Formats: MP3 & M4V
Faculty Perspective: Regulation, Deregulation,
and the Market Meltdown
At the Smith School’s Town Hall meeting with MBA students on September 26,
Haluk Ünal, professor of finance, presented a thoughtful analysis of the current
financial crisis—and came to some conclusions that might surprise you.
The next town
hall meeting is on Oct. 31. Details
It is clear that an unprecedented re-imagining of the nation’s entire
financial system is thrashing its way to a painful birth, and nobody quite knows
what comes next. But to anticipate what comes next, you have to understand how
we got here. Or, as Haluk Ünal, Smith School professor of finance, puts it: “Why
are we in this mess, and what needs to be done next?”
Ünal, the school’s resident banking expert, has over 20 years experience in
exploring and understanding the supply, demand, and regulation of financial
services, which gives him a unique viewpoint on the events of the last month.
To hear Ünal describe it, the current financial crisis seems perfectly
understandable and almost inevitable. It started with years of reckless
underwriting standards and excessively low interest rates, as a phenomenon Ünal
described as “ninja” loans—“no income, no job” loans—made mortgages available to
a wider range of homebuyers than ever before. The availability of mortgages
drove up the demand for housing. As demand for housing increased, housing prices
boomed. Developers, trying to take advantage of high housing prices, over-built.
This was, quite naturally, followed by a housing price bust and a dramatic
increase in current and future default rates. Institutions holding assets based
on mortgages experienced large capital losses. Creditors, quite naturally, don’t
want to loan money to institutions with huge capital losses. The flow of credit
contracted, and here we are.
Experts have described this series of events as a “perfect storm” for the
financial system, a category 5 financial hurricane. Financial institutions took
big risks, for many years reaped big rewards, and are now suffering big losses.
The economic recovery plan, says Ünal, is akin to an insurance payout after a
disaster, with the federal government—and the U.S. taxpayer—making the payout.
“Any insurance company would ask two simple questions before writing a check
for an insurance payout,” says Ünal. “Did you pay your insurance premiums? And
what was your deductible?”
Ünal traces part of the current problems back to the passage of a crucial
piece of legislation, the Federal Deposit Insurance Corporation Improvement Act
of 1991 (FDICIA), which mandates that the FDIC stops collecting insurance
premiums when the size of the insurance fund exceeds 1.25% of the total insured
deposits from banks that are highly rated.
By preventing the FDIC from collecting premiums when times are good, says
Ünal, this legislation kept the government from having the assets on hand to pay
out in the case of a financial disaster just such as this one. And investment
banks (like Lehman Brothers and Goldman Sachs), mortgage giants (like Fannie Mae
and Freddie Mac), and insurance giants (like AIG) do not pay any insurance
premium at all.
The result is that minimal insurance premiums were collected from financial
institutions in the past 10 years. In 2006 the FDIC collected just $32 million
dollars total from the entire financial system. In hindsight, this looks like an
act of sheerest folly. Why would we absolve institutions from taking
responsibility for the systemic risk they were creating?
Had the FDIC collected just $5 billion per year in insurance premiums from
the banking industry since 1997—the average amount collected between1991 and
1996—the agency would have $120 billion on hand today, says Ünal. In addition if
we had also collected insurance premiums from investment banks and the mortgage
and insurance giants, Ünal estimates it would now have $250 billion in its
coffers—about one-third of the amount that Treasury Secretary Henry Paulson
plans to disburse in the first phase of the bailout.
What is worse, says Ünal, is that the $700 billion rescue plan reflects the
barest minimum of the actual cost of the financial meltdown to the American
taxpayer. The current insurance liability of the FDIC is $4.2 trillion dollars,
the estimated amount of deposits covered by the FDIC. During the last three
weeks $3 trillion dollars have been added to this liability in order to shore up
Merrill Lynch, Morgan Stanley and Goldman Sachs. Add to this the $3.5 trillion
resulting from the rescue of Fannie Mae, Freddie Mac, AIG, and Bear Stearns and
the federal government now has an explicit insurance liability of $11 trillion.
“If the loss on the assets backing those liabilities is 28 percent, as was
the case in the recent failure of IndyMac, then taxpayers are now $3.1 trillion
in the hole,” says Ünal. “Taxpayers can expect to pay for those losses through
either increased taxes or decreased government services.”
Ünal acknowledges that some kind of rescue plan is required, but he’s not so
certain that the Paulson plan will do what the government hopes it will.
The bailout plan proposes to purchase mortgage bonds of dubious worth from
the financial system and let the Treasury department manage them. In theory, the
government will eventually be able to sell these assets for something closer to
their real economic worth. This will cover the cost of purchasing them in the
first place, and in a truly rose-colored world, even net the taxpayer a tidy
profit. But Ünal wonders if the plan’s underlying assumptions—that the financial
system will make better choices the second time around, and that the government,
not the markets, is better able to manage these troubled assets—are sound.
If the bailout plan doesn’t work, says Ünal, taxpayers face additional risk
and additional economic costs. And even if the bailout plan does achieve its
aims, the taxpayer still faces risk but doesn’t benefit from the return.
“Taxpayers need to share on the upside of the $700 billion the financial
industry needs right now,” says Ünal.