The subprime crisis “was a wreck that could have been predicted,” Wharton finance professor Jeremy Siegel says in this interview. Siegel 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: Some people have described the subprime meltdown as kind of a perfect storm, with a combination of events that don’t happen at the same time very often — and that was rising interest rates, falling home prices and incomes sitting still. Other people think that this was predictable and that the financial institutions that were writing subprime loans and other risky kinds of loans were just ignoring the risks. Was this an unpredictable perfect storm, or not?
Siegel: I think that they were ignoring the risks. I think what happened was that it was very profitable to write these subprime mortgages; in other words, the fees were very, very high. And, as long as the lenders said that they could package it in a way that they could sell it to the public — well, then you’ve got lending, you’ve got financing … and everyone nodded their heads [and thought], “Houses always go up; I don’t have to worry.”
Deep down they might not have believed it, but every thing looked so fine and was so profitable; and, actually, I think that this was a wreck that could have been predicted. What I think was not predicted and [was] underestimated by the Fed and many others was that many of us — and I’d have to include myself — thought that these risks were spread among many, many different funds and investors, hedge funds and others who could afford to take these risks.
I guess the shock was that the I-banks and the regular banks themselves held on to this. We thought it was packaged and distributed throughout the economy. I think that’s what shocked us. I can see why these people created [these loans] — for the profits. And, I thought that they got rid of them. Some of them tried to, but it was a little too late; they couldn’t, and they got caught holding them.
Knowledge at Wharton: A year or so ago, when the first problems were really confined to the subprime mortgage area, a lot of people were saying, “Well, this is one of the great benefits of securitization,” which has been growing so much in recent years — that the risks are passed on to the investors who can handle them the most. And, now we are starting to wonder whether this was really a mechanism for spreading the contagion around the world. Do you think that securitization has been a benefit in this crisis, or a problem?
Siegel: Well, don’t forget that mortgage-backed securities have a history going back twenty-five years, with very little problems. I mean, it was an excellent instrument; there were no problems with it. The best people handled it, its yield was a little over treasuries, but good enough for people to want to finance — and it helped our entire housing industry.
In the extremely low interest rate environment of 2002, 2003 and 2004, people got very hungry for yields. They said, “I don’t want to accept 1% or 2% — I want to get it a little bit higher.” They were saying, “Oh, here’s a security collateralized against real estate, against a home — that never declines in value. Hey, this is safe; we’ll dice it and chop it and make sure that there are safe segments, and we’ll only give the riskiest segments to people who want to really bear that risk.”
Everyone was under the illusion that all of this was happening in an efficient way … and it turned out that it wasn’t. It wasn’t distributed enough; people were holding a lot and then they were holding their breath. What was shocking was that so many of the financial institutions kept on creating this, even after they had trouble selling it. A lot of those institutions — from Citigroup on down — deserve the knock that they’ve had, because they should have known better. And, they’ve wiped out a lot of their own equity and a lot of head rolling has taken place. I feel not in the least sorry that they are taking the hit.
Knowledge at Wharton: What’s your overall assessment of the way the Federal Reserve has handled this crisis, starting with the subprime meltdown and then all of the ripple effects through the credit markets?
Siegel: I think that on the whole, excellent — the innovative type of facilities, the term auctions facilities, the lowering of the discount rate, and the extension of the discount rate to I-banks. And I even approve of the Bear Stearns rescue. I won’t call it a bailout; in a way, it’s sort of a rescue, more than anything else. The Fed has been very innovative and very appropriate — and very timely.
What I question is whether Bernanke had to go down on the rates as much as he did and as quickly as he did. I think that has worsened some of these inflationary pressures that we now see in the commodity market, the energy market and in the food market, etc. We do note that other central banks, particularly the ECB [European Central Bank], have not lowered rates, even though they have also been hurt by the housing situation. They’re standing firm against inflation. I think that this is what’s hurting the dollar and ultimately hurts us through higher prices of imported goods.
Knowledge at Wharton: I want to zero-in on a couple of things that you just said, because I think a lot of people, when they think of the Federal Reserve, immediately think about interest rates and this routine of cutting and raising rates. But, in this case, there have been, as you have said, some innovations: for example, lending treasury bonds and taking mortgage-backed securities as collateral, and things like that. Which of these maneuvers have been the most innovative in your view, and the most worthwhile?
Siegel: I think that all of them have been. Again, there was a terrible shortage of treasuries because they were regarded properly; so were safe securities and everyone wanted [them], driving their yields down. Here, the Fed had a portfolio of $700 billion. It doesn’t have to have those. And what it did was say, “I will take some of your collateral over here … qualified collateral in exchange for these treasuries.”
