MIT Panel Discusses the Financial Crisis

'If we get through the next few weeks...', MIT News Office: A panel of five MIT faculty experts in economics and business analyzed the ongoing financial crisis in the U.S. and world markets at a special session Oct. 8... The panelists focused on different aspects of the history, the present unfolding, and the likely future of the financial mess, and emphasized that the situation is far more complex -- and the long-term outcome more uncertain -- than is typically portrayed.

"The popular story is way too simplistic," said Ricardo Caballero ... who organized and moderated the panel.

For one thing, he said, the crisis has been brewing much longer than many people realize. "Things began to change quite dramatically in the summer of 2007," he said, as house values began to flatten out or decline after years of rapid escalation. That's when new financial instruments became widespread that packaged mortgages of varying risk levels into forms that made it difficult to assess their underlying value.

But while the loss of value of these instruments caused investors to panic and began a downward spiral in financial markets that has unfolded over the last year, "the impact of the financial crisis on the real economy, Main Street, had remained contained until only a couple of weeks ago," Caballero said. "All this changed on Sept. 15," when investment bank Lehman Brothers declared bankruptcy and the government decided not to step in to save it. "This changed entirely the dynamics of the game."

William Wheaton, professor of economics and urban studies..., stressed that part of the reason for the real estate bubble -- and its resulting collapse -- had to do with an excess of capital globally. Much of that ended up going into American real estate, as a result of these financial instruments that bundled mortgages in a way that was perceived as greatly reducing the risks involved. That influx added to the pressure for lenders to offer more loans "to people who were incredibly more risky," he said.

While the averaging out created by these securities helped to smooth out the risks of individual mortgages, Wheaton said, that process "really offers no advantage against systematic risk," such as the overall downturn in housing prices -- an event he compared to a "100-year flood" in economic terms. But the storm was created in large part, he said, by an excessive boom of housing construction while the prices were rising. "I actually think it was oversupply" of housing that caused much of the problem, Wheaton said.

To fix the problem, he said, in economic terms it is more important to stabilize house prices than it is to keep people in their homes. While that may seem cold, he said, much of the boom was fueled by what he called "marginal" buyers -- those buying second homes or investment properties on speculation, who had no strong attachment to the properties. The current slump in home construction, he said, may actually be good for restoring the economy.

Andrew Lo,... Professor of Finance..., said the underlying concept of "securitization" of mortgages -- the creation of a secondary market in mortgage-backed paper that helped to create definable levels of risk -- "is a good one, in fact a brilliant one." The problem came when investors around the world began to see these instruments as being so safe that they used excessive leverage to buy into them.

When prices began to fall, though, "when markets are under duress, it's very hard to set values," and liquidity of these assets began to freeze up. Fear has taken hold of the markets, he said, and since "fear by definition does not have to be rational," it's hard to predict the near-term future. "We will be able to get through this, if we can get over the next few weeks," Lo said. In fact, we will "be stronger and better for it."

Bengt Holmstrom,... Professor of Economics, said that contrary to widespread belief, greed on Wall Street, "I don't think is the real problem." Rather, he said, politicians share much of the blame. "Pressure came from the top, from politicians who wanted to increase lending to poor families." While prices were booming, "everybody wanted to get into this game."

While the focus now is on having the government step in to buy up the "toxic" bad loans, Holmstrom suggested it might be wiser for them to channel fresh capital into 100 of the best, strongest banks, and let some of the weaker ones fail.

James Poterba,... Professor of Economics, said that trying to deal with the economic crisis while in the midst of the present turmoil is a bit like trying to keep species alive amidst the swirling dust and debris after an asteroid hits the planet. "We have really shaken to the core the role of the state," he said.

But Poterba, who is also the president and chief executive officer of the National Bureau of Economic Research, said he takes some comfort from the fact that one of those working on handling the crisis is Federal Reserve head Ben Bernanke, who earned his PhD from MIT and much of whose research was on the Great Depression. "He's one of the best people you want to see" in the midst of a crisis like this, he said.

