A conversation with ...

Professor Jayaraman discusses the recent federal “bail out” bill

This year’s election proved no tranquilizer for a quickly destabilizing market—powerful forces are in effect. Just weeks prior, President George W. Bush and congressional leaders passed a sweeping $700 billion “bailout bill” for the nation’s financial sector, hoping to ease economic strains and lessen what could be a long-term recession.

But, as the recent candidates were fond of saying, what does the Wall Street bailout mean for Main Street? The Whistle caught up with College of Management Professor and Area Coordinator for Finance Narayanan Jayaraman, asking for his perspective.

What is the origin of the crisis?

	Narayanan Jayaraman

The fundamental [problem] is that people who should not have been given loans, got loans. And the reason for that is that money was cheaply available in 2001 and 2002. The interest rate was really low, and the originators of the loans—the mortgage companies—didn’t keep the loans on their books. Their incentive was just make the loans, take their 1 or 2 percent commission, and then sell them. Then Fannie Mae [Federal National Mortgage Association] and Freddie Mac [Federal Home Loan Mortgage Corporation] would buy these home loans, repackage them and sell them as securities.

For example, all the ZIP codes in Atlanta, or stuff like that. Whoever buys those mortgage-backed securities, their return would depend upon people who borrowed the loans paying their interest payment. When you get those thousands of loans together, you then slice them into, say, six categories, [ranging from] high-quality, people with good credit, that sort of thing. What happened, I think, is that the rating companies did not do a good job of grading the loans. [Regarding] the people who should not have been given the loans, the idea was that housing prices would continue to increase, so there wouldn’t be any problem to entice someone to sign on to [and buy] the loan.

Then people started defaulting on their home payments, which affects the securities backed by these loans. Compared to the ‘olden days,’ there was no direct relationship between the bank who gave the loan and the homeowner. So, if I had a loan and I got laid off from my job, I could go to my bank, and ask for, say, three months’ forgiveness on the loan.

Exactly—they could work it out. The one-to-one correspondence got completely lost. What happens is the whole pricing of that mortgage-backed security depends upon some assumptions about what [how many] people are going to default and not make those interest payments. Sometimes the assumption is that if I buy a mortgage pool, then 1 or 2 percent of the people cannot make their payments, so that is factored in the pricing [of the security]. But when wholesale large amounts stop making the payments, then the value of that security falls.

A related item is called a credit default swap. Let’s say I buy one of these one of these mortgage-backed securities. And I’m expecting to get—hypothetically—$1,000 every quarter on that payment.

That’s what I would make. But I’m a little concerned that I won’t get this money every quarter, so I could go and buy an insurance contract [credit default swap]—‘in the event that I don’t get the $1,000, you would pay me the money,’ for which I’m willing to pay a small fee. Companies like AIG insurance issued those contracts. So, you have all these homeowners defaulting, and now everybody is running to AIG.

The best analogy would be with Allstate and homeowners’ insurance. If a couple of homes get burned down in Buckhead and a couple in Decatur, if I’m Allstate, I can make the payments [to those homeowners]. But if the entire city of Atlanta is burning, I don’t have enough money to make good on the payments. The whole insurance concept is based upon random homes burning.

Suddenly the entire economy is going down, and homeowners are not able to make their payments. Home prices are going down—not through the entire United States, though. Some markets, like California, Florida, Nevada were part of a bubble. Now, the way most states allow home loans are called “loans without recourse,” so if I’m not able to pay my home mortgage, I can walk away from the home. The lender cannot come after my other assets. So the banks repossess the homes, and there’s nobody to buy them.

It is less. So banks like Citigroup have a lot of these mortgage-backed securities on their books. And fundamentally nobody knows how to value these prices. In this country we have about 60 million mortgages outstanding [people holding these loans]. We have about 3 or 4 million mortgages that are in default. That’s about 5 percent of the mortgages. If we can creatively identify those 3 or 4 million who are not able to make payments and separate out the genuine cases—that is, they were mislead by the mortgage originator—and keep them in the home it could be valuable.

But in many of those there are speculators who are involved. And given the economic conditions, people are losing jobs—currently the unemployment rate is about 6 percent, and it is expected to go to around 8 or 9 percent, in the next one or two years.

Remember, in the Great Depression years it went to 25 and 30 percent. So, yes, while things are bad, they’re not as bad as we’ve seen.

[The home crisis] ultimately started with people [taking] what we call NINJA loans—“no income, no job, no assets”—poor credit­–quality people were getting loans. This became globalized because a lot of people like Japanese, Chinese and Germans had a lot of capital, so they were buying these mortgage-backed securities. Which in turn were rated by Standard & Poor’s as triple-A, the highest quality. But truly they were not triple-A.

So this is where you feel the rating system broke down?

There are only three rating companies, and there were some conflicts of interest. All they were interested in was delivering the triple-A rating. They did not conduct due diligence, and their [rating] model is not publicly known. There is blame to go around everywhere, including the CEOs of the banks. Their compensation and bonuses were determined by the year’s profit. So if I am Merrill Lynch or Citigroup’s CEO, I made a lot of money in 2005 in 2006. If you are a top manager you had every incentive to take a risky strategy on this, too, and make the money.

One of the things that is likely to happen is the bonus pools for top management will be more buffered. Whatever profits a CEO makes in 2008 will probably not be given in the beginning of 2009, but in probably three to five years. You don’t want the CEO to cash in and move on. The [present] compensation system is a little bit distorted.

But there really is no one ‘villain’ in all this. It started with low interest rates, people were getting loans they should not have gotten them, and the rating agencies were giving ratings that weren’t deserved. Everybody is on the gravy train.

OK, how do we fix the problem?

