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Crunch Time

Four Kellogg School finance faculty examine the recent market volatility

By Chris Serb

Ed. note: This story reflects events as of April 11, 2008, when Kellogg World went to press.

The international credit crunch began with bad news last summer about higher-than-expected default rates among a risky segment of mortgage borrowers. The situation was unfortunate, especially for those who might lose their homes. But observers saw little cause for alarm, since subprime mortgages were considered a relatively small part of the economy, and some defaults were expected.

Deborah Lucas  
Deborah Lucas  
Arvind Krishnamurthy  
Arvind Krishnamurthy  
Jonathan Parker  
Jonathan Parker  
Sergio Rebelo  
Sergio Rebelo
All Photos © Evanston Photographic Studios

Since then, the dominoes have fallen. AAA-rated bonds that were backed by many of those defaulting mortgages suddenly weren't such a good investment. Large, esteemed investors took heavy write-downs and became skittish about risking their own capital. Home prices slumped to pre-2005 levels; retail sales growth slowed; and the stock market fell nearly 15 percent off of last year's record highs.

Add to the mix recent Federal Reserve action to facilitate JPMorgan Chase's fire-sale purchase of investment banker Bear Stearns for $2 a share (subsequently revised to $10), and what looked like a hiccup now has the earmarks of something more troubling.

"The problem in the market wasn't about subprime loans; it was that everything — all asset classes — were becoming very expensive," says Deborah Lucas, the Donald C. Clark/Household International Professor in Consumer Finance. "The situation grew out of a large increase in markets' willingness to bear risk for years. At the time, the economy was flourishing, and professional investors became more and more risk-tolerant while looking for higher returns."

Many of those high-risk, high-return investments didn't pan out, which is to be expected. "Anyone who was around the subprime market knew this was the riskiest segment, they knew to expect defaults there," says Arvind Krishnamurthy, the Harold Stuart Professor of Finance. "The puzzling thing was how something so small can have such a big effect. It seems that general uncertainty, rather than defaults among a certain group of borrowers, was the key in setting up the crisis."

When securities that were partially backed by subprime mortgages slumped, that uncertainty kicked into high gear. "If subprime mortgages hadn't been securitized, people would have said 'These mortgages are just riskier than we thought,' and this would be a small crisis," says Professor of Finance Jonathan Parker. "But they were securitized, recommended, reprocessed and sold as significant portions of AAA-rated securities. When those underperformed, people called into question the entire rating system, and they became suspicious about all securities."

Some observers believe that this credit crunch is uncharted territory because of the relative newness of mortgage-backed securities, the losses by established investors in an unfamiliar market, and the increasing interconnectedness of economies around the globe. But Kellogg professors see parallels to previous turmoil.

"The present situation bears some similarity to the financial crises common in the late 19th and early 20th century," says Sergio Rebelo, the Tokai Bank Professor of Finance. "During those periods, reduced confidence in a few banks often spread throughout the financial system, leading to liquidity shortages and credit contractions."

Parker sees an analogy in the Eastern European financial crisis a decade ago. "The real crisis occurred in Russia, but other developing economies with no fundamental problems in their economy saw foreign capital exiting," Parker said. "It was contagion, like what we're seeing now. People thought, 'If this happened in Russia, it could happen in other developing economies,' and so people pulled out their investments in those economies."

Closer to home, Krishnamurthy sees a parallel to the 1990-1991 U.S. recession. "You had drops in real-estate values and losses in the banking sector, both then and now," he says. "This is not like the 2000-2001 slowdown when the technology sector went into contraction. This is specifically tied to the financial sector suffering lots of losses at the same time that the real-estate market is slumping."

Policymakers have intervened to stem the crisis. The Federal Reserve Board began trying to ease credit flow last September by cutting its benchmark federal funds rate from 5.25 percent to 4.75 percent. Since then, the rate has fallen to 2.25 percent.

But the Fed's moves carry their own risks. "The Fed is using its ammunition, just as it did in 1990 and 1991," Krishnamurthy says. "The real concern is, we're in an environment with inflation risk, and that might limit the Fed's options. It's hard to know if what the Fed is doing is appropriate or not. They're trying to strike a balance between stimulating credit and guarding against inflation."

But inflation isn't the only risk. Lower short-term interest rates accompanied by higher long-term rates helped fuel the growth in subprime and adjustable-rate mortgages.

"The monetary policy of lower short-term rates helps people not to default, but the lower short-term rates were part of the problem in the first place," Parker says. You don't want to help firms that may have nudged people into taking out loans that they shouldn't have taken."

Congress and the Bush Administration have a few tools at their disposal, including a voluntary plan, backed by Treasury Secretary Henry Paulson, which would encourage mortgage renegotiations.

"The spirit of that plan is the right thing to do," Lucas says. "Some nightmare policies have been proposed like 'Let's put a cap on mortgage rates,' which would cause an arbitrary transfer of wealth from banks to their customers. I'm advocating intervening more by setting the tone or framework of renegotiation, but not by forcing any particular renegotiation. This must be done through leadership rather than mandates."

Another tool, the $168 billion stimulus package that Congress passed in February, may be just about right to jump-start growth again. "The package we have is transitory, it's timely, and it's pretty well-targeted," Parker says.

Business leaders clearly have been affected by the credit crunch too, and they have roles and opportunities in the crisis.

"The sooner people figure out at what reasonable price they can transact, the better, and that's not something that government can regulate," Lucas says. "There are lots of incentives for everyone to figure out the least costly way to fix this, and it will take time to work that out. But focusing on improving one's business is the responsible thing for the economy."

Quickly writing down losses should also help get things back on track. "It is important that banks recognize their losses and, if necessary, be recapitalized," Rebelo says. "This restructuring process is taking place, which is very encouraging. Otherwise, you might see a repeat of Japan's experience with its 1992 financial crisis, where Japanese banks avoided recognizing their losses and it took a long time to revive the economy."

Opportunities should also arise from the stimulus package. "If you're in retail, you want to be prepared for the money that's going to be in consumers' hands in June," Parker says.

The credit crunch lends itself to several lessons that will benefit business leaders once the economy is back on track.

"Mistakes happen, and you should expect them to happen, especially on investments and activities that are new, like securitized products based on subprime mortgages," Krishnamurthy says. "You find out what was a mistake in hindsight. You have to be wary of novel creations — don't avoid them altogether, but be more skeptical of them than a more established investment."

Adds Parker: "The broad lesson is that you need to be able to value an asset before you buy it, and that's one of the things that the Kellogg finance curriculum teaches well."

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