He also emphasized that much of what is seen as spending by the government in this situation is really just a transfer of assets, and that in many cases the government may actually profit from these "bailout" moves.

Comments

[Bruce Wilder]

William Wheaton: "To fix the problem, he said, in economic terms it is more important to stabilize house prices than it is to keep people in their homes. While that may seem cold . . . "

Is this code for, "it is more important to make the banks whole, than to help poor or middle class people who live in houses"? It doesn't sound cold to me. It sounds like a career move, by a corrupt academic.

Bengt Holmstrom,... Professor of Economics, said that contrary to widespread belief, greed on Wall Street, "I don't think is the real problem." Rather, he said, politicians share much of the blame. "Pressure came from the top, from politicians who wanted to increase lending to poor families."

Oh, wait. Wheaton sounds like a great humanitarian, compared to this eight-ball. Those billions in bonuses handed out at Bear Stearns were nothing as compared to the Poor Lobby in Washington, and their well-known lock on the Congress. There's no more corrupting special interest than the poor.

Andrew Lo,... Professor of Finance..., said the underlying concept of "securitization" of mortgages -- the creation of a secondary market in mortgage-backed paper that helped to create definable levels of risk -- "is a good one, in fact a brilliant one." The problem came when investors around the world began to see these instruments as being so safe that they used excessive leverage to buy into them.

Let's see they create definable levels of risk, but no one read the definitions? Is that Lo's thesis?

James Poterba,... Professor of Economics, said . . . "We have really shaken to the core the role of the state,"

Oh, yeah, as finance capitalism collapses in a cloud of dust, it is the "role of the state" that's shaken.

[paine]

this wheaton is a boob

"the storm was created in large part, he said, by an excessive boom of housing construction while the prices were rising"

over production eh ??
my my
and he's an urban economist
the one field where ground rent is taken seriously

btw

it wasn't the risky loans that caused the trouble it was the bubble bursting ..period

consider this

defaulting into a rising market is hardly a big problem

the default rate has risen recently but if lot values had continued to climb

these loans were originated with an un-official
whispered to suckers and rubes expectation

default is no big whoop in an ever rising market for house lots

[paine]

bruce nice notes

i'll admit i think the security innovations are neat

and were the "but now its different "gizmo
that put minds at ease
perpetuum mobile baby

forget bs about how
a house lot
can be more then the discounted sum
of its future lease rates

"why pard
these here fancy formula instruments
have domesticated risk itself
turned the tiger into a tabby
so how many you need ..."

[paine]

"We have really shaken to the core the role of the state,"

a line that swallows its own tail

[James Kroeger]

...contrary to widespread belief, greed on Wall Street, "I don't think is the real problem." Rather, he said, politicians share much of the blame. "Pressure came from the top, from politicians who wanted to increase lending to poor families."This is, of course, the major argument being advanced by the Republicans to blame the crisis on the Democrats and their damned bleeding hearts.

Can someone tell me how it is that 'the Democrats' forced banks to take on risks that they did not want to take on? I find it unfathomable that any bank would have taken on such risks without first obtaining some kind of guarantees that would reduce their actual risk.

Of course, I can see how bankers would be more than happy to extend loans to risky borrowers if they knew they could immediately pass those risks on to some secondary market gamblers who were flush with cash following George Bush's 'free money' tax-cut giveaway.

But then, that would be the problem, wouldn't it?

[Bruce Wilder]

"The panelists . . . emphasized that the situation is far more complex -- and the long-term outcome more uncertain -- than is typically portrayed."

I suppose that the above is just standard-issue meaningless hack journalism written by a junior flack in the MIT press office -- the kind of mindless verbiage turned out every day by corporate cogs, to be re-printed with no intervening thought, by so-called journalists.

What disturbs me is that the economists, apparently, think that their roles also require the same kind of mindless hackery.

