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.