, September 30th, 2008
Bailout, subprime mortgage, toxic assets, insolvency, systemic risk, reverse auction, recessionâ€¦for those not in the financial world, these phrases in the news are more than alarming, they are also confusing. Cutting through the jargon, two representatives from Bank of America spoke to an audience of Mays Business School students at Texas A&M University on September 24, about the current economic turmoil in the U.S.
Roger Davis ’84 and Richard Stein ’92, senior vice presidents in lending for lodging and real estate, and energy and sports, respectively, presented students with an in-depth and understandable perspective of the marketplace.
According to Roger Davis ’84, the most striking aspect of the current market decline isn’t the size of the shift, but the speed.
Davis asked, what is the market’s oldest barometer, the Dow Jones, telling us? “It’s an unprecedented shift in the market,” he said, not due to the size of the shift, but the speed. He says there have been much bigger market declines over the years. For perspective: the crash of ’29 was an 89 percent decline over three years. Today’s shift has been 23 percent over less than one year. “Are we in the beginning of another great depression? I tend to not think so,” he said, drawing parallels to the S&L (savings and loan) crisis of the 80s and 90s. “It took seven years to work it out and Texas was in a recession,” he said, noting that eventually, the state got through it.
Davis said that if you want to point fingers, the blame belongs on investment banks for engaging in risky financial behavior; residential loan clearing houses Fannie Mae and Freddie Mac for encouraging irresponsible borrowing; commercial banks that lent money based on the credit of collateralized debt obligations, which were often stuffed with sub-prime securities that few investors really understood; and rating agencies like Moody’s and Standard and Poor’s for not understanding the risk involved in the subprime mortgages they were evaluating and recommending as sound investments. What it came down to was that everyone predicted that far fewer borrowers would default on their mortgages than what actually occurred.
Davis reminded students that though home ownership is wonderful, not everyone can feasibly afford to buy a house in places where the cost of living is high. Too frequently in recent years, even those that couldn’t afford a house were approved for a loan because banks saw the house as a good investment: either the borrower will repay the loan, or they will default and the sale of the house, which should have appreciated in value, would cover any losses. However, as the bottom has fallen out of the housing market, banks were getting stuck with defaulted loans and depreciating properties.
This bad debt scenario has lead to a lack of liquidity in bank assets, so that the continuous flow of loans from one financial institution to another is seizing up. (That is, when bank A owes bank B money, and bank B owes bank C money, when A can’t pay, B doesn’t get paid, then C doesn’t get paid, and so on.) The Bush administration’s bailout plan would purchase these “toxic assets” and free up funds so that banks would start lending againâ€”to each other, as well as to individuals and corporations.Â Davis also mentioned that the distress of American banks is having an impact globally, as the financial industry worldwide is intertwined. He says foreign banks are now very hesitant to do business with American ones because they fear they will not recoup their investment.
On the bright side, Davis did tell students that the next 18-24 months might be a great time for them to buy a house, if they get a good job after graduation and can afford the payments. He predicts home prices are going to stay low for another year or two before they will stabilize. However, he also told students that it is probably going to be harder for them to find a job after graduation if the economy is still in recession. So far, Texas has not been greatly affected by this credit crisis. Davis told students they would do well to look for jobs in Dallas or Houston after graduating, as those are areas that are still experiencing growth.
Davis and Stein reported that economists predict America has a 50 percent chance of a mild recession, with slightly negative economic growth and slightly increased unemployment. They also said there’s a 45 percent chance we’ll have a deep recession, with increases in unemployment and inflation, which would lead to a global recession. In a time of recession, a major problem is wealth-hoarding: companies prefer to keep what they’ve got, rather than risk anything on new ventures. Stein says that the economic system has stalled because no one is buying at the moment, since the markets seem shaky. He sees the government bailout as a necessary evil, as it will hopefully free up cash, which will allow banks to start trading again.
“The financial arteries of the nation are clogged,” he said. “We’re about to have a heart attackâ€¦if [the bailout] is not passed by Tuesday, we are in serious risk of a meltdown.” Stein told students that Tuesday is the start of the new fiscal quarter, when it will be essential for new trading to begin. In his opinion, the government could actually make money on the bailout, as they will be buying discounted assets that, with proper handling, could turn a profit.
At the end of the presentation, Davis asked the student audience, “How many of you are scared right now?” Nearly every hand went up. “We will come through this,” he assured students. “We’ve been through worse. We will survive this.” He also counseled students to take notes, as they are not likely to ever again have an opportunity to learn so much about how the economy works.
Since Davis and Stein’s presentation, the Emergency Economic Stabilization Act of 2008 (the bailout plan) failed in the House of Representatives on September 29. The plan was revised and passed on October 3.