Is our entire culture trapped like a polio-paralyzed body in an iron lung of corporate hackery? (Please, don't answer the question.)

[Robinia]

OK, Bruce Wilder, won't answer your question...

BUT, what Bruce Wilder said, AND...

Doesn't it just make you so reassured that

Poterba, who is also the president and chief executive officer of the National Bureau of Economic Research, said he takes some comfort from the fact that one of those working on handling the crisis is Federal Reserve head Ben Bernanke, who earned his PhD from MIT

If the guy in charge of the Fed earned his PhD at your University... and the Treasury Secretary has now hired his prior VP for Housing from when he was CEO of an investment bank to handle the bailout... well, surely we can TRUST THAT, eh? (Or, is that hackery?)

[OhNoNotAgain]

Something tells me that, going forward, we're going to see a major whitewash job on what happened over the last 8 years. And, because of it, we will be doomed to repeat it. It's like we're afraid to admit that our capitalistic system does not work correctly when left to its own devices. So, instead, we make up stories for ourselves so we can feel better about things: "Oh, it was just those poor people cheating the system again and getting something that they didn't earn", or "Yeah, it's the government screwing things up again, just as expected".

[bullbust]

Just for fun, this should be compared to the same thing done by Princeton economists.

http://krugman.blogs.nytimes.com/2008/09/26/crisis-at-princeton/

[Cynthia]

These Boston Boys could easily pass for Chicago Boys. But I suppose that once you've heard one set of boys at the top of the academic food chain you've heard them all.

And I've gotta say, the Academic Boys from Boston, just like the ones from Chicago, are living proof that the boys at the top of the finance food chain have got them by the balls!

[ken melvin]

"btw

it wasn't the risky loans that caused the trouble it was the bubble bursting ..period

And what caused the bubble that did the bursting? Bubbles burst.

[Bruce Wilder]

OhNoNotAgain: It's like we're afraid to admit that our capitalistic system does not work correctly when left to its own devices. So, instead, we make up stories for ourselves so we can feel better about things

Consensus reality, manufactured with the aid and assistance of the so-called mainstream Media, has been synthesized to facilitate the machinations of a kleptocratic plutocracy. The political discourse is daily flooded with hackish public pronouncements, and the public stage is crowded with mindless fools parading about.

If you happen to be one of the hacks, and you've made a good living as a teevee talking head, op-ed columnist, or Federal Reserve Bank President, or an economics Professor, or as some wingnut welfare queen, you sure don't want the gravy train to stop running.

Larry Kudlow is going to start talking sense in a crisis? Robert Samuelson is going to learn something about economics, just because the Market is in decline? Bill Poole is going to quit his Cato gig and ask for rich people to be taxed? Greg Mankiw is going to vote for Obama? Jonah Goldberg is going have an epiphany: "'liberal fascist' is an oxymoron!"

I don't think so.

The Right completely dominates the political discourse in this country, because they are not participating in it. They say stuff that makes no sense, and has no connection to factual reality. They listen to the Left, only to create opportunities to deliberately pretend that they are "outraged" by something that isn't outrageous at all.

Do you think Bengt Holmström is going to be the least bit embarrassed by echoing Republican talking points that have no other purpose than to distract attention from an acute, critical problem facing the country, while poisoning what few, piddly claims the poor make? I don't. He's not required to make sense, and he knows it.

The Left can be noisy and annoying, from time to time, when one of our elite opinion-makers does something more egregious than usual. But, unless the offender is on the Left to begin with, he or she is not likely to lose her job.

The daily white noise of senseless error just goes on, undiminished. Because it is well-funded and serves the purposes of the many of the most powerful people in our society.

It isn't that "we" as a society are afraid to face the truth. It is that consideration of the truth is being drowned out. Honest deliberation and debate is not possible in too noisy a room, and some people have paid out serious money to make sure the room is way too noisy.

[Patrick]

Cynthia

Did you watch the Princeton talk? I saw no indication of Wall St. having them by the short and curlies. Care to elaborate?