This lowered the risk premium on some of those riskier securities and raised the interest rate a bit on these treasury securities and brought them more in line. That was very innovative — to extend discount financing to investment banks and broker dealers, as well as to commercial banks. Don’t forget, the Fed was founded almost a hundred years ago and our world has changed a lot. And yet, the structure of discount lending was almost always the same — to commercial banks only. Well, I-banks and all of the rest have become just as important, and we really have to bring them under the umbrella.
The rescue of Bear Stearns was an important part of that at a very critical point in the market. If you take a look, that was the low [March 17th]; risk premiums have gone down since then — not back down to what they used to be, but down from there. The market has bounced up over 10%. I think that will be viewed as a good move. All of these moves, I think, have been innovative.
There used to be a one-point wedge between the discount rate and Fed funds; that was then lowered to one-half point last August and just a couple of months ago down to one-quarter point, again opening up the discount window for borrowing. I think that Bernanke will look very good in history, on following all of those features. Again, the only area where he runs the risk is that with all of those measures, did he have to move rates down as aggressively as he did? We will have to wait and see how that plays itself out.
Knowledge at Wharton: Some people argue that a repeal of the Glass-Steagall Act a few years ago allowed financial institutions that had been separated to merge into one another’s areas of business — and as a result, doing business in ways that were no longer really regulated by anybody. Are there gaps in the regulatory system now, or should it be unified in some way?
Siegel: You know, it’s hard to say. Personally, I think that the same crisis would have hit had Glass-Steagall still been on the books or not. If you take a look, these were very profitable loans. They were mortgage banks, savings banks and others. We could talk about the fact that Greenspan and other regulators didn’t speak out against these no-doc, no income 110% loans that were pumping up home prices, very definitely.
There was regulation on the books and room to come down on that. Again, Greenspan himself admits that he thought that the risk was more well distributed throughout the world’s financial system, and he didn’t realize how concentrated it was. So, there were a lot of misestimates. I don’t think that Glass-Steagall really played a major role. I think that this crisis would have proceeded otherwise. The only way that it wouldn’t have proceeded is if the regulators came down and said, “No, this is contributing to a bubble.”
And, by the way, let me mention the following: Had they done that — everyone in retrospect has said, “Oh, that’s what they should have done” — there would have been yelling and screaming from the housing industry, from all of those people who wanted to buy homes that weren’t home owners before. I don’t think that it would have been politically simple to really shut this process down, because a lot of people got a lot out of this. And, at that time, they thought that they were getting great bargains with their mortgages and they would have been very resentful had the government stepped in at that time. So, it would have been much harder than a lot of people think.
Knowledge at Wharton: All of the discussions of remedies, or reforms or whatever follow-up is necessary here, seem to break down into three broad categories. There are people that would say, “Do nothing; the markets are solving this themselves — they’re not writing these subprime loans any longer, for example.”
Then, there are those who say, “All we really need to do is ensure better transparency” — that a lot of people didn’t really understand what was going on with some of these mortgage-backed securities that were moving out into the marketplace.
And then, there are others who say, “Well, we need a much more rigid set of controls and monitoring over what hedge funds and other sorts of players in today’s market are doing.” Where, along that continuum are you?
Siegel: Well, in a way, a lot of this is closing the barn door after the horses have escaped. And, right now, no one is writing subprime. We don’t have to have regulation against a 110% no-doc loan, because no one is giving those and no one will for many, many years to come. You know, we have to remember that in a free market economy, we’re going to have bubbles of various sorts. If you want to move to 2% growth and no fluctuations, you’re going to have to move to a socialist economy — and no one wants to do that because that will obviously harm all of the productivity. We’ve got to learn how to accept them, but we also have to learn how to devise, as I think the Central Bank has, ways to mitigate the crisis.
I think that we’re going to get through this with a mild recession or less. Think about what happened 70 years ago with the Great Depression, when a similar set of circumstances hit: The Fed didn’t come to the rescue, the whole banking system went up, and unemployment went up to 25% and GDP contracted by one-third. I mean, these are magnitudes that we can’t even imagine today. But, it shows you how bad things can be.
My feeling is there has to be transparency — and particularly if we’re going to bring investment banks back under the fold, so that they can be rescued, we have to make sure that they have enough of risk capital, just like we do with the banking system now. So, in a way, we have to make sure of that. But, I also would not put an end to hedge funds where qualified investors know the risk and will move into the markets as they think. I do not believe that they contributed to this. I think, as I have said, that the forces were very different that contributed to this problem.
We still want the free flow of capital; we all benefit from that. We just want to make sure that we have a regulatory system that will minimize some of the worst shocks that could come from normal fluctuations in these markets.