A think tank comprised of faculty members from Texas A&M University’s Mays Business School recently addressed a gathering of 160 Houston-area business people on the current economic crisis. “This is the first of what I hope will be many venues we will use to bring our faculty and their expertise to touch our former students,” said Dean Jerry Strawser. The panel featured eight speakers with different areas of financial expertise addressing the causes of the crisis, its scope, and potential solutions.
The popular idea that the burst of the housing bubble was a major factor in the collapse of the U.S. financial markets is not entirely accurate, according to the panelists. The group asserted that causes for the current financial situation are many and complicated, going well beyond even the subprime mortgage debacle, to things like corporate accounting practices.
David Blackwell, Mays’ associate dean for graduate programs moderated the event. The speakers were: Mark Dotzour, chief economist for the Real Estate Center at A&M; Mary Lea McAnally, associate professor of accounting; Donald Fraser, professor of finance; Arvind Mahajan, professor of finance; Michael Gallmeyer, assistant professor of finance; Sorin Sorescu, associate professor of finance; and H. Alan Love, professor of information and operations management and of agricultural economics. Also participating was Dale A. Whitman, Fred Parks Distinguished Chair at South Texas College of Law, and professor of law and dean emeritus at the University of Missouri-Columbia.
Cause and effect
The presentation began with a recap of events in the housing market that contributed to the financial crisis. Love stated that the bubble grew between 2000 and 2006, when the average home prices in the United States rose by 90 percent. “The real estate bubble was fueled by cheap and easy money, by financial liberalization that resulted in subprime loans, the idea that housing prices wouldn’t fallâ€¦these forces put in place a situation where a small economic hiccup of any type would burst the bubble and deflate it,” he said.
A panel featuring eight Mays faculty members with differing areas of expertise discussed the current financial crisis, addressing its causes, its scope, and potential solutions.
Since 2006, home prices have fallen 20 percent, meaning that many banks now hold loans for far more than the homes they represent are actually worth. Love says, however, the crisis is not spread evenly across the nation,
Dotzour agreed, saying that the market in Texas remains relatively strong, despite struggles in other parts of the U.S.
The liquidity of the mortgage market between 2002-05, when interest rates were lower than at any time in history, created extreme home price inflation during that period, said Whitman. The flip side of that coin is that this year in California, Nevada, and Florida, the rate of home price decline is greater than 10 percent. In many other states, prices are declining at a slightly slower rate. No state is showing positive growth beyond five percent. This raises the question, which came first, the collapse of the housing market, or the beginnings of the overall financial crisis? Whitman says they are intertwined. Currently, the downturn in the housing market is worsened by the recession and its consequent illiquidity of finances, tighter credit standards, and high rate of defaults and foreclosures flooding the market.
Gallmeyer brought clarity to the issue of credit default swaps and the decline of insurance giant AIG, explaining that banks purchased insurance on a variety of collateralized debt obligations (CDOs) including some containing subprime mortgages. That way if the borrowers defaulted, the lender calls in the insurance policy and doesn’t lose any money. AIG’s distress was caused by credit rating downgrades of both the securities that they had insured as well as AIG itself. This triggered a large increase in required collateral that AIG had trouble meeting. Gallmeyer said that AIG, along with many other entities in the financial markets, were not giving due diligence to these issues before they exploded in the current economic morass.
McAnally agreed with Gallmeyer, saying the credit default swaps, “took the monitoring away from the loan.” Formerly, one bank would be involved in a loan transaction. Today, different entities arrange the loan, make the loan, and buy and manage the loan. This fracturing of the process causes confusion about the value of the asset. McAnally reminded the audience that reliable, verifiable, and relevant accounting is important for evaluation of performance and valuation. The way these loans were recorded on the balance sheet was sometimes misleading, said McAnally, adding there needs to be better regulation in the way those items are categorized. “Accounting rules are not strong enough to understand the full risk of some of these financial instruments.”
This problem goes far beyond the borders of the United States, said Mahajan and Sorescu, who touched on the international impact of the financial crisis. The International Monetary Fund predicts that next year’s growth is going to be negative, reports Mahajan, adding there has been a uniform reduction in interest rates globally. Moreover, developing countries that rely on exports for a majority of their economy have been hit especially hard as American and European markets have declined. “Things are going to get worse before they get better,” said Sorescu.
Where we go from here
Moving forward is tricky agree the panelists, and fully understanding the causes of the crisis is imperative to solving the problem and preventing future ones. Gallmeyer reminded the audience that the government’s rescue plan is still in its infancy. “Basically we’ve taken the financial system and walked it into the emergency room and we’ve stabilized it,” he said. “We haven’t done anything else to the financial system yet. We haven’t addressed the deeper problems that are in the financial system. And there’s a long list. And until we sort out some of these issues, we’re going to face a great deal of volatility.”
Over 150 business leaders from the Houston area attended the panel discussion.
Though Americans are familiar with the price tag on the U.S. financial bailout, McAnally says in truth it could get a lot more expensive than $700 billion. However, “with some clever planning, the government could actually even come out not so far behind,” she said, if things are handled well. She suggested that standardization must occur in the credit default swap market to defer future risk.
Sorescu recommended that in the future more regulation is needed for investors to understand their complex commodities and to punish those who manipulate securities. “I fully anticipate that there will be significant effort on the part of the government to try to bring some sort of clarification to these marketplaces, not just here but worldwide,” he said. Mahajan added that better risk assessment tools must be created so that future crises can be averted.
There is culpability at a federal level, said Love, who reminded the audience that many of the problems we’re now facing aren’t new. “We’ve learned these lessons already,” he said. The panel discussed the mistake the government made in repealing the Glass-Steagall Act, enacted after the Great Depression to regulate risk by preventing investment and commercial banks from mingling. The act was modified in 1999.
Some still question whether or not the bailout was the best way to approach the crisis. Fraser commented on the illogic of the bailout, which he says incentivizes taking on more risk that you can handle. Essentially, if you protect people from their risk, they take more risk, he said. In the long run, it can be a problem. However, in the short run, it’s necessary. Mahajan agreed, saying that at this junction the bailout is necessary to stop the bleeding.
The response from the audience was positive. “The facultyâ€¦presented an understandable, comprehensive, and unbiased look at the structural underpinnings of the current economic crisis,” said Jason Armenta, a vice president with the Calpine Corporation and a current A&M EMBA student. “As a finance professional, it was one of the best I’ve seen.”
“I felt the presentation was very timely, as most Americans do not understand the gravity of this worldwide financial crisis,” said Jay Wendell, chairman and founder of J.M. Wendell, LLC and Southern Mark Homes, LLC. Wendell is an ’08 graduate of the A&M EMBA program. “The more we discuss and disseminate this information, the closer we are to formulating an exit strategy out of this dilemma. My take-away is that this crisis will not be resolved by the U.S. alone, but the world leaders must come together in a united front.”
About the Texas A&M Executive MBA Program
The Texas A&M Executive MBA Program, delivered by Mays Business School faculty, equips today’s working leaders with the skills and knowledge they need to excel in a rapidly changing organizational environment. Based in The Woodlands just north of Houston, the unique program is built around an ongoing study of how value is created in all aspects of an organization’s operations. Peer discussion and real-world case studies replace the typical lecture-driven classroom format. The result is a highly interactive learning environment that provides each participant with knowledge they can put to work immediately. The 18-month program begins a new class each August. For more information, please contact the Texas A&M Executive MBA office at firstname.lastname@example.org.