[Organic George]

I did come away with one nugget that corporations are leading directly to other corporations, bypassing the weak banks.

Why does that fact not make me feel comfortable.

Yea I agree these guys are tools.

[lark]

This panel seems to me to be nothing more than the grinding gears of the conventional wisdom as it tries, and fails, to gain traction.

says...

No need to listen. Futures are voting and everything MIT geniuses know about human nature is wrong. This is not a bottom up "real estate" bubble but a top down fraudulent "financial innovation" pyramiding ponzi that transferred as yet unearned wealth from underpaid over-indebted wage earners to the aristocratic financiers. Game over. The only good news is it ends where it began under Republican pseudo-aristocrats.

[ken melvin]

Yes 'tis strange, this talking about the 'economy' as if it were a ball of plasma suspended above us and everything. Lo I think i see the face of god.

[Cynthia]

No, Patrick, I haven't had a chance to listen to the Princeton talk. So perhaps you're right, the Princeton Boys have an entirely different take on the financial meltdown. But this still doesn't take away from the fact that these Boston Boys sound like the Good Ol' Boys from Chicago.

[jm]

The underlying cause of all this is the immense Asian vendor financing fraud, which corrupted pricing signals throughout the world's economic system.

[hari]

I suggest it's these *stupid8 economic brains who don't understand the fundamentals of *political economy* since they were once the lobbyist for laissez faire capitalism with almost all their academic colleagues in the profession.

Like in Mao's time, I think there is a basic need for a real *cultural revolution* in the dismal science to clean up the weeds and restructure the financial system.

Compare this to Stiglitz seminar in Vienna we saw yesterday.
Where is the culpability of the professional hacks?

[Elastic Supply]

"...an excessive boom of housing construction while the prices were rising."

Yet markets with the most restricted supply were are the ones experiencing the largest price drops. Free building Texas didn't have any great price rise, and not much price fall. Restricted California experienced tremendous price rises, and a large subsequent drop. Indeed, take restricted states out of the picture, and the problem was manageable. It was California et al jingle mail that magnified the problem into a global calamity.

[Fred]

>some people have paid out serious money to make sure the room is way too noisy.

Yeah, well that is pretty much true in every society that has ever existed, though sometimes money isn't necessary. Rather, the ruling class simply executes/tortures a few noisy protesters from the underclass as a warning to the others.

The ruling class IS losing money from this debacle. Who do you think can afford to invest in hedge funds other than members of the ruling class? Nor is the ruling class particularly sanguine about the Chinese surpassing us economically/militarily, which is exactly what will happen if we allow the economy to fall into stagnation. So we WILL get fundamental economic system reform and this reform WILL provide rewards/incentives for the essential worker bees. On the other hand, this reform will probably not do much for the poorer sort of drones (uneducated workers, poor retirees). Katrina was just a harbinger of what awaits these hapless folk. My guess is the majority of them will be disposed of during the next flu pandemic. After all, we tolerate people dying of starvation and disease in places like Bangladesh and Ethiopia, so there is no reason we can't tolerate poor people dying similarly en masse in our own country.

[lark]

I have to say again how utterly unimpressive this panel is. No wonder we are in such dire straits. Economics profession, heal thyself.

[Holly W.]

"I actually think it was oversupply" of housing that caused much of the problem, Wheaton said.

Huh?! Oversupply of housing caused the prices to rise so high that the only way to keep the mortgage party going was to hand out liar's loans and exploding ARMs?

Where was this guy when we were all being told (at least here in the MIT local area) that there was a chronic undersupply of housing to meet the demand? Until the very day that suddenly no-one wanted houses any longer, realtors were telling everyone there was a shortage of homes for sale.

As Paine said, if these are the guys with the best brains to analyze this bubble, woe to us all.

[Owe Jessen]

Well, I think Lo showed convincingly that the road to hell is plastered with good intentions.