Experts attempt to parse the ‘crisis in the markets’

“We’ve been in a slow-motion train wreck … and now it’s just a train wreck.”

This quip, by Jay Light, Dwight P. Robinson Jr. Professor of Business Administration and dean of Harvard Business School (HBS), was one of the observations offered at a panel discussion Sept. 25 intended to explain the Wall Street financial crisis to the Harvard community.

The six-member panel, convened on short notice by Harvard University President Drew Faust, filled Sanders Theatre even as Congress struggled in Washington to work out a deal to restore the functioning of the nation’s financial markets.

The panelists explained in turn how the current situation on Wall Street is more than the worst financial crisis since the Great Depression:

The problem of a “severely weakening middle class” constrained by stagnating real incomes at a time of price increases on all fronts, particularly healthcare and education, according to Robert Kaplan, professor of management practice at HBS.

A crisis that, “at its heart,” was caused by “selling mortgages that were simply unsustainable … a dirty product,” according to Elizabeth Warren, Leo Gottlieb Professor Law.

An indication of a bloated financial services sector that needs to slim down to greater efficiency if it is to regain its stature as a flagship sector of the U.S. economy, according to Kenneth Rogoff, Thomas D. Cabot Professor of Public Policy.

An illustration of the principle that “there is a structural relationship between innovation and potential crisis” and that the regulatory infrastructure that protects against crises takes time to develop, according to Robert Merton, John and Natty McArthur University Professor.

And it’s also, according to Light, the first real test of the de facto new system of housing finance introduced over the past 15 years.

In the system that prevailed until the early 1990s, Light said, the entities that originated loans — typically local savings and loan associations — tended to hold them. Thrifts evaluated prospective borrowers themselves and assumed all the risk of the loan.

But recent years have seen the rise of national mortgage companies that originate loans and then resell them. Eighty percent of such mortgages end up in the portfolio of Fannie Mae and Freddie Mac, and the riskier ones end up on Wall Street. The effort to spread risk is in principle a good idea. But in fact, as Warren explained, this slicing and dicing means that there are “a thousand different entities that own a piece of your mortgage,” and that in case of trouble, there is “no single entity properly authorized and properly incentivized to work out a deal the way the old-time investor would.”

The problem was compounded when the insurance giant AIG offered (unregulated) credit default swaps. This amounted, in Warren’s view, to “offering insurance on mortgages doomed to fail.”

She called for changes in the bankruptcy laws and for a “financial product safety commission” similar to the Consumer Product Safety Commission. She noted that in the United States, “every physical product that you touch” has to meet some basic safety standards, and compared the balloon mortgages introduced in recent years to a toaster that has a 1 in 5 chance of bursting into flames. “It would not be acceptable to put something like that on the market, even if you could do it for $2 less.”

Kaplan, noting how health care and education costs have risen, even as middle-class earnings have stagnated, defended homeowners who took out second mortgages to keep themselves afloat. They were “behaving rationally” when they tapped the rising equity of their homes, even though this meant increasing leverage of assets.

Gregory Mankiw, Robert M. Beren Professor of Economics and a former chairman of the President’s Council of Economic Advisers during the latest Bush administration, predicted, “This isn’t going to be one of those cases where people will walk off in handcuffs.”

He also said that both he and his Clinton administration counterparts had sought reforms for Fannie Mae and Freddie Mac but had trouble getting legislation passed. This sort of financial regulation isn’t the kind of legislation that’s of interest to congressmen trying to get re-elected, he suggested.

Merton, who won the Nobel Prize in Economics in 1997 for his work in devising a new method to price derivatives, used the example of high-speed trains running over tracks that weren’t really built for them to illustrate how supportive infrastructure tends to lag behind innovation. It can’t be predicted which innovations will succeed and which will fail. And it’s not practical to create support for an innovation (whether in the form of government regulation or railroad track) until it’s clear that it will succeed. So in the near term, yes, there are some accidents until the track can be upgraded.