Dr. Anne MacyGene Edwards Professor of Finance

West Texas A&M UniversityPersonal Financial Literacy in the 21st Century

April 21, 2012

The Weeks That Changed Everything

The dominoes fell one right after another: the demise of Lehman Brothers tipping into the rushed sale of Merrill Lynch to Bank of America, followed by the federal takeover of AIG. Then, the desperate credit crunch of Wednesday caused the emergency maneuvering by the Federal Reserve and the Treasury on Thursday and Friday.

In a week, the financial crisis of 2008 changed everything —

Read more: http://www.time.com/time/business/article/0,8599,1843213,00.html#ixzz0rhUqzvbI

Financial CrisisSmart people made smart decisions and the result

was an asset bubble followed by a credit crisis followed by a recession.How did this happen?

Economic agents respond to incentives.While there are some altruistic actions, the majority

of the actions in the marketplace have the goal of profit.The rules of the game have to be set with this in mind.

Set the incentives accordingly.Recognize short-run effects.Make sure they are not in conflict with long-run goals.

Emphasis was on quantity.Everyone thought that the mathematical

models were perfect.Law of large numbersDiversificationA hurricane can wipe out an insurance company.Unlikely that a hurricane will take out the entire

country. Everyone thought that the “price” issue was

someone else’s concern.

Quantity AND Price

Models did not predict correctly the risk/default rate.Models are based on past trends and do not always capture

shocks. Models assume there is always a buyer.

Financial institutions were borrowing short and lending long.When the price in the short-term market exploded in

September 2008, their ability to maintain their business models eroded.

ContagionHousing bubble turns into a credit crisis.Massive hurricane takes out the entire country.

Large banks had both mortgages and CDO’s on their balance sheets, which multiplied the effect.

But Price Does Matter

So What Happened?Incentives did work as expected. Mortgage originators were paid based on

production and not quality.Tremendous pressure to not lose market share.Did not understand fully that some customers are

not worth the risk.But if the risk is passed on to others, what

difference does it make?Home buyers saw the low interest rates, easy

terms, and opportunity to gain wealth. Used new equity in homes to refinance.Housing bubble caused prices to rise allowing even

more refinancing.

FinancingNew credit scoring techniques for consumers

created a different way to measure risk.Investors wanted a part of the housing boom.Wall Street creates products such as collateralized

debt obligations to meet the demand.Mutual funds had rules to invest only in highly-rated

bonds.Ratings agencies complied.

Law of large numbersDid not recognize the contagion effects.Law of large numbers assumes independent

observations.Example: Health insurance – should your family history

count against you?

CEO CompensationCEO compensation is tied to stock price and earnings

performance. New mortgages and financial innovations increase profits,

which increases stock price, which increases CEO income. Allowed and encouraged the financial innovations that

increased risk in hopes of increasing return. A large part of CEO pay is stock options. An option only has

value above a certain stock price.Example

Stanley O’Neal left Merrill Lynch with a severance package of $160 million + stock options in Oct. 2007.

Charles Prince of Citigroup left with $29.5 million and no severance one week after O’Neal but with millions in stock options.

Notice emphasis on short-run stock price.

Incentives mean that short-run actions dominate in a competitive market that analyzes and rewards on a short-term basis. Quarterly earnings reports. What would happen if firms only had to report once a year?

Think about a student who manages his checking account. If he has to fess up each week as to his account balance, it keeps him honest – right?

If he runs short one week, he might lie to cover the one week knowing that he can make it up for the next week. Incentive to lie increases with the size and severity of the

punishment. Maybe it is better to make him reveal once a month.

But there is the incentive to “window dress” the value at the reveal time.

The punishment (incentive) needs to be larger for not revealing.

This is one dilemma of the financial regulation issue.

Short-run vs. Long-run

Financial RegulationNeed to address the incentive structure within

the financial industry.Do not want to stifle growth but do not want to

encourage risky behavior with no consequences.Failed bank list at FDIC.

2000-2004: 24 banks2005-2006: 0 banks2007: 3 banks2008: 25 banks2009: 140 banks2010: 157 banks2011: 92 banks2012: 16 banks (as of 4/13)

TBTF: in 1990, the 10 largest banks controlled about 25% of the industry’s assets. By 2000, it was about 45%. By 2009, it was about 60%.

Can’t sell these banks to just anyone. Can’t just close them. Banks focused on their balance sheets and did not lend.

Interest rates rose even though the Fed had lowered rates. Additionally, investors were no longer willing to buy TBTF bonds,

which would have normally provided the needed funds to increase the capital.

Banks used the various Fed lending instruments to clean up their balance sheets.

Bank lending channel does not work as expected. Incentive is to repair balance sheet and not to lend.

Regulatory and Monetary Policies Meet “Too Big to Fail” by Rosenblum, Renier, and Alm. http://www.dallasfed.org/research/eclett/2010/el1003.html

Bank Lending Channel Clogs

To Big To FailTBTF banks shareholders and bondholders

lose value of investments but the value did not go to zero.Credit default swaps

Financial regulation needs to hold everyone responsible but at what cost?

What happens if a TBTF bank does fail? Who pays or do we let everyone just lose? What about the effect on the financial system?

Did TBTF banks learn a lesson?

Market began to turn in 2005 and 2006 but we ignored it.

Greed or ignorance? When in a bubble, the euphoria is intoxicating.

In a bubble, we all agree to believe. Hide in the crowd and blame the other people.

There is no incentive to stand up and take responsibility.

Desire to compete dominates.

Why did it take so long for the bubble to burst?

