Calloway School professor Rob Bliss explains the recent failure of Lehman Brothers and what lies ahead for the economy.
Wild ride on Wall Street
What does the market shakeup mean for the economy?
By Kim McGrath
Office of Creative Services
The government stepped in when Bear Stearns and Fannie Mae and Freddie Mac were on the verge of failing, but not with the more recent crisis at Lehman Brothers. Professor Rob Bliss talks about what makes the Lehman Brothers failure different and why there may be light at the end of the tunnel despite all the recent bad news. Bliss is a professor in the Wayne Calloway School of Business and Accountancy, where he holds the F.M. Kirby Chair in Business Excellence. He joined the faculty in 2004 and teaches courses on derivatives, fixed income, financial engineering and risk management.
Why did Lehman Brothers fail?
Lehman Brothers failed because people thought the company was insolvent — not because they actually were insolvent. So much of what we are seeing has been fueled by speculation and fear, not by hard information, and that's one of the characteristics of markets when crises occur.
What was the government's role with regards to assisting Lehman Brothers?
The government refused to provide public funds to support the corporation. Having already used the Treasury to support two failing financial institutions, the government decided that the financial markets would have to come to a solution on their own. And they did a terrific job figuring out what to do. Ten banks have joined together to set up an emergency fund of 70 billion dollars, and any bank that is a member can draw up to one-third of the money out for liquidity needs. The major derivatives dealer held a special trading session to reduce exposures to Lehman in advance of its bankruptcy, reducing the impact of that event.
Why did the government decide not to intervene this time?
There is some concern that if bailouts continued, institutions would come to expect the government to step in. And as it turns out, the financial industry came up with solutions for dealing with the collapse. Wall Street knew Lehman Brothers' bankruptcy filing was coming and prepared for it.
What made Lehman Brothers situation different from Bear Stearns?
Bear Sterns was bailed out because it's a major derivatives dealer and it was at the center of a network of complex relationships that would have been disrupted had it failed. Because of this, the Fed bought the dubious assets — $30 billion in assets that no one knew their value — and left the good parts of Bear Stearns, which were then sold to JP Morgan. By the time it was Lehman's turn, the government had already bailed out Fannie Mae and Freddie Mac as well, and drew a line on further bailouts. Maybe if Lehman had been first it might have turned out differently.
Why did Bear Stearns fail?
Bear Sterns failed because of a risky business model. They had to raise funds in the capital markets, which they then used to finance acquisition of securities and run their business — as do all corporations. But Bear Sterns was raising almost half its funds in a manner that required it to refinance itself almost every day. Every day, lenders had to make an assessment as to whether the institution was solvent, and when rumors started to circulate, lenders began to refuse to finance the company. Financing on a short-term basis can cause a quick collapse.
What do mortgage failures have to do with the failure of investment banks?
In 2006-2007 there was a fall-off in prime mortgages so banks shifted into sub prime mortgages to keep up their volume of business. This set the stage for the initial trigger. A sub prime mortgage is a mortgage originated to a person with weak credit who would not normally qualify either because they have no credit history or no down payment. Banks shifted from lending based on the ability of the borrower to pay to lending based on the belief that the value of the house would increase and could therefore be sold in the event the buyer defaulted.
Why does this affect the whole financial market and not just the banks that made the sub prime loans?
Most mortgages are put into securities. The banks sell them and they are packaged and resold to investors. Last year, about 70 percent of all mortgages went through Freddie Mac and Fannie Mae.
Is this why Freddie and Fannie received government backing?
They are huge companies, and they are in one line of business — buying and securitizing mortgages. Their financial work is concentrated in an industry that is at the center of the financial crisis. They were also extremely vulnerable. They were set up by Congress and were allowed, by law, to operate with low equity. As soon as housing crisis spread from sub prime to prime, questions began to be raised as to whether Fannie and Freddie could both pay on their debt and guarantee their mortgages. Default rates have risen to unimagined levels. They are not that high, but they were unexpected, and Freddie and Fannie didn't have enough equity to ride out the storm.
What does the future hold for the housing market?
One of the reasons Fannie and Freddie were bailed out is that when the decline in the housing market stops, as it is expected to by the middle of next year, a mechanism for financing mortgages must be in place. If Fannie and Freddie disappeared it would be hugely more difficult for the housing market to turn around, with the effects spreading through the economy.
What affect will these failures in the financial market have on the average consumer?
A lot depends on what's going to happen the next few days in the stock market. I'm hopeful this might be the beginning of the end of the credit crisis. Right now, we don't see a huge demand for credit. The slowdown in the economy is not primarily coming from the financial markets. If the economy were booming and people were in need of credit, then the credit crisis would have had a greater effect.