Balance Due

Faculty experts provide analysis on nation’s financial crisis

Oct. 6, 2008

The United States is in the midst of an economic crisis that is threatening the country’s financial stability, as well as the global economy. The crisis began with a collapse in the subprime mortgage market, and, in short order, longstanding institutions such as Lehman Brothers, Merrill Lynch, Fannie Mae, Freddie Mac, as well as several well-known banks, failed, filed for bankruptcy or were taken over.

It may be months before the full impact of the crisis can be assessed, even with the United States Congress passing a $700 billion taxpayer-funded rescue bill.

Commentary around the water cooler and in the news media has ranged from those who feel Congress was right to act quickly to pass a rescue bill to those who feel America is better off allowing troubled firms to fail–after all, that is what the free market is all about.

At The University of Texas at Austin, reaction from students, staff and faculty is as diverse as the potential solutions. In that light, we asked 10 professors from varying disciplines to share analysis on the dilemma.

We’ve also included a glossary of terms that the faculty members use in their assessments.

For more analysis, watch an economic panel featuring finance faculty at the McCombs School of Business. Also, Law School Professors Henry Hu, Tom McGarity, Dan Rodriguez and Jay Westbrook discuss what proposed solutions to this crisis may mean for the future of our economy and our country in the webcast “Models and Mayhem: The Current Financial Crisis.”

Robert D. AuerbachRobert D. Auerbach
Professor of Public Affairs
LBJ School of Public Affairs

A major cause of the present financial crisis is the flawed regulation of the banking system by the nation’s central bank, the Federal Reserve. To begin with, since two-thirds of the nine directors at each of the 12 regional Fed Banks are selected by the bankers in their district, the bankers are charged with regulating themselves. What is needed is an independent federal government banking regulator, independent of the private banking firms being regulated, with well paid experts in accounting, digital information systems and fraud detection.

Michael BrandlMichael Brandl
Senior Lecturer in Finance
McCombs School of Business

One thing to remember about the current financial bailout is that it is not anything new. The U.S. taxpayer has consistently been expected to pay for the U.S. banking system’s failures. The U.S. taxpayer has either directly or indirectly paid to bail out U.S. banks during the peso crisis of 1994-95, the Asian financial crisis of 1997-98, the Argentine crisis of 1999-2002 and now the U.S. mortgage crisis of 2007-08. History repeats itself because instead of addressing the causes of financial market weakness, policymakers and regulators focus on the symptoms of the problem, such as the current lack of liquidity we are are seeing. Thus, we bounce from one crisis to the next.

James K. GalbraithJames K. Galbraith
The Lloyd M. Bentsen Jr. Chair in Government/Business Relations and Professor of Government
LBJ School of Public Affairs

Going forward let’s think about the next upswing in our economy and how we can help power it. If the 1960s were about raising baby boomers and the ’90s about technology, what should the ’10s and ’20s be about? It’s obvious: energy and climate change. That’s where the present great unmet needs are.

So, let’s use the next few years to plan, mapping out a program of energy conservation, reconstruction and renewable power. Let’s get the public sector and the universities working on it. And let’s prepare the private sector so that when the credit crunch finally ends, we’ll have the firms, the labs, the standards and the talent in place, ready to go.

Some will ask if we can afford it. To see the answer, don’t look at budget projections. Just look at interest rates. During the current panic, in mid-September the interest rate on the 90-day Treasury bill hit zero. This meant the federal government could fund itself, short term, for free. It could have raised money for 30 years and paid less than 4 percent. That’s far less than it cost back in 2000.

No country in this situation is broke, or insolvent, or even in much trouble. For once, Wall Street’s own markets speak the truth. The financially challenged customer isn’t Uncle Sam. He’s up on Wall Street, where deregulation, greed and fraud ran wild.

