Professor Jon Duchac, who teaches accounting at the Wayne Calloway School of Business and Accountancy, is spending a semester at the Vienna School of Economics as a Fulbright Distinguished Chair.
The view from Vienna
Fulbright Professor Jon Duchac on the economic crisis
Jon Duchac, the Merrill Lynch Professor of Accounting and the director of the program in Enterprise Risk Management in the Wayne Calloway School of Business and Accountancy, is the first Wake Forest faculty member to be named a Fulbright Distinguished Chair. He is teaching at the famed Vienna School of Economics this semester. He spoke recently on the global financial crisis at the U.S. Embassy in Vienna.
Is this the worst financial crisis in a generation?
Unfortunately, it's starting to look that way. During the last six months we have seen some unprecedented economic and political events including:
- The U.S. government takeover of Fannie Mae and Freddie Mac;
- The demise of the large investment bank, once the symbol of Wall Street;
- A “lock-up” in credit markets and inter-bank lending;
- A 25% drop in most major stock market indices during a single month;
- A 35% drop in the Dow Jones Industrial Average since the beginning of the year;
- Government bailouts of financial institutions around the world; and
- A western European country teetering on the brink of bankruptcy.
How did the financial markets get into this situation?
Well, I'm not sure that we'll ever be able to answer that question definitively. Future research will definitely take us a long way to making the causal connections, but with that said, there are some data points that are starting to emerge that provide the seeds of a compelling explanation. World events, monetary policy, lending practices, technology, market sophistication, the regulatory environment and the coming of age of the baby boom generation combine to provide a pretty compelling story of how we got to this point.
How did the baby boom generation contribute to the crisis?
The baby boom generation hit their peak earning years in the late 1990s, and those peak earning years continued until about 2005. During this same period, technological advances increased access and lowered the cost of entry to financial markets. Having this wave of people hit their peak earning capacity en mass certainly has the potential to change the dynamics in the financial markets. Both the stock market bubble of the late 1990s and the real estate bubble of the mid-2000s both occurred when baby boomers were in their peak earning years.
To what extent did 9/11 cause markets to spiral?
There is certainly a compelling argument to suggest that the reactions to the events of September 11, 2001, events played a role. Prior to September 11, the U.S. was in the midst of the post-technology bubble recession. The Enron scandal emerged less than two months later, and Worldcom emerged the following summer. The events of September 11, however, created a highly uncertain environment. There was a lot of fear that additional terrorist attacks were on the horizon. Air travel had virtually stopped, and there was quite a bit of political and economic uncertainty. In response to this uncertainty, the Federal Reserve began aggressively cutting interest rates.
So interest rate cuts by the Federal Reserve contributed to the problem.
We have to remember that this was a highly uncertain time, and the Federal Reserve had to make a call in the face of this uncertainty. Unfortunately, uncertainty often leads to panic, and panic leads to reactions that tend to focus on short-term issues rather than longer-term consequences. In this case, the Federal Reserve cut interest rates dramatically after September 11, and kept them low for quite some time. This put a lot of money into the system that appears to have added fuel to a real estate bubble that had been forming in the U.S. since the late 1990s.
How are these interest rate cuts and the real estate bubble connected?
The data suggest that the rate cuts prior to September 11 sparked a refinancing boom, where higher-quality (prime) borrowers refinanced their existing home mortgages at lower interest rates. Once all of the prime borrowers had refinanced, the money in the system started to funnel to new homebuyers with lower credit ratings — the famed sub-prime borrowers. This started to occur around 2003. The increase in sub-prime borrowers appears to have put upward pressure on home prices, which then attracted speculators to the market. While the percentage of speculators in the real estate market had been increasing since the late 1990s, the last leg up came between 2003 and 2005.
How were sub-prime borrowers able to get loans so easily?
