in all of them.
There are fundamental dynamics in housing and property markets that lead to speculative bubbles and inevitably bring some financial systems down with them, because financial systems are heavily involved in mortgage lending.
Knowledge at Wharton: Well, thank you. I’m sure we’ll be back talking about it again. Professor Herring, Professor Wachter, Professor Allen, thank you very much.
