Reasons for the international financial crisis and potential solutions were the focus of an Oct. 10 faculty panel presentation, “What Happened? Why? What’s Next?”
“The financial regulators’ job is to make sure banks engage in prudent lending,” said Margaret Levenstein, associate research scientist in the Institute for Social Research and one of six panelists who gathered in the dining room of the Executive Residence. The Stephen M. Ross School of Business organized the event in response to the Wall Street crisis, to bring U-M experts together to discuss financial markets, the federal bailout and ways in which the larger economic and business landscape is affected.
“They (mortgage lenders) got it really wrong, they didn’t know how bad the defaults would be,” Levenstein said, after interest rates rose significantly on home loans.
Paolo Pasquariello, assistant professor of finance, identified three decisions taken by U.S. and world governments in the last few weeks “that are puzzling and will carry very severe consequences going forward.”
First, the government’s decision to prohibit short sales “hurts the market’s informational and allocational efficiency.” Second, he said it was wrong to let Lehman Brothers fail, as the firm’s transactions, “many of which simply motivated by risk management, are now worthless bringing back all risks that investors and companies thought they had hedged.”
Third, Pasquariello said global implications are being ignored. “It means that now all markets face the risk that governments may change the rules of the financial game while the game is played,” he said, adding the end effect will be slower recovery from the economic slowdown.
“My main point is that blaming Wall Street for being uncharacteristically greedy doesn’t make much sense,” said Gerald Davis, Wilbur K. Pierpont Collegiate Professor of Management and professor of management and organizations. “Wall Street took advantage of a regulatory patchwork, exactly as we would expect them to do. But we are all tied to Wall Street more than we might realize.”
A real estate boom from 2004-06, Davis said, fueled mainly by home refinancing “was papering over other cracks in the U.S. economy.”
“And we will all be feeling the effects of the market tanking either directly, because half of households are invested in the stock market, or indirectly, because the economy runs on credit.”
Catherine Shakespeare, assistant professor in the School of Business Administration, said problems began when “Wall Street started to deals for the sake of doing deals. As long as you could sell it no one asked what was it worth from a fundamental perspective.”
She said this led to much-higher defaults than anyone estimated, while creating huge uncertainty about the value of securities.
Shakespeare said the result was the creation of a perfect storm of historically low interest, rising house prices and innovation from Wall Street of securitizations, which convert mortgages notes and other receivables and loans into cash allowing banks to lend out again.
“This in of itself is not a problem as long as you have the right control systems and incentives in place to ensure credit standards are maintained,” she said. “However, as you all know serious issues about mortgage lending has come to light.”
