2008 Headlines
Market Chaos Unraveled
Sept. 24, 2008, 4:30 PM - 5:30 PMProfessors Bob Jarrow and Maureen O'Hara and Senior Lecturer Rich Marin presented their interpretation of the current, unprecedented turmoil in the financial markets in a panel discussion moderated by Associate Dean Doug Stayman. Addressing a standing-room-only crowd in Sage Hall B09, plus an overflow audience in B08 via video, Jarrow set the stage by discussing the framework that led up to the crisis, O'Hara explained what's happening with credit markets and liquidity, and Marin addressed Wall Street as a model - what's broken and what's not.
Jarrow opened the discussion by outlining the root causes of the crisis: Subprime-backed bonds are complex, highly leveraged derivative securities, and rating companies rated them incorrectly. "Rating companies used historic data, and these types of bonds don't have much history," he said. "They had a strong sample period bias, could only look at a market with rising housing values." In addition, he cited an incentive problem: "Rating agencies are paid by the entities being rated . . . a structure not conducive to accuracy."
In her presentation, O'Hara addressed credit markets and liquidity. "The Fed's primary job is to lend liquidity and keep the markets afloat," she said. "By last Monday, the banks were unwilling to lend in short-term markets. So the Fed pumped hundreds of billions of dollars into the system."
Yet the banks were unwilling to lend to each other in overnight markets, because they were uncertain of counter-party risk. So they started hoarding cash. "Excess reserves reached $190 billion; on an average day, excess reserves are at about $2 billion.
This coincided with and was exacerbated by a run on money market funds: investors withdrew $144 billion last week; the previous week, withdrawals were about $7 billion." The reason: many money market funds were left holding worthless commercial paper from bankrupt investment banks, leaving them without the capital to pay the principal and interest owed to investors.
Liquidity was compromised by loss of confidence in both counter-party lending and money market funds, O'Hara said. "When that is lost, the system collapses to its safest point - treasury bills. If people lose confidence in our system, everything unravels. The market also needs confidence that loans will be paid back, and has to be convinced that problems can be fixed.
The central bank, and executive and legislative branches moved quickly to shore up confidence and thus improve liquidity and markets last week by taking four steps, O'Hara said: guaranteeing money market funds, the proposed $700-billion bailout of investment banks, restrictions on short-selling certain stocks, and the conversion of the two remaining independent investment banks to regulated bank-holding companies. "The guarantee of money market funds is absolutely necessity in my view," she said. "But it's a stop-gap measure."
Rich Marin, executive in residence in asset management and former chief executive officer of Bear Stearns Asset Management, applied his analysis to the future. The Wall Street model is broken, he said, and will not survive. The biggest shakeout is likely to occur in the prime brokerage businesses of the major Wall Street firms.
Prime brokerage businesses are a fundamental engine for investment bank profitability, Marin said. But bans on short selling of financial stocks and the growing reluctance of pension funds to lend securities for short selling mean that prime brokerage is severely crimped. Marin predicts the crisis will create new business models and new entrants to this business, which until now, was dominated by large investment banks.
And why should main-street America care one whit about the fate of prime brokerages, investment banks, and any other finance business? Put simply, without a functioning Wall Street, there is no market for home mortgages. "Community banks aren't holding mortgages any longer," Marin said. "Without Wall Street, you can't have mortgage finance." What's more, the value of the $3 trillion in outstanding mortgage-backed securities can't be determined until housing prices hit bottom, Marin said. "What is the chance you can get a floor on housing prices if you can't get financing."
