BY LINDA LEE
A standing-room only crowd packed Austin North Wednesday evening to hear Professors Lucian Bebchuk, Howell Jackson, Hal Scott, and Elizabeth Warren discuss the current financial crisis. The majority were in support of passing the current Senate bill, if the only alternative were inaction; however, all panelists expressed concerns about the bailout plan. Dean Elena Kagan moderated the panel, asking them to speak to “how we got here, where we are, and what we should do about it.”
To start, Jackson gave a brief background of the events leading up to the current situation. For reference, he described the savings and loan (S&L) crisis in the 1980s, during which the federal government spent $160 billion to rescue failing S&Ls; according to Jackson, this would be $465 billion in today’s dollars. After the S&L crisis, mortgages began to be financed through the capital markets, rather than by the financial institutions themselves. Mortgages were securitized (MBS, or mortgage-backed securities), and these assets were sold in the U.S. and abroad, usually institutional investors.
Warren stressed the role of mortgage originators who produced “tricks and trips” mortgages, most notably adjustable-rate mortgages (ARMs) with “teaser” rates – interest rates at a low fixed percentage for the first few years that jumped to an adjustable interest rate for the remaining term of the loan. Warren believes that the key reason for the current crisis is the explosion of these instruments as the housing market stopped rising and borrowers were no longer able to refinance based on the appreciation of their homes.
The room broke into laughter as Scott interjected, “All I want to say is that during this time, I refinanced my house three times.” On a serious note, he stated that many borrowed against – speculated on – the appreciation of their home to finance consumption. He suggested that the factors leading up to current financial conditions were more complicated than Warren’s explanation implied.
Bebchuk offered the housing bubble as a major contributing factor. While noting that there were massive interest rate reductions after 9/11 and a similar phenomenon worldwide, he stated that there were certainly aspects of the housing bubble that were not driven by fraudulent practices and occurred for the same reasons bubbles happen for other assets. Whenever bubbles burst, people spend less on consumption, which could lead to a recession.
Beginning a year and a half ago, Jackson continued, banks began recognizing losses on these mortgages. The assumptions that had been used to model the values of the loans were based on data collected from the prior decades, so as default rates for mortgages increased, riskier borrowers entered the markets. At the end of 2007, banks tried to recapitalize. In spring of 2008, the Federal Reserve stepped in and facilitated the sale of Bear Stearns to JP Morgan Chase.
When asked by Kagan whether the professors approved of the Bear Stearns bailout, only Jackson raised his hand. Bebchuk agreed that the bailout was necessary. However, he felt that the Fed spent too much money on the transaction; it took on a large liability and did not receive any upside. Scott and Warren both disapproved of the Fed’s actions in the Bear Stearns failure. According to Scott, “What happened to Bear Sterns was a classic run on the bank.” Instead of a bailout, he said, the Fed should have lent money to Bear Stearns on reasonable terms. Warren believed that the “Lehman was the right answer – do an orderly liquidation.”
Warren advised the audience to consider how much of the current crisis is due to actions taken this spring. Government is supposed to back low-risk institutions. “By tying money to Bear’s neck to get it sold, we started the problem we’re seeing today because it changes to calculus,” she said. Because the government overpays, financial institutions that should be exiting the market will instead hold on in hopes of a government rescue.
Bebchuk explained that Bernanke’s bailout of Bear Stearns, though not an ordinary bank, was still very crucial. Though many people are conflicted about rescuing investment banks because they are not subject to regulation, Bebchuk claimed that, “the modern financial system is such that we can’t have [them] go down.” Scott added that the Fed believed Bear Sterns was too interconnected to let fail.
Kagan next asked the panelists whether they would vote for the current bill. Warren opposed the bill, Scott and Jackson supported it, and Bebchuk abstained. After Kagan pressed him for a vote, Bebchuk said that he would vote for the proposal if the only alternative was no action, but that he believes there are better options.
Warren opposed the bill, describing it as lighting a fuse without knowing what will happen. To her, it would be ineffective to “shovel money” in the back end-at the securities-when the assets at the front end-the mortgages-are bad. “This shows how old I am,” Warren joked, “but I remember two weeks ago when I thought $85 billion was bad,” referring to the AIG bailout. Criticizing Paulson for not articulating a concrete plan for the $700 billion proposal, Warren said, “he can’t even change shirts before he goes out there and says, ‘oh! Let’s save that one!”
Jackson stated the proposal is crucial in alleviating the worldwide liquidity crisis. He also argued that the current situation is not comparable to the S&L crisis because the Treasury would be receiving assets in return.
Scott stated that the proposal would fend off a crisis of confidence in the U.S. and its leadership. However, he doubted that the plan would solve the liquidity problem. While the plan will inject capital to the financial institutions because the government will be overpaying the financial institutions for these “toxic” assets, the connection between capital and liquidity is unclear. Most importantly for Scott, it is unclear what will happen or be done in the several months before the sale of assets take place.
Finally, Kagan invited the panelists to identify problems with the current plan and to share their recommendations, if any, for dealing with the current crisis. While stressing again the need to deal with the bad mortgages, Warren emphasized that the plan needs a coherent theory of how the failure occurred and how the proposed bill would fix identified problems. Jackson agreed with Warren’s critique about the bill’s failure to deal with the underlying problem of bad loans.
Scott reiterated his concern about the absence of a plan for the next few months before the current proposal can be put into effect. He recommended that Bernanke announce on Monday an intention to lend whatever is necessary to address the liquidity problem. Additionally, citing the need for continuity in implementing successful plan, Scott suggested that the presidential candidates come to an agreement that Treasury Secretary Paulson and Federal Reserve Chairman Bernanke remain in place for one year.
Bebchuk referred the audience to his whitepaper in which he offered critique and solutions for weaknesses in the plan. Concerned about overpaying for assets, he suggested that the funds authorized under the bill be divided among different managers, who would receive a portion of the profit they earn on their “funds.” Because of this financial incentive, the managers would bid realistically against each other, creating a market for the assets to help reduce the government’s risk of overpaying for the assets. He also recommended that the Treasury be given the authority to purchase new equity in financial institutions as a way to infuse capital directly and quickly.