One of the fixes is that housing prices have to come back up to reasonable levels.

Well, do you think they’re undervalued now? Or do you think the fall of housing prices gives that reasonable level?

No. It’s still less. The Case-Schiller National Home Price Index forecasts that housing prices have to go down some more—some 15 or 20 percent, I think. That index suggests that prices will not start rebounding until late 2009, or early 2010.

So once that starts picking up … clearly, people have stopped building new homes, which is good …

Do you think there was overbuilding toward the end of all of this? 

There was definitely overbuilding. So they expect that to stabilize. It’ll take a year or two to clean up that mess. Another aspect is when new starts don’t take place, you don’t need new refrigerators, that sort of thing. [Construction and] housing are almost 1/8 of the U.S. economy. So that will that be a big drag. And, again, all these banks are sitting on underperforming loans. Condos may be overbuilt.

Which brings us to the $750 billion bill.

I think it’s the right thing to do. But how it’s executed is going to be an issue.

In the first stage, the government has decided to give banks $250 billion for capital, so they can start loaning the money. But the problem is some of the banks continue to pay dividends, which they should not be doing. They are just taking money from the taxpayers and giving it to the shareholders. SunTrust Bank announced they are going to cut their dividends. They are accepting [government] money, so the bank’s board has said it’s improper to pay out. Not all the big banks have agreed to do it, though.

Unfortunately, the government has not put a condition [on the money]. They did for the Chrysler bailout in the 1980s. You’re hoping that the boards of these banks will say it’s not the right thing to do [to pay out]. We’re talking about $25 billion as the dividend payments from [some of] these banks. Hopefully this will be sorted out soon. The banks should do the proper thing, [especially] if they need to go back to the government [for help].

With the second $250 billion, the government is thinking of acquiring the bad assets on the banks’ balance sheets, so there may be some pressure on the banks to cut their dividends. Another thing to be decided is how the government is going to price these assets on the bank’s balance sheet. As an example, let’s say Citigroup is sitting on assets of $1 billion on the balance sheet. They currently recognize that the quality of the assets is not worth $1 billion—let’s say they have valued it down to $650 million, or 65 cents on the dollar. How do we know the true value? Let’s say the true value is $500 million, it should be 50 cents on the dollar.

So the government wants to take [these assets] off of the bank’s balance sheet and put it on the taxpayers’ balance sheet. The big question is how do you come up with that number. If the government says it is only going to pay $400 million, the bank may not have an incentive to move items over. Somebody will have to take a cut, so the government needs to devise a mechanism to determine the price. They’re still debating what kind of an auction process it should be. Merrill Lynch, before it was sold over, had valued many of its assets at 23 cents on the dollar.

Implementation is important. If it is done rightly, then hopefully things will get sorted out in the next six months to one year.

And the last $200 billion?

The other aspect I had read about is the government is thinking of directly injecting some of the money to homeowners, to buy some of the mortgages. Let’s say a homeowner has a loan with a 9 percent rate. [The government] will tell the bank, ‘if you’re wiling to rewrite the contract at 7 percent fixed rate, we will guarantee that if the homeowner is not able to make the payment, we will pay it.’

So they are targeting the economy in three different ways. They are giving money to the banks so they can use the capital to loan to businesses; taking bad assets from the banks so that the capital ratio is better, because the banks are under-capitalized; and they are directly going to the homeowners who deserve a break. Not the speculative guys. They should absorb the loss, because they knew what they were getting into.

And I think they’re trying to encourage the strong banks to take over the weaker banks.

Is that a good thing—consolidation and fewer banks overall?

I think so, because for a developed country like ours, we have far too many banks. We have 8,000 banks for a population of 300 million people. That number is very high, it’s too high a bank ratio. If you go to Germany or Japan, they do not have that same ratio. Some consolidation needs to happen. A lot of European markets, the originator of the loan keeps the loan on the books. They can go back to the bank and renegotiate if needed.

Things look gloomy now, but I have a lot of belief in the American economic system. It will all come back. I saw where the third quarter of the U.S. economy shrank by .3 percent. They expect the fourth quarter and the first quarter of next year to be a negative growth. So, there’s going to be a deep recession, but it will come back. We are a $14 trillion economy, and things have to work their way through. Ultimately, there will be more regulation. They know we were too lax [before], so they will correct it by probably overshooting it.

What about the Federal Reserve Bank’s lowering of the interest rate right now?

It’s going to help some, I think. But it’s not going to help in a big way, because the Fed is almost taking the lead from the financial markets. [Two days prior] the markets went up 800 or 900 points, because they were anticipating the Fed rate cut. Ideally, I don’t think the Fed wanted to cut the rate, because remember this whole trouble started with a low interest rate. You can’t keep the rates too low for too long.

All the banks are trying to use this opportunity to strengthen their balance sheets. They just want to wait it out at least for one more quarter. Plus there is an also an issue that since the economy is shrinking, maybe companies don’t want to ask for more loans. The Fed’s lowering the interest rate makes sense, but it’s not being documented as businesses approaching banks and the banks saying ‘we cannot give a loan.’

Essentially, consumers have shut down, everybody’s trying to reduce their debt. Starting with the banks, companies, now even the individuals like you and I are trying to think instead of blindly going and sliding our plastic card.

Jayaraman is the Evelyn T. and Mallory C. Jones Jr. Professor. His research interests are in corporate finance, options markets, Japanese capital markets, corporate bankruptcy and entrepreneurship. He has won several teaching awards, such as the Institute Junior Faculty Teaching Excellence Award, Roe Stamps IV Excellence-in-Teaching Award, Lily Teaching Fellowship Award and Core Professor of the Year award in the MBA program.