Accountable Strategies blog

A blog about accountability issues in the public, private, and nonprofit sectors

We’re halfway through the credit crisis

Posted by David Kassel on April 20, 2008

We’re about halfway through the current mortgage credit crisis, and it will take a combination of self-discipline from the financial markets and government intervention and regulation get us the rest of the way through it.

That’s the message I took from Robert R. Glauber, a former chairman and CEO of the National Association of Securities dealers, who discussed the origins of the crisis and  what needs to be done to end it, in a seminar at the Harvard Kennedy School last week.  Glauber described the credit crunch as “an accident waiting to happen.”

He noted that housing prices have dropped 10 percent in the past year and are projected to drop another 10 percent until possibly well into 2009.  Mortgage delinquencies will continue.  Projected losses due to defaults in the subprime mortgage market could reach $300 billion.  But Glauber doesn’t think it will end there.  Another $200 billion in defaults on commercial real estate loans are likely among other losses.

He compared the “credit bubble” to the “dot-com” bubble of the late 1990s.  In both cases, Wall Street had “manufactured” companies as investment opportunities.  In the current crisis, hedge funds invested in mortgage securities.  Regulators allowed investment banks to create highly leveraged, off-balance-sheet investment mechanisms that were built on subprime mortgages.  It was a natural thing to do because there was a trillion-and-a-half dollar supply of those mortgages around.  This created a housing bubble, which started to collapse at the beginning of 2007.

How will it all end?  Two things have to happen, Glauber says: One, the markets, aided by government, have to stop the downward spiral of contracting capital markets.  The feds have started this to some extent by lending to investment banks.   Glauber termed it a “major step” in easing fears among banks and investors.

Secondly, investment banks have to write down their assets and raise new capital.  The problem is that the banks are reluctant to take that second step.  They’ve gone about halfway, but they are waiting for the cost of capital to bottom out.  

Meanwhile, the U.S. Treasury has proposed a “Blueprint” for tighter regulation of Wall Street, including standards for mortgage participants and the first ever regulation of hedge funds and private equity funds.

Thus far, Glauber said, the markets haven’t done a very good job in policing themselves.  The question is how much additional regulation will be needed to supplement market discipline.  That regulation can range from information gathering to systemic controls on investment banks and other mortgage institutions.  Glauber suggested that the line should be drawn between institutions that are federally insured (they should have more regulation) and those that aren’t (not as much regulation needed).

Glauber also acknowledged that part of the reason for the mortgage crisis involves a conflict of interest on the part of ratings agencies such as Standard & Poors, Moody’s, and Fitch, which investors relied on to rate mortage-backed securities.  Those ratings agencies are paid by the issuers of the securities to rate them.  But the conflict may not explain the whole thing.  The argument can be made that the magnitude of the mortgage defaults have turned out to be so massive and unprecedented that the ratings agencies could never have predicted it.  Even if the ratings agencies had considered the the most dire data they had on the securities they were rating, they would have missed the crisis by a factor of three, he said.



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