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University economists give views on financial crisis

By Lauren Otis, The Packet Group
   A panel of five Princeton University economics professors were in accord on Tuesday over how big a mess the current Wall Street crisis is, but said the $700 billion bailout proposed by Treasury Secretary Henry M. Paulson Jr. and Federal Reserve Chairman Ben S. Bernanke is both lacking in detail and ill-considered in its current form, and should not be rammed through Congress without major revisions.
   ”What are they doing? I think the answer is they don’t really know,” said Professor of Economics Paul Krugman of Secretary Paulson and Mr. Bernanke, before a packed audience of hundreds at McCosh Hall on the Princeton University campus.
   The original three-page document outlining the $700 billion bailout over the weekend contained “no details of how the money will be spent,” Professor Krugman said. Public statements by Secretary Paulson and Mr. Bernanke did not help either, he said.
   Professor Krugman singled out one statement: “Our former department chair used it this morning, ‘what we need to do is take the troubled assets off the balance sheets, remove the bad stuff.’ That is an extremely evasive phase. I think it avoids the critical issue. The question isn’t taking troubled assets off balance sheets but at what price?” His reference was to Mr. Bernanke, who chaired Princeton’s economics department before becoming Federal Reserve chairman.
   The question of whether Treasury would go in and pay above the current market price for the assets, helping financial firms but a questionable use of taxpayer money, needed to be addressed, said Professor Krugman, who is an op-ed columnist for the New York Times.
   One clause in the document — referred to as Section 8 — effectively states “the Treasury secretary can do whatever he feels like and there can be no second guessing after the fact by anybody, which I feel is quite extraordinary,” Professsor Krugman said. In appearing to put itself above review and the law, Treasury could no longer be viewed as acting in good faith, he said.
   ”When I read it I really didn’t know whether it was a joke or a disgrace, I still don’t know,” said Alan Blinder, Gordon S. Rentschler memorial professor of economics, of the bailout proposal.
   Professor Blinder, who served on President Bill Clinton’s Council of Economic Advisors, said the proposal needed major changes before it might be appropriate to enact, including removing the “Section 8” provision absolving the Treasury secretary from oversight and being held responsible for his actions. On the contrary, he said the bailout would need substantial transparency and extensive oversight.
   ”Why do we need $700 billion from day one?” Professor Blinder asked. Congress could tier its outlays, starting the bailout with $100 billion or $200 billion, and adding more as needed, he said.
   Additionally, even with $700 billion “you can’t buy it all” in the $11 trillion U.S. mortgage market, Professor Blinder said. “With $700 billion there is still a budget constraint, you have to figure out what to buy.”
   Of the “big rush” to set up Treasury as the agency orchestrating the bailout, Professor Blinder said, “I don’t believe this for a minute. They don’t have a unit in there of a thousand people trading these lousy assets.” To the contrary, the further away from the politically driven Treasury Department the decision-making for the bailout mechanism could be situated, the better, he said.
   Professor Blinder said it was absurd for Congress to be told by Secretary Paulson and Mr. Bernanke that “if you don’t do it within 24 to 36 hours the sky will fall.” Noting that “markets are, or at least we imagine them to be, forward looking,” Professor Blinder said it was sufficient at present for the financial markets to understand that Congress would adopt a measure soon, not necessarily within 36 hours.
   Professor Krugman agreed, noting that large parts of the economy were unaffected by the financial markets crisis and still could obtain credit and operate. “I think we have time to work this out,” he said, noting that only if Congress did not adopt anything after several months might there be cause for concern.
   Professor Krugman acknowledged the severity of the crisis, saying the housing bubble was a long way from being deflated — “we are not by any reasonable measure back where we started,” he said — and investment losses could increase substantially. The financial markets have only acknowledged $480 billion of mortgage losses, but if housing prices fall by another 10 percent that figure will rise to $636 billion, and if prices fall 20 percent mortgage loss estimates are in the $868 billion range, Professor Krugman said.