Daniel S. HamermeshDaniel S. Hamermesh
The Edward Everett Hale Centennial Professor in Economics
College of Liberal Arts

What we have here is a classic panic of the kind we had during the Depression in the 1930s and at occasional intervals since. Credit dries up because of a crisis of confidence. Of course, the federal government can buy up bad debt. But the more important thing is the restoration of confidence so that lenders are willing to lend. Talk will not do–nobody trusts President Bush on anything right now, and clearly most do not trust Congress either. Increasing the FDIC insurance on bank accounts from $100,000 to $250,000 is a good first move–it encourages the average consumer. Better still would be a statement, and an explicit plan, from the federal government to isolate the bad loans and those parts of derivatives that are built on them, value them quickly and conservatively, and buy them up. This essentially means a federally supervised restructuring of debt. In the end, if the valuation is done correctly it should cost the taxpayer very little, while at the same time isolating the infection that has been built upon the subprime bust that occurred as housing prices began to fall.

Laura Starks

Laura Starks
The Laura T. Charles E. and Sarah M. Seay Regents Chair in Finance
McCombs School of Business

What started as a credit crisis in the financial markets is mushrooming into a much bigger problem without government intervention. Businesses, from multinational corporations to the small individually owned shops down the street, need credit to keep the wheels of business going. Imagine life without a credit card for simple transactions like purchasing gas or groceries. Without that credit, businesses grind to a halt and start shutting down. It is unfortunate that the government plan has been called a “bailout.” We should think of it instead as support for our financial system to keep businesses functioning normally. Until this week the stock market has been remarkably resilient in light of this credit crisis, suggesting that supporting the financial system will provide the underlying help needed for Main Street. This in turn will preserve the retirement assets of millions of U.S. workers.

Eli Cox

Eli Cox
The La Quinta Motor Inns Centennial Professor in Business
Chair, Department of Marketing
McCombs School of Business

Americans increasingly distrust free-market capitalism. Sadly, this distrust is justified as too many corporate executives have adopted the creed of greed. The creed is often based on the false belief that Adam Smith, in “The Wealth of Nations” published in 1776, argued that the personal vice of greed is transformed into the public virtue of economic growth. Smith would be disgusted, as he actually wrote, in “The Theory of Moral Sentiments” in 1759:

“Justice [the human virtue of not harming others]…is the main pillar that supports the whole building. If justice is removed, the great fabric of human society…must in a moment crumble into atoms…if the principle of justice did not stand…a man would enter an assembly of others as he enters a den of lions.”

Milton Friedman, who won the Nobel Prize for Economics in 1976, used Smith to support the argument that executives should maximize profits without engaging in “socialist” activities such as caring for the environment. Friedman failed to acknowledge that many executives maximize their wealth at the expense of stockholders.

The current crisis on Wall Street and in our economy can be traced to the creed of greed. Smith is rolling over in his grave.

Ramesh Rao

Ramesh Rao
Professor of Finance
McCombs School of Business

We need to rethink the way we look at the stock market. Today, only future earnings estimates are considered important for stock prices. The amount of “riskless capital”–for example, cash and resalable assets–on corporate balance sheets is considered unimportant. This is what is generally taught in finance classes all around the country, and it is not accurate.

In reality, riskless capital is critical for the workings of the market. This explains why all ongoing discussions of rescuing Main Street from the excesses of Wall Street involve injections of riskless capital onto balance sheets. It also explains why one cannot legislate capitalism and free markets in poor countries. It takes time to build the property rights infrastructure that can create riskless wealth.

Ehud I. Ronn

Ehud I. Ronn
Professor of Finance
McCombs School of Business

The publication of the Black-Scholes option pricing formula in 1973 permitted the spawning of the derivative industry, in that the model demonstrated how we might accurately price derivative securities. In theory, such derivatives permit more efficient allocation of risk and the cheaper raising of finance in the economy.

The current crisis demonstrates there are problems in our financial system that the free market cannot accommodate. Specifically, there is now substantial unwillingness on the part of financial institutions to trade derivative mortgage securities, whose prices depend on fixed-rate mortgages, at prices that would require these financial institutions to “mark-to-market” their portfolios to substantially lower prices, and thus report how poor their current balance sheets are.

The current predicament is offensive in three ways. First, the free market is requiring public intervention: That is not what proponents of free markets seek. Secondly, proposed rescue plans are unintentionally aiding the very companies, individuals and public officials who caused the problem. Finally, it would appear free market proponents will have to accept greater regulatory supervision.

Sheridan TitmanSheridan Titman
Professor of Finance
McCombs School of Business

With the current crisis, the public has become particularly aware that highly leveraged institutions can be taken down by relatively modest declines in the value of their assets.

