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Government backing of banks through FDIC probably helped avert an even more dire liquidity crisis, said Professor Robert McDonald during a Sept. 24 Kellogg School panel discussion on recent U.S. economic turmoil.

Professor Bob McDonald

Fed bailout

Finance professors explain origin of Wall Street woes and respond to proposed solutions

By Rebecca Lindell

10/11/2008 - The current turmoil in the U.S. financial markets is on everyone’s minds – including those at the Kellogg School of Managemeent.

Finance professors explain origin of Wall Street woes
Financial Meltdown 2008: Finance Department faculty members explain the source and fallout of the growing liquidity crisis.

Video is password protected for the Kellogg community.
Professor Deborah Lucas
During the Sept. 24 Kellogg panel discussion, Professor Debbie Lucas expressed concern that financial sector regulation could do more harm than good.Photo caption here
Photo © Rich Foreman
Professor Mitchell Petersen
Professor Mitchell Petersen shared his views of the U.S. financial crisis during a Sept. 24 Kellogg School panel discussion. He said it is likely that new regulatory legislation will be passed soon that will have long-term repercussions.
Photo © Rich Foreman
Hundreds of Kellogg students packed a classroom in the Donald P. Jacobs Center Sept. 23 to hear Finance Department faculty members explain the source and fallout of the growing liquidity crisis. Professors Mitchell Petersen, Robert McDonald and Deborah Lucas offered their analysis of the meltdown and the government’s proposed $700 billion bailout plan.

Petersen, the Glen Vasel Professor of Finance and director of the Heizer Center, noted that repercussions from the crisis are only beginning. “In the next 24 months, we’re probably going to rewrite some financial legislation,” Petersen said. “We are then going to live with that legislation for the next 20 or 30 or 40 years.”

He urged students to look critically at the laws that will be proposed, noting that some entities will use the new regulations to their own advantage.

McDonald explained how the crisis developed, illustrating his examples with detailed empirical data. The signs of the impending collapse in the housing market were clear as early as June 2006, he said, when the housing futures market suggested a coming 10 percent decline in housing values. Even so, subprime mortgage loan originations continued apace, peaking in July 2006.

Today, investors are undeniably anxious, McDonald said. “The system has been designed since the Depression to not have bank runs. You’ve all seen the photos of people lined up around the block, waiting to get their money out of the bank. I’m sure we would have seen that [situation] this year had it not been for the FDIC” and its promise to insure bank deposits, said McDonald, the Erwin P. Nemmers Professor of Finance. “The system has forestalled a certain kind of bankruptcy.”

But he noted other worrisome activity, such as the recent run on money-market funds. He also observed that General Motors decided to draw down $3.5 billion in credit last week and wondered if other companies will follow suit. “Will banks stop offering credit lines if they are afraid of runs?” McDonald mused. “There are a lot of things going on that are making people unwilling to transact.”

Lucas, the Donald C. Clark/Household International Professor in Consumer Finance Fund, identified what she sees as the two biggest fundamental hurdles facing the markets: limited capital and a lack of trust among institutions. She said the government’s proposed $700 billion bailout to rescue U.S. banks from bad debt solves neither issue.

It’s the “shock and awe approach to financial markets,” Lucas said. “If you just put up $700 billion, you’ll scare people into submission.” The proposed bailout, as written, does not ensure the government will pay a fair price – a lapse that puts taxpayers at risk, she said.

A more constructive role for the government, Lucas argued, would be to improve transparency. “The government could send auditors to these finance corporations and they could say, ‘You have to open your books,’ and we could figure out who’s OK and who isn’t,” she suggested. “To the extent that this calms down the markets, that could be a help.”

But Lucas said calls to step up financial sector regulation could do more harm than good. “The world is a much richer place now than it was 20 years ago,” when deregulation ushered in a new era of financial innovation, she said. Lucas added that she worries more about political leaders who might “regulate away” the financial markets than about the prospects of the country falling into another depression.

The forum was co-sponsored by the Kellogg School’s Zell Center for Risk Research in partnership with several student clubs.

Read more about this topic in the faculty blogs Everything Finance and Finance and the Public Interest