   Professor Krugman urged a rescue plan that gave the government an ownership stake in the financial firms it helps, as Democrats in Congress are calling for. “They are trying to sell us a plan with no quid pro quo, no government stake, and I don’t think that plan is going to fly, I hope it doesn’t,” he said.
   Professor Krugman said of the government’s $85 billion rescue of insurer American International Group, for which it will get a large equity stake, “that was a good rescue, that was the kind of thing we should be doing” with the current proposal.
   Other economists on the panel attempted to explain how the ongoing subprime mortgage crisis could have triggered such a rapid unraveling of former Wall Street titans like Merrill Lynch, Lehman Brothers and AIG within such a short period.
   Starting in the 1980s, broker-dealer holdings of mortgage-backed financial instruments exploded, overtaking banks as market-based holders of mortgages around 1990, said Hyun Shin, the Hughes-Rogers professor of economics at Princeton.
   Investment banks like Lehman Brothers and Bear Stearns had substantial collateralized borrowing to support such investments, and when the collateral — such as mortgage securities — loses value, the funding dries up in an escalating downward spiral, Professor Shin said. “If there is a run it is going to be an extremely rapid withdrawal of funding here,” he said.
   ”This is the Bailey Savings & Loan on steroids, this is a fierce run,” Professor Shin said of the rapid implosion of Wall Street investment banks as a result of mortgage investments, referring to the failed S&L in the movie “It’s a Wonderful Life.”
   Edwards S. Sanford Professor of Economics Markus Brunnermeier said much of the current problem could be traced to the growth of “maturity mismatch” within financial firms as they invested heavily in securitized mortgages, and a lack of regulatory attentiveness to the risks involved.
   Mortgage investments are long-term assets with maturities of 10 years or more, but were financed by huge amounts of lower-rate short-term funding, often with terms of a day or two, Professor Brunnermeier said. This meant investment banks had to roll over short-term debt, and obtain more, every day, he said.
   ”The investment banks have to roll over one quarter of their balance sheet every night, and if something goes wrong it goes very quick,” resulting in a “liquidity spiral” of selling assets ever cheaper to obtain ever more expensive financing, Professor Brunnermeier said.
   Financial firms “ended up being caught holding a lot of bad mortgages, and not only that but got caught holding bad mortgages with a lot of borrowed money, in fact an insane amount of borrowed money,” said Harrison Hong, the John Scully ‘66 professor of finance.
   A lack of understanding by financial firms of the larger perils of a housing bubble — which turned out to be far more perilous than stock market bubbles such as the dot-com bubble of the 1990s — aided the current meltdown but so did poor regulation and government oversight, Professor Hong said.
   ”How did the SEC allow banking to go to a 30-to-1 leverage ratio?” Professor Hong said of regulators allowing financial firms to carry huge debt loads.
   Asked if the risks were understood by the CEOs of the now-troubled firms and they bore responsibility, Professor Blinder replied that leadership was lacking. “Was the risk management done disgracefully badly? Yes,” he said.
   Despite this, Professor Blinder said he felt the current call to place curbs on CEO pay would not be worth the effort. During the Clinton administration he worked on this issue, and found that board of directors compensation committees always found ways around CEO compensation curbs, Professor Blinder said.
   Curbing the distribution of dividends would be more worthwhile, Professor Blinder said. “If we are going to pump money into these companies through the front door we don’t want it going out the back door,” through dividends, he said.
   Professor Blinder said there was a possible upside for taxpayers in the government rescue. “I believe that a lot of these assets have been beaten down to absurdly low levels, a negative bubble,” he said, and in buying up these assets the government will be able to dispose of them later for substantially more.
   ”This is one of the reasons to do it right in the first place and not screw it up,” Professor Blinder said of the current bailout. “This to me is another reason to take time and design it well,” he said.
   Noting how much was still up in the air concerning the bailout plan, Professor Blinder said, “this is a moving target, lots of issues are being bandied about in Congress, and they should be.”