Sept. 30, 2008

Wall Street model is broken: Roots of financial crisis explained by panel at Johnson School

"Why should Main Street care about Wall Street?" Rich Marin '76, executive-in-residence in asset management at the Johnson School, asked this question of students, alumni and faculty in a panel discussion Sept. 24 in Sage Hall.

Answering his own question, he said, "Until you have a bottom on housing prices, you can't stabilize this market. Without Wall Street, you can't have mortgage finance."

Marin, former chairman and CEO of Bear Stearns Asset Management, joined panelists Bob Jarrow and Maureen O'Hara, both professors in the Johnson School, to examine the nation's financial meltdown; their discussion was moderated by Johnson School Associate Dean Doug Stayman.

The Wall Street model, based on leverage (i.e., borrowed capital), is broken, said Marin, but its mechanisms are not. However, capital markets are frozen, trading activities are impaired and securities lending is at risk.

The root cause of the financial crisis, according to Jarrow: subprime loans in which mortgages were given to individuals who were unworthy creditors. These doomed mortgages were later backed by bonds whose value was further distorted by incorrect favorable ratings from independent sources, such as Moody's Investors Service.

Profits from these loans encouraged more lending, and to further raise volume, teaser rates (low, introductory rates on adjustable rate mortgages) fell to below-market rates. When housing prices rose, borrowers refinanced their homes, resulting in new teaser rates. Commercial banks, investment banks, hedge funds, pension funds and money markets competed for funds in this low-interest-rate environment.

"Everything is working great, housing prices are up. You get this image of this bubble rising, and then you pop it," said Jarrow. "You throw in the Iraq war, the increasing budget deficit and oil prices. Interest rates start rising. Shock occurs, and the very high leverage multiplies the shock throughout the system. By this time, the bonds are held internationally. There's ... not enough capital to go around."

Ultimately, Americans need to have confidence in their financial institutions, O'Hara said. But, she said, the banking system lost track of the risk of financial assets, and the regulatory system allowed the risk to be transferred.

In recent days there has been a flight of investments to U.S. Treasurys. "Treasury securities are the safest in our system, but at some point, people may lose confidence that the U.S. Treasury is up to the job of stabilizing the financial system," O'Hara warned. "Liquidity depends on confidence, and once that's lost, the system collapses. ... We ultimately need to redesign the financial system to recognize where the risk is and manage it, with the goal of having a strong market that can provide liquidity."

Nina Zhang '09 is a writer intern at the Cornell Chronicle.