Wall Street just ended a dramatic week that saw nothing short of the restructuring of America's financial system. In a five-day span, the public watched Lehman Brothers file for bankruptcy, Merrill Lynch sold to Bank of America for a fire-sale price, and the federal government launch what could be a superfund to absorb as much as $700 billion in bad loans. To help understand and explain the week's events, The Tennessean assembled four investment and banking experts. The full round-table discussion was Webcast on Tennessean.com on Friday and is available there for replay.
Were the actions taken by the government enough to restore investor confidence? And was it the right thing to do?Stephen Frohsin: The government is the only one with the balance sheet that could have come in to do what needed to be done. It's almost like the Treasury coming in and calling a timeout in the middle of a game. A lot of the measures taking place … are temporary, but they're meant to keep the capital markets intact. It was necessary to keep our markets solvent, both the capital markets and U.S. commercial banking system.
Matthew Wright: I think it's the enormity of the situation. What the common person on the street doesn't really recognize is that a company like insurer American International Group is such a large institution … if that institution were to fail, everyone who wrote (certain) contracts with them would fail, whether they be hedge funds, whether they be investment management firms, whether they be firms that manage money market accounts. And it would just permeate through the entire financial system.
Tim Davis: I'm not sure it's necessarily fair. But what it comes down to … was a lack of confidence. How do you restore that confidence? It's like a wildfire that you see out in California in the summertime. It's very hot, and they start sending in ground firefighters to put it out and aerial things to put it out. American households are wondering, if I wake up tomorrow, can I get up and use my ATM card? Right now, everyone is staying (home).
Will a government-run fund to absorb bad loans for the banking industry actually work?Wright: I think ultimately it will work. The government is going to be taking on these loans at a discount and these loans are at depressed values, so there is some opportunity for some upside. The more troubling thing is what position does it put our economy in as it relates to our ability to finance this? The government can print money, but they have to issue debt to counterbalance the issuing of money. The implications of this is going to be higher interest rates, as we issue more debt to attract more assets to us to pay down these expenditures and, quite possibly, higher taxes.
I think what we all have to think about here are the long-term repercussions. This instills confidence … into the system, but there are some long-term pains that we all will have to endure as well. There's going to be a burden for our generation, the next generation and probably the one after our kids' generation.
Frohsin: For us to have gotten into the situation where insolvency was the next step for a lot of large financial institutions, well, you can say it's a bear market. But something about this economic situation was so different that it caused 150-year-old businesses to fail. The medicine here was an emergency application. That's why it's temporary, like the short-sell rule.
This was such a failure of all the regulators to allow major investment banks to take on 30-to-1 leverage on a balance sheet. When it works, that's what drove earnings and that's what made executives a lot of money. But you got to a point when the leverage no longer worked, when everyone is trying to sell an asset at the same time, and there are no borrowers.
Going forward you're going to see a lot less leverage from whatever investment banks are left. Right now there are two. This is a lesson, but it's also an awfully expensive lesson.
Have we crossed a line, where the regulatory environment going forward for years to come will be much stricter? Is there any going back to the old way?Frohsin: Things ebb and flow. I think things are going to get a lot tighter. In 20 years, maybe people will forget.
Davis: I think with mortgage rates, you're going to see long-term mortgage rates decline over the year. We saw a great drop in long-term fixed rates this week when the stock market fell. That's great if you can qualify.
We have to make it not so tough to qualify. The homeowner that got into something that was exotic, with a hybrid mortgage, an adjustable-rate mortgage, they need a little bit of relief, because they're still making an income. We're going to see lenders not worried as much about these loans and more willing to do loan modifications. If you are a homeowner and made a bad decision in your loan, chances are you can call your lender and make some changes.
What about an effect on commercial lending?Frohsin: We're looking out the window now (of The Tennessean building) at a couple condo projects. Anecdotally, here in Nashville, people who came here to do a deal, the bank required 5 percent equity and they borrowed the rest. They had very little skin in the game.
Those same builders are being required to come up with 20 percent equity. These are multimillion-, tens-of-millions-of-dollar deals. You have to be able to raise capital now. That will flush out the Johnny-come-lately builders. I'm not a commercial lender, but a lot of those deals were put together with five-year terms, but I can imagine those terms will be tighter when they come up for renewal. Residential real estate is the first to see the shoe drop, but I think oftentimes, commercial real estate is the last place to see the shoe drop. I'm pretty bearish on commercial real estate.
Do you feel there's a criminal element in what we're experiencing that hasn't come to light?Michael E. Ryan: In this situation it doesn't feel like there's illegal or criminal activity like there was back in 2001 or 2002. We'll know in probably a year or two when the first business book or second book comes out. We'll know what went on like we do with all these financial crises.
I just moved to Nashville six months ago. Prior to that, I was in New York and I spent seven years at J.P. Morgan, and we had pretty strict financial controls. There were deals that we passed on that were clearly over the line … but other firms gladly took them because they were a revenue generator. I think you see J.P. Morgan coming through this because of the financial controls internally. Some firms just got way over the line.
Frohsin: It was greed that drove us to this crisis more than any criminal element. This was pure greed, particularly on Wall Street. There are certain firms that escaped a lot of this — firms like J.P. Morgan who have done a pretty good job of staying out of trouble. There are other CEOs, some of whom are no longer at their firms, who took on such leverage to grow earnings … that led to a combination of greed, and a poor, poor regulatory environment allowed these portfolios to continue to grow when they should have contracted.
There's been some talk that the government's actions may lead, or have led, to something approaching socialism. What's your reaction to that?Wright: Whenever you have massive intervention like this, it takes away natural economic opportunities that should evolve and materialize, and by having such intervention it has the head of socialism. But I think the biggest thing is that it takes away a sense of accountability from the investor's standpoint. People should understand the difference between risk and reward in the decisions they make.
Frohsin: Let's hypothesize what happens if there wasn't any "bailout." Quite possibly you'd have had a run on the banks. Wouldn't people then have been looking at the government to do something?
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