Recession ended three years agoNBER stated the recession ended June 2009

http://www.nber.org/cycles/cyclesmain.htmlLagging effects:

Bank lending channel – banks have slowed lending and are improving balance sheets instead. Do not see the growth in small businesses that we

normally see after a recession. Causes monetary policy to have less of an effect.

Unemployment is still high. Labor market is a buyers’ market. We view ourselves

as consumers so we prefer a suppliers’ market.

UnemploymentUnemployment lags.

Unemployment rate around 8.2%.Frictionally unemployed and structurally unemployed =

natural rate of unemployment (NAIRU). Range has been 4% to 7%.

U6 rate around 14.5%. Discouraged workers leave and UE rates fall. Discouraged workers re-enter job market and rates could rise.

When workers go from part-time to full-time, the traditional

unemployment rate does not change. New employees are expensive so wait to hire until really need

the person. 30% to 40% extra because of benefits.

Immigration has slowed. How will this affect future economic growth?

What is the new normal?

Unemployment Stays High

New Job MarketBenefits decreased.

More of the cost of benefits that remain are shifted to employees. Less matching for retirement. Higher premiums and co-pays.

More overtime for existing employees.Many middle-aged workers and older do not have

the skills needed for today’s jobs.Social media

Older workers are not retiring. Reducing advancement for younger workers.Plastic surgery.Should increase entrepreneurship like the 1950’s and

1960’s.

New Job Market, 2Workers are competing in a global labor

market.International workers do not demand same

level of benefits or wages. Middle-class student vs. working-class student

– what is the wage anchor?Role of unions is diminished.Retail jobs replace manufacturing jobs. Can

you support a family on this wage?What about benefits?

Incentives can have unintended long-term consequences.Risk-return relationship. If return is higher than the

corresponding risk would normally indicate, you might have found a good deal. But if the “good” deal lasts, it means that you mispriced the

risk. Abnormal returns do exist but not forever.

Sale at JCPenney.Shirt for $25. But if still available for $20 a few days later, you should have

waited to buy. You didn’t price it correctly. Not as likely to buy when you see a sale at JCPenney. You

don’t know if it is a good price or not. Did this example in 2010 – how did JCPenney change pricing

in 2012?

To Buy or Not To Buy?

Walmart CEO stated that mobile communication negatively affects WMT profitability because of the increase in price transparency. Lost leaders may not have as much of an effect on buyers.

Price of risk is hard to measure. Need to recognize domino effect (contagion). Interest rate on subprime mortgages and CDO’s were not

priced correctly.

Who is ultimately responsible for the correct pricing? Normally, we let the market correct itself. But with TBTF

and the huge contagion effect, we were not able to let the market correct itself.

So, now we look to more regulation. But much of the financial innovations took place outside the

sphere of regulation.

Price Transparency

Everyone is responding to incentives. The clogs in the various lending channels

means that the low interest rates are not spurring economic growth as expected. The recession was deeper and longer.

Deflation was short-term concern.Inflation is long-run concern. Unemployment is still high.

How Does This Affect Me?

CPI stays above recent trend

PPI fluctuating more

Families are more focused on debt reduction than on spending. U.S. net wealth fell 18% in 2008 (11 trillion dollars).Design on a Dime vs. Flip This House

Firms that had strong balance sheets before recessions are on a buying spree. Consolidation in the various industries will affect prices in

the future. Competition is reduced but customer doesn’t realize this

because the old websites are maintained. Amazon vs. Walmart.

What will be the new normal?Growth of the last 20 years has been artificially higher

because of the increase in leverage.We have to get used to slower growth until real growth

increases.

Balance Sheet Revisited

Net Wealth

Slow Recovery in Wealth

Lessons Learned: Need Skin In The GameDown payment must be enough.

20% versus 1%.Difference between putting down 1% and only

being able to put down 1%.Mortgage compensation also based on

quality.Create asset bubble.Mismatches in risk and return.

Lessons Learned: Out of Thin AirCreation of financial derivatives. Misalignment of risk and return.Banks held checking deposits and derivatives

on derivatives.Contagion moves quickly.

There are not always buyers.

Lessons Learned: Wall Street PayWall Street pay has moved so far ahead of the rest of

AmericaBonuses range from 40% to 70% of total pay.

Average Wall Street bonus:2011: $121,1502010: $138,9402009: $123,8502008: $99,2002007: $177,8302006: $191,360

Consider farmers – what would be the outcry if there were agriculture bonuses like this?Modified beef product – pink slime.

Clawback provisions.Misalignment of time.

Lessons Learned: Fed Is Not PerfectFederal Reserve cannot control economy.

Cannot force us to grow.No regulation is not good.

Derivatives market.More regulation increases costs and creates

incentive to beat the regulation.Smart regulation.

Lifelong bureaucrat does not know how to beat the system.

Short-term bureaucrat is beholden to industry, where he goes for his next job.

What is the new natural rate of unemployment? Will it even change?

Less than 50% of U.S. households pay federal income taxes. New war between the classes?

Large fiscal deficit. Europe. Middle East. Health Care reform.

Short-term deflation concerns. Interest rates stay low until employment responds.

Long-term inflation concerns. Inflation expectations are increasing.

Where is the next bubble? Gold? Bonds? Health care? Government debt?

New Economy?

Still have high education levels.Still have economic conditions to encourage

entrepreneurship.Still have functioning financial system.Still have leadership role in the global economy. Still have wealth. Still have a role for immigrants. Do not have to be the prettiest girl at the dance.

Comparative not absolute advantage matters.

New Economy, part 2

Big Personal Finance LessonYou are responsible for yourselfWhat can you afford?Will you be bailed out?Who will pay for your retirement?Who will pay for your health care?