As I mentioned earlier, the Federal Reserve interest rate cuts put a lot of money into the system. That money ultimately ended up looking for a place to be invested. At the same time, mortgage brokers, who had sprung up during the refinancing boom, were looking to originate new mortgages and generate fee income. Since all of the prime borrowers had refinanced, sub-prime borrowers were the next logical step. New financial structures provided the mechanisms, called securitizations, to get money from investors to sub-prime borrowers. In addition, changes in lending regulations spawned new mortgage instruments that allowed sub-prime borrowers to aggressively leverage home purchases. Mortgage brokers happily facilitated these transactions to generate fee income, and credit rating agencies provided AAA ratings for the securitization structures — generating fee income every time they provided a rating. When sub-prime borrowers entered the housing market, it drove real estate prices up, creating an “illusion of wealth” for the sub-prime borrowers and attracting speculators and more sub-prime borrowers. This exacerbated a real estate bubble that had been building since the 1990s.
So, how did this turn into a problem?
The increase in sub-prime lending really started to ramp up in mid-2003. Most sub-prime mortgages are variable rate loans whose interest rate and monthly payments reset after 24 months. Beginning in 2005 interest rates started to move up pretty significantly. Interestingly, defaults on sub-prime mortgages started to jump up in mid to late 2005, pretty close to 24 months after sub-prime lending started to get heated. Defaults on sub-prime loans continued to escalate throughout 2006 with the first signs of a significant problem emerging in early 2007. As the value of the mortgage loans and the real estate that serves as collateral for these loans started to deteriorate, the value of the investments plummeted. Financial institutions holding these investments had maintained reserves to buffer against potential losses, but the magnitude of the losses turned out to be much greater than expected. This drop in asset values created a panic in the market place, driving asset values down further, ultimately leading to the failure of several financial institutions. When financial institutions started to fail en masse during September and October, it created panic in the financial markets, which further exacerbated the problems.
You mentioned that the regulatory environment also contributed to the crisis.
There were several significant regulatory issues that can certainly be connected to the crisis. One of the most significant was the deregulation of the financial services industry in 1999. Prior to deregulation, financial services companies were subject to the Glass-Stegal Act, a depression-era regulation that legally separated the activities of commercial banks, investment banks and insurance companies. The goal of the act was to protect bank depositors and insurance company policyholders by keeping commercial banks and insurance companies from exposing themselves to the more aggressive risks that an investment bank might undertake. The act was also designed to avoid a situation where a single financial services company could become “too big to fail.”
In 1999, the Financial Service Reform Act was passed which repealed the substantive aspects of Glass-Stegal. While the banking industry had been gradually deregulating since the mid 1980s, this change opened the door for financial institutions to become bigger, and for commercial bank and insurance holding companies to engage in riskier activities.
The regulatory environment during the past decade also played a big role through its inability or unwillingness to regulate certain complicated financial instruments, such as credit default swaps. Regulatory activities are essentially economy-wide risk management activities. The failure to put in place regulatory or market-based mechanisms to manage the system-wide risk of these instruments effectively exposed the economy to an unmanaged financial market risk.
And you mentioned that technology contributed as well?
The technological advances of the late 1990s made financial markets faster and more easily accessible. Significant increases in computing power also opened the door to sophisticated financial modeling techniques. These models spawned a variety of financial instruments that allowed the financial markets to cut risk into very small pieces and disseminate these risks to a wide range of investors. Overall, these advances were very good for the economy and have created enormous value. However, in recent years it appears that the models have gotten a bit ahead of themselves. In addition, companies have become more willing to leverage the values generated by these models. The data suggests that the models weren't able to measure risk as accurately as anticipated, nor were they able to anticipate the effects of the increased leverage. These quantitative risk management tools have come under quite a bit of fire in recent months.
Did this change the way market participants behaved?
It certainly appears that way. Modeling sophistication lets market participants become very comfortable putting a value on future cash flows, even though those cash flows are highly uncertain. Unfortunately, the values generated by models are subject to error, and it appears that many of the models in place were not able to fully model the realm of possible future outcomes with the accuracy that was originally anticipated. In the end, humans drive markets and human behavior can be difficult to model.
The technological and financial product sophistication also led to an environment where credit decisions became disconnected from the party taking the risk. This created an environment that promoted more transactions, even when the expected return was not consistent with the risk being taken.
Are there other factors that contributed to the current situation?
Certainly. Like I said earlier, this is just a starting point for the discussion. The list of possible causal factors is long, and future research will certainly provide greater insights into the events that have transpired in the financial markets.