BOSTON — As the economic crisis began to spread from Wall Street to Main Street and beyond, Harvard Business School Dean and finance professor Jay Light convened a panel of fellow faculty experts yesterday to provide some explanation and perspective on the historic series of events that have thrown U.S. and world financial markets into a state of turmoil unseen since the Great Depression of the 1930s.
Joining Dean Light on the stage of Burden Auditorium before an overflow crowd of more than 900 students and other members of the HBS community were Professor Robert Merton, winner of the Alfred Nobel Memorial Prize in the Economic Sciences in 1997; Professor David Moss, author of When All Else Fails: Government as the Ultimate Risk Manager; Lecturer Nicolas Retsinas, Director of Harvard University's Joint Center for Housing Studies and former U.S. Assistant Secretary for Housing; and Senior Lecturer Clayton Rose, former head of the Global investment Banking and Global Equities Divisions at JP Morgan & Co.
Dean Light began the proceedings by pointing to three key factors that lie at the heart of the current crisis: leverage, transparency, and liquidity. In the midst of the housing bubble and the easy money that went with it, he said, there was "too much leverage, with too little ability to understand the risks." Wall Street banks were doing deals with $30 dollars of borrowed money to one dollar of their own. As mortgages were "sliced and diced" into various forms of securities, the complexities of these instruments strained the understanding of even the experts. And new mark-to-market accounting standards did nothing to clear up the picture. What we're left with are failed institutions, the disappearance of liquidity, shattered confidence, and for many, fear of what the future may hold.
According to Light, three tasks lie ahead: "First, stabilize the patient, fix the problem, and finally, think about rehabilitating and getting the patient back on his feet. That's what the $700 billion bailout is all about."
Following the Dean's remarks, Nicolas Retsinas provided an historical overview of the housing market, explaining that before the New Deal, buying a home required a 50 percent down payment. President Franklin D. Roosevelt's reforms were designed to lower the barriers for many more people by opening credit lines through bodies such as the Federal Housing Administration and the National Mortgage Association. In the 1980s, he continued, loans were made by regulated banks, but in the 1990s, there was a significant change as "neighborhood banks were transformed into large national mortgage banks," and as further assistance in absorbing risk came from Fannie Mae and Freddie Mac. All this fueled the housing boom of the 1990s, with skyrocketing prices and 25-30 percent of homes being purchased by investors. By 2005, said Retsinas, subprime lending was commonplace. "Everyone was extending credit. People who couldn't pay off their mortgages said they'd simply sell and walk away. But when the bubble burst, they couldn't." The result: a record number of delinquencies and defaults.
Focusing on Wall Street, Clayton Rose noted that over the past few decades, as deregulation and other changes took place in the world of banking, oversight was missing in action. The Securities and Exchange Commission imposed light capital requirements on investment banks, which, he said, "deployed more and more of their own capital to see higher returns" in things like mortgage-backed securities. "This worked well until a few months ago." With no access to deposits or Federal funds, brand-name firms began to go under. And those that didn't - Goldman Sachs and Morgan Stanley - were required to become bank holding companies - and as such, subject to much more regulation.
David Moss expressed concern that the bailout might encourage the continuation of excessive risk taking. "The federal government has been managing risk for a long time," he said, "with the likes of the limited liability law, workers' compensation, and the Federal Deposit Insurance Corporation. But it also has to be worried about the potential for moral hazard" - that is, creating incentives for people to make the same mistakes repeatedly because they know that the government will come to their rescue. As a result, Moss advised, it's not enough to just offer a multibillion-dollar bailout. "The Secretary of the Treasury also has to figure out a mechanism for monitoring and controlling moral hazard."
Robert Merton noted the huge amount of wealth that has been lost as a result of this crisis--$3-4 trillion. But he also pointed out the structural relationship between financial innovation and crisis. "Successful innovation will always outstrip the regulations necessary to support it," he said. "Looking forward, I agree that we need regulatory changes, but I'm concerned about unintended consequences. I'm hopeful that we will have serious discussions before we make recommendations." And as Merton sees it, it would be wrong to recommend the removal of the "technical people" responsible for the innovations that will continue to be developed in finance in the years ahead. Managers and regulators have to be "more savvy," he concluded.