Understanding the ‘Street’

A Challenge, Given That it Doesn’t Really Understand Itself

The previous two weeks have been called the most turbulent ever in Wall Street’s 200 year history, and with good reason. We’ve witnessed the bailout of Fannie Mae and Freddie Mac, the bankruptcy of Lehman Brothers, the sale of Merrill Lynch, the $85 billion dollar federal loan to AIG, and the pièce de résistance, the Treasury’s plan to purchase $700 billion in securities from troubled financial firms.

We’ve also witnessed a great deal of confusion and frustration among everyday people who have watched the Dow Jones Industrial Average drop 8 percent in three days, and are justifiably concerned for their own investments. Many people do not understand how the Street works, and so are often shocked or even outraged to hear of billion dollar bailouts and waves of foreclosures.

Part of this stems from a tendency to view the problems of any large firms as being the result of avarice or downright incompetence of a fat-cat management. For similar reasons, populism always makes a strong showing during economic slumps, with people proclaiming the capitalist system unfair or skewed towards the wealthy and powerful. My goal is to clarify these perceptions.

However, while we in academia may reside in our own bubble and be concerned with dorm security, the bubbles I will discuss involve price inflation while the securities deal with mortgages. To start, it is crucial to have an idea as to how the financial system functions and how government actions in the past years have shaped our present situation.

The financial markets consist of two main players: commercial banks and investment banks. A commercial bank is what people normally refer to as a “bank,” where they deposit their checks into savings accounts or take out loans or mortgages. The branch of Bank of America in the Student Center fits this description.

In contrast, an investment bank deals primarily with trading assets. They invest money on behalf of their clients, who are people (called investors), businesses, or other banks. Investment banks trade stocks on stock exchanges, such as the well-known New York Stock Exchange, though they are also involved in trading securities, commodities, and anything else that is bought or sold on contract. The stereotypical stock broker who wears a white shirt and screams trades into a headset on Wall Street would work for an investment bank such as Goldman Sachs.

Most people are unaware of the breadth of what can be traded by investment banks. Mortgages are packaged into securities (a process known as securitization) and sold to investors, commodities such as oil, corn, and steel are bought on futures (contracts that give the owner a right to a certain quantity of the material at a set future date), and treasury bonds are traded freely by investment banks.

After the Great Depression, banks were prohibited from engaging in both investment and commercial activities, which kept their power in check at the cost of reducing their competitiveness. In 1999, however, Bill Clinton signed a bill that effectively repealed this restriction, and led to a rush of consolidation among different types of banks. It is this change that helped to ignite the rush of events leading to our current credit crisis.

This is not to say that banks have been given free reign to do whatever they please for the last decade, however. The job of regulating the banking industries falls to many agencies. The Office of the Comptroller of the Currency (OCC) is in charge of national banks such as Bank of America, the Office of Thrift Supervision (OTS) regulates smaller banks who are more focused on commercial banking, while the Securities and Exchange Commission (SEC) has control of markets. The OCC and OTS are divisions of the Department of the Treasury, while the SEC is a separate agency.

In addition the above three letter agencies, the Federal Reserve is in charge of the economy as a whole, and influences inflation, growth, and the money supply. Now, they are working with the Treasury and other agencies to resolve the credit crisis.

This brings about a major issue with the current banking system: multiple agencies all working on fixing their own problems. The complexities of this regulatory system makes it extremely difficult to implement reform or to fix potential problems before they arise. After the 2001 slump, for example, the Fed dropped its’ target interest rate to below the current inflation rate, effectively making it profitable for banks to take out loans. With access to this money, mortgage rates hit all time lows, and the housing boom took off as people were able to afford massive loans to construct and buy equally massive new houses.

Furthering the impact of the law of unintended consequences was the voice of Washington continually urging the benefits of homeownership, as incumbent politicians love to boast about creating more homeowners (as if the forty year adjustable rate mortgages hanging from many of these homeowners heads wasn’t their own financial noose). While all of the signs pointed towards ever bigger and more complex mortgages, regulation surrounding these mortgages did not adapt.

