Economic Crisis: Updated Q&A

Saturday, November 15, 2008

What happened to our economy? What caused this crisis, and who is to blame? Was it Wall Street or the government? Was it the lenders? Or was it us, the citizens, who just couldn’t get enough? Dr. Maury Randall, chair of the Department of Finance at Rider University, answers this and more in an informative Q&A.

Randall’s expertise includes investment markets, Federal Reserve decision-making, analysis of current business conditions and selected areas of personal financial planning. He earned a Ph.D. in Economics and Finance from New York University, an M.A. in Economics from the University of Chicago and a B.A. in Mathematics and Economics from NYU. What follows below is an updated, amended version of the article that originally ran in the October 9, 2008, edition of News@RIDER.

Q:
Is the current financial crisis related at all to the surge in oil and gasoline prices we’ve experienced over the past year?

A:
I believe it is. The increase in gas prices aggravated the recession. The economy was already slowing when prices spiked, and higher energy prices caused consumers to cut back on their spending in many areas. They had to spend more to drive to work and for other commitments, so households became even more financially pressed. The rising fuel costs also made it more difficult to pay bills, including mortgage payments. This subsequently resulted in delinquencies and mortgage foreclosures.

Q:
For years, it appeared as if our economy was flying high. Real estate prices soared, and with that, the banks couldn’t give enough loans to homeowners who found their equity higher than they would have imagined. Was it real? What happened?

A:
It is true that these events did occur. From about 2002 until the beginning of 2006, interest rates were low, the economy was growing, and more people were buying homes, driving up the prices. Seeing the price appreciation, more and more people began borrowing money and investing in real estate. This is how the speculation began.

Home prices rose to levels that were unsustainable and out of line with underlying economic conditions. The speculation continued because people thought prices would continue to go up. Meantime, other homeowners decided to borrow and spend with home equity loans that were available because their houses were worth more. Lenders and borrowers got way too overconfident. Lenders, looking for high returns, devised all sorts of gimmicky loans, with adjustable and variable rates.

Realizing that the economy was overheating and fearing inflation, the Federal Reserve tightened up, making money more expensive, but home prices had been pushed too far. People who speculated in houses tried to cash in their chips and sell those houses. But with higher interest rates fewer new buyers were entering into the real estate market. There were more properties on the market and home prices fell. For many of the sellers, the sales prices were less than the value of the loan. Therefore, we saw an increased rate of foreclosures. 

Moreover, other foreclosures were occurring because there were too many subprime loans. Lenders provided massive amounts of money to people who were incapable of making the future payments. This eventually caused tremendous losses for financial institutions.

Q:
Even recently, to those who don’t take the daily pulse of the economy, things appeared to be normal. Then, all of a sudden, Lehman Brothers was gone, Merrill Lynch had to be saved by Bank of America and AIG needed to be absorbed by the federal government. To the layman, it seemed rather out of the blue. Was it really, or was this an earthquake waiting to happen? Was it influenced by greed?

A:
You can go back to the beginnings of recorded history and you’ll find plenty of evidence of greed, so this was caused by much more than that. Simply put, borrowers and lenders just didn’t understand the risks they were taking. Compounding those problems were all sorts of newly created financial instruments that were very complicated. Those instruments, which were backed by mortgages, were not well understood by those who created, sold, or purchased them.

There is a lot of blame to spread out here across a wide range of parties – the financial institutions, the government, the investment ratings services and the borrowers. Things got very complicated. In the old days, when you wanted a mortgage, you took a loan from a bank. In more recent years, we saw financial institutions initiate the loan, then sell it off for a commission. They would package a group of mortgages transfer them to federal agencies like Fannie Mae (the Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation).

All the while, none of this was properly regulated by Congress, even though Alan Greenspan, the former chair of the Federal Reserve, warned that these agencies were getting too big and providing too much money without properly regulating the risk.

Companies like Bear Stearns and Lehman Brothers were acquiring mortgages and cutting them up to sell to investors. I met with people from these firms who honestly did not realize how risky their firms had become.

At the same time, the credit rating agencies were still giving top-notch ratings to a lot of those toxic risky securities. That lulled everyone into a false sense of confidence. AIG claimed they would file for Chapter 11 bankruptcy if they did not receive their $85 billion loan from the federal government in September. Yet, they were getting “Aa” or “A” ratings, which indicate little if any risk. That makes absolutely no sense.

In short, many smart people created a complicated financial Frankenstein. They thought it was great until it turned against them and against the entire country. We are now paying the price.

Q:
It took World War II to jumpstart the American economy from the Great Depression. How bad can this recession get, how long will it last, and what will be the thing that brings us out of it?

A:
I think it will continue throughout this year and bottom out in 2009. We have already been in a recession for nine months. Although the government was reporting that Gross Domestic Product was going up during that time, unemployment was continuously rising for those 9 months. Things will get worse, but it’s hard to predict just how much.

As far as coming out of it, it will take time for financial markets to stabilize. It is difficult to obtain loans and the government has been adding funds into the financial system. Eventually, the stock market will hit a bottom, normal lending will slowly be restored and the economy will be in a position to start a recovery. During the process, we will see labor and capital being reallocated from declining sectors such as automobiles and home-building to growing sectors such as energy and health care. 

Q:
What can be learned from this crisis?

A:
Many things have to be re-learned. Investors must diversify their investments across asset classes. Too much in one type of investment is not a good strategy. We’ve always known this, but the lesson really hits home now.

Financial companies must be careful to know and understand what they’re buying. These chopped-up mortgages were too complex and hard to understand.

The credit ratings agencies really screwed up, too. They have to find a better way of giving reports and ratings to the public.

Government regulation must be improved. If they are called on to bail companies out of trouble with taxpayer money, those companies must be subject to different rules and requirements.

Also, executive compensation has to be re-examined. Look at all these CEOs who did a lousy job and walked away with millions of dollars. We need laws to motivate corporate boards to carry out their responsibilities and protect the interests of shareholders.

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