February 27, 2009

Cooling the Meltdown

Finance experts convene at Columbia to talk solutions to the financial crisis.

Mary Bridges

Finance experts convene at Columbia to talk solutions to the financial crisis.

The week’s headlines hadn’t been promising: lawmakers couldn’t agree on how, if at all, to provide financial help for U.S. automakers. First-time filings of unemployment claims reached a 26-year high. And U.S. homeowner equity fell to its lowest level ever recorded by the Federal Reserve (44.7 percent). But to several professors at Columbia Business School, the grim economic news also translated into opportunity: What better time to bring together 140 leading economic and legal scholars, regulators and finance-industry executives to compare perspectives on the crisis and consider possible solutions?

So on a drizzly morning in December, the School’s Sanford C. Bernstein & Co. Center for Leadership and Ethics hosted a group of finance experts at the neo-Renaissance palazzo on Amsterdam Avenue—Columbia’s historic Casa Italiana—to make sense of what had gone wrong and examine how to fix it.

Of all the controversial subjects on the table, such as how to stabilize Detroit and how to bail out U.S. homeowners, one of the most frequent points of contention was the name of the event itself: “Preventing the Next Financial Crisis.” “My only criticism is the title,” said Jean-Charles Rochet, professor at the University of Toulouse School of Economics. “There will be financial crises in the future—this is inevitable.” It’s also hard to think about the next crisis while economic uncertainty is still growing, noted New York Times chief financial correspondent Floyd Norris ’83. “We’d like to get out of the current one first,” he said.

“The title came up last January, and to be quite honest, we thought it’d be over by now,” explained Bruce Kogut, the Sanford C. Bernstein & Co. Professor of Leadership and Ethics, who organized the event with colleagues Professors Patrick Bolton and Tano Santos. “But we may be having a conference about preventing the next financial crisis next year as well, given the current trend.”

The factors that contributed to the economy’s downward spiral were clear enough: Asian nations built up large precautionary savings, effectively depositing cash into U.S. “parking spots,” as MIT Professor Bengt Holmström described it. Lax monetary policy in the early 2000s “poured gasoline on the fire,” according to Dean Glenn Hubbard, the Russell L. Carson Professor of Finance and Economics. And financial innovation created new tools, such as the bundling and reselling of subprime mortgages, that introduced huge, unforeseen risks. The result was a “positive feedback loop of negative consequences”—as Frederic Mishkin, the Alfred Lerner Professor of Banking and Financial Institutions, called it—that caused the S&P 500 to lose almost half its value in one year and has transformed the U.S. economy.

The fall has been so precipitous that most speakers compared it, not to the dot-com crash or even the Scandinavian banking crisis in the early 1990s, but to the Great Depression. “It’s my forecast for you that next year, 2009, will be like 1933,” said Hubbard, not in specific economic terms, but “in terms of a total rethink of the nation’s regulatory processes.”

In other words, a financial crisis is an ideal time for academics, practitioners and regulators to reexamine basic principles. One of the most basic of these principles is the need for stability in the U.S. housing market, or “the elephant in the room,” as Hubbard called it. A major challenge facing U.S. homeowners is financial illiteracy, according to research presented by Stephan Meier, assistant professor of management. His survey data revealed that 30 percent of homeowners with adjustable-rate mortgages didn’t realize they had that type of loan.

Another problem has been the steep decline of housing prices, a trend Hubbard and his colleague Chris Mayer, senior vice dean and Paul Milstein Professor of Real Estate, hope to reverse. Hubbard and Mayer presented a plan that involves guaranteeing a 4.5 percent interest rate for American homeowners. As Mayer explained, since the government took conservatorship of Fannie Mae and Freddie Mac, American taxpayers are already “on the hook” for the country’s housing woes. Why not turn failing mortgages into profitable assets? He proposed issuing $2 trillion in Treasuries “backed by newly underwritten mortgages with solid equity” and strong credit scores, which would allow 34 million American households to refinance their houses at an average monthly savings of $428. “Glenn talked about a chicken in every pot—that’s a new car in every driveway,” Mayer said. “That’s very different from a temporary stimulus.”