First, the regulation in place completely missed some of the newer and more exotic financial firms who played less traditional roles in the economy. They were able to expand into mortgages to subprime borrowers or specialized in risky interest only loans made to people with poor credit. While some claim that lenders preyed on unsophisticated borrowers, the truth is that many borrowers let dreams and optimism drive their financial lives and built their own ‘castles in the air’.

Additionally, the linking of investment and commercial banks meant that mortgage backed securities became increasingly prevalent. Buoyed by bullish reports about ever rising home values, investors paid premiums for complex securities without fully understanding the value of what was packaged within them. Now ubiquitous, subprime mortgages were bought by even seasoned financial veterans (illustrating the power of blissful ignorant optimism on the markets). Those same securities are now a major cause of the financial industry’s problems.

As I’ve mentioned before, investor confidence is one of the most important aspects to Wall Street’s survival. Unless one party has the confidence to exchange their money for the promise of another type of asset to be repaid in the future (a bank issues a mortgage with the promise that the homeowner will repay it, an investment bank makes an overnight loan to another bank to allow the latter to balance their budget sheet, etc.), Wall Street grinds to a halt. This concept, also known as liquidity, refers to how easily assets can be exchanged between parties. In the case of some toxic mortgage backed securities, their liquidity is basically nonexistent.

This has been the case this past week. Especially after Lehman Brothers bankruptcy, banks have found it almost impossible to follow through with their transactions. And because so much of Wall Street is interconnected, when one bank can’t complete a trade, no other bank down the line can complete a related trade. When that happens, everyone attempts to look out for themselves by being extremely cautious. Money doesn’t get lent, trades don’t happen, and the institutions that need to trade or take loans in order to survive (like AIG) fail.

Which brings us to the government’s current efforts. While until now the Treasury has focused only on specific cases of institutions deemed “too big to allow them to fail” (Bear Stearns, Freddie and Fannie, AIG), the proposed $700 billion plan is an attempt at fixing all that currently ails the industry. By serving effectively as the buyer of last resort — much as the Fed has been the lender of last resort for decades — the Treasury hopes to remove what would otherwise be unsellable assets from banks. As they say in a recently released fact sheet, “removing troubled assets will begin to restore the strength of our financial system so it can again finance economic growth.”

I have no doubt that putting this much money into the banks will help resolve the liquidity crisis, although I also have my concerns. First, many experts estimate the total cost will actually exceed $1 trillion, essentially all of which will be added to the federal debt. While this doesn’t necessarily bankrupt future generations, it still isn’t an ideal situation. If we as taxpayers get lucky, the Fed will be able to hang onto these securities long enough to see them increase in value again, and might possibly even make some money from this bailout. Anyone who claims that the Treasury is permanently adding $700 billion to the national debt is ignoring their ability to resell the securities.

Additionally, this bill has the potential to be loaded up with extraneous spending before it is approved by Congress, which has the tendency to trade higher inflation for temporarily higher approval ratings. There is also the concern that future banking regulation will go too far, and in the end crimp economic growth. Regulation is an essential part of a functioning capitalist economy, but there is a difference between more regulation and more effective regulation. To start, I propose consolidating the regulators in the Treasury with those of the SEC to form a single body responsible for managing all financial firms. Ensuring that everyone plays by the same rules will make avoiding future crises easier. Meanwhile, the Fed needs to have the scope of its mission reduced to the fundamentals: maintaining a stable rate of inflation. Much as Fannie and Freddie were unable to appease both their public and private masters, the Fed is not the agency that should be attempting to regulate overall economic growth.

It is important to keep in mind that it is easy to overstate the severity of a panic when one is still wading through the wreckage. As MIT students, we owe it to the world to have an adequate understanding of the market economy that will one day employ us, so learning the basics now is essential. The current mortgage crisis has been the culmination of years of bad decisions, from Washington to Wall Street and from the floors of the stock exchange to the kitchen tables of homeowners. We as a society have made poor decisions regarding our financial future. Understanding what the right choices are and speaking out ensure their implementation is the best way of ensuring our future prosperity.

Joe Maurer is a member of the Class of 2012.