It is therefore surprising that the current discussion by policymakers ignores the fact that we have a tax system that encourages the use of financial leverage. Because interest payments are tax deductible, but dividends are not, a bank’s cost of capital is lower if it takes on more financial leverage. These firms require cheap capital to compete, and as long as our tax code makes debt the least expensive form of capital, financial institutions will be highly leveraged.

Removing the tax incentive is a simple and straightforward move in the right direction. We can do this by allowing our financial institutions to convert into pass-through investment trusts that pay no taxes. This, of course, would result in a reduction in tax revenues. However, that loss would be small relative to gains associated with a more stable financial system. In the long term this will lead to a deleveraging of our financial institutions.

As a second step to address the immediate crisis, the U.S. government should make a preferred stock investment in financial institutions rather than current rescue plans that call for buying assets from the institutions. From the perspective of the banks, the advantage of preferred stock over raising more debt capital is that preferred dividends can be suspended during a downturn. However, this advantage of preferred stock is offset by a tax disadvantage under the existing tax system, but if the institutions are converted to pass-through investment trusts this disadvantage is eliminated.

The advantage that preferred dividends can be deferred can be viewed as a disadvantage to the U.S. government, which holds the instruments. However, this disadvantage can easily be corrected. If the financial institutions are required to suspend all bonuses whenever their preferred dividends are suspended, the dividends will only be suspended when the banks are in real trouble, exactly those situations where we would like the banks to conserve their capital.

Jim Deitrick

Jim Deitrick
Professor and The KPMG Peat Marwick Centennial Fellow in Accounting
McCombs School of Business

My colleague Michael Granof and I recently visited Richard Causey to see what insights he could offer. Residing in a gated community, one with a welcoming sign marked ‘Federal Correctional Institute,’ Causey-the former chief accountant of Enron-has had ample time to think about our current financial mess.

Causey maintains that even after Enron, we continued to write accounting rules that were easily circumvented. New rules were supposed to make it more difficult for firms to keep what were called “special purpose entities” off the books. As is obvious from the billions of write-offs that major banks have had to take as a consequence of commitments made on their behalf by these off-the-balance sheet entities, the new rules have failed.

For accounting purposes, today’s financial institutions valued their assets according to mathematical models in which underlying estimates and assumptions were made by their own people. The resultant numbers allowed firms to promote a healthy visage when the market was strong while masking the diseases eating away at the inner organs. The same thing happened at Enron.

Even more disquieting to Causey, in the case of Enron the executives never quite understood the company’s complex contracts and derivatives. For certain, the derivatives that are today discombobulating Wall Street are no less convoluted than the energy trading contracts that brought down Enron. And there is no reason to believe that the governing boards of today’s banks and investment houses are blessed with any more IQ points than their counterparts at Enron.

Glossary of Financial Terms

Balance sheet–a statement of the financial position of a business on a specified date. Assets, which are things of value, must equal the sum of what is owed to others (liabilities) plus the difference, which is called net worth. The balance sheet equation is: assets = liabilities + net worth.

Derivative–a complex financial instrument whose value depends on the value of other underlying financial assets. One type of derivative is a mortgaged-backed security which is a group of mortgages bundled together. The mortgage-backed security derives its value from those underlying mortgages.

FDIC–Federal Deposit Insurance Corporation is the agency that insures bank deposits in the United States. It will replace deposits up to $100,000 (per account per institution) in participating banks, and there are proposals to increase it to $250,000.

Leverage–taking on debt to finance business investments and processes.

Liquidity–the ease and cost at which one asset can be converted into another asset.

Mark-to-market accounting–assigning value to an asset based on the current market price for the asset. For example, the final value of a contract that expires in six months will not be known until it expires. If it is marked to market, it is assigned the value that it would bring in the open market currently.

Securitized mortgage–the process by investment banks of pooling mortgage loans together and creating securities that can be bought and sold like stocks and bonds.

Subprime lending–mortgages offered to those with poorer credit histories and lower credit scores that have a higher interest rate, and therefore, a greater risk of default.

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For more information, contact: Photos of professors Starks and Titman: Marsha Miller