But what if Americans use this savings to pay down debt, rather than to buy cars and resume their usual spending habits? That question concerned more than a few participants at the symposium. When Deborah Jackson ’80, founder and president of DBJ Capital, asked panelists about other “ticking time bombs” that could still roil the economy, Patrick Bolton, the Barbara and David Zalaznick Professor of Business, referred to the same problem: a long-term decline in U.S. consumption. “You have to find a way to get households to spend,” he said. “You could very easily have everyone holding back.” It’s not just economic fundamentals that need to be restored: there’s also the problem of confidence.

Monetary policy plays an important role in restoring this confidence, as Mishkin explained in his keynote address. Having recently returned to Columbia after two years as a governor at the Federal Reserve, he focused on the growing view that monetary policy has no effect in a time of financial crisis. “It’s a fallacy that monetary policy has been ineffective, and it’s dangerous thinking,”he said. Recent actions have lowered interest rates and the spread between Treasury bonds and “riskier” assets. And the alternative—inaction—could have been devastating, he argued. Charles Calomiris, the Henry Kaufman Professor of Financial Institutions, proposed a different type of regulation—“macro-prudential regulation”—that would respond to a range of economic indicators and prevent credit markets from growing too quickly. He argued that such policies prompted regulators in Colombia to increase reserve and capital requirements on banks, which helped rein in excessive growth two years ago. In either case, the current crisis presents a chance to understand how conventional as well as innovative regulation can stimulate lending and spark a turnaround. “As a scholar, as a teacher,” Mishkin said, “it doesn’t get any better than that.”

The exact shape of regulation—from interest-rate adjustments to SEC reform—will remain a subject of vigorous debate, but consensus among the participants was clear: systemic risks of trillion-dollar markets are too big a concern to go unchecked. Even though the securities in question are “very opaque,” as Tano Santos, the Franklin Pitcher Johnson, Jr., Professor of Finance and Economics, explained, the failure to regulate them could jeopardize the entire financial system.

The event provided an opportunity for a handful of regulators to talk directly with academics and practitioners. In one such moment, Til Schuermann, a vice president of the Federal Reserve Bank of New York, claimed “moderator’s prerogative” because “it’s not often that I have three leading economic theorists hostage.” He used the opportunity to solicit ideas: “How should we at the Fed think about an exit strategy?”

His question generated few simple answers, but panelists agreed that setting clear principles, rather than adopting ad hoc responses, must be a key part of any strategy. Economist American business editor Matthew Bishop bluntly called Treasury Secretary Henry Paulson’s handling of the crisis “rather catastrophic,” for failing to do exactly that. “Letting Lehman go,” he said, “was almost as stupid as the decision to invade Iraq.” Chrystia Freeland, U.S. managing editor for the Financial Times, agreed that the shifts in policy have disoriented the market. “Everyone I talk to who’s holding these [toxic assets] is sure that the Treasury is going to come in and buy [them] as per the original plan,” she said. But ongoing indecision leaves financial institutions in a holding pattern. Until their balance sheets are cleaned, financial institutions will continue to distrust one another, and lending markets cannot resume efficiency.

This back-to-basics approach puts economists in high demand and left a number of participants in the room feeling more sought-after than usual. As Erica Groshen, vice president and director of regional outreach regional affairs for the New York Fed, said to her tablemates over lunch, “It used to be, when I told people at a party that I’m an economist for the Federal Reserve, their eyes would glaze over. Now everyone wants to know what I think.” “Everyone” included Ken Austin ’03, a vice president and senior analyst at Indus Capital Partners, who chatted with Groshen about over-the-counter financial products and whether the Fed would issue its own debt.

“We as economists must become more involved with practitioners,” Hubbard urged at the outset of the event. To that end, the event’s organizers plan to publish a book based on the symposium that will propose a series of regulatory reforms. Will that be enough to prevent the next financial crisis? Maybe, but there is sure to be another after that.

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