As 'behemoths' fall and Congress votes, Cornell experts offer a primer on the financial crisis

As the crisis in the U.S. financial markets worsens and the credit markets tighten, all eyes are on the $700 billion bailout plan passed by the U.S. Senate on Wednesday (Oct. 1) night and the vote on the bill by the U.S. House of Representatives Friday morning (Oct. 3). Shortly before the Senate vote, a panel Cornell experts met to address the "dire circumstances" of the situation.

The panel, organized by students for the Cornell International Affairs Review, confronted the events that have caused the "erosion of confidence and trust" and "financial behemoths [to] fall almost every week," in the words of Review president Luis de Lencquesaing '10. Those behemoths include Bear Sterns, Fannie Mae, Freddie Mac and Lehman Brothers.

The kernels underlying the faltering financial system, the panel agreed, are lack of liquidity in the system -- banks refusing to lend to each other -- and proper valuation of mortgage debt instruments. Panelist Robert Andolina, a visiting senior lecturer in finance and former managing director of Lehman Brothers, explained that as consumer credit and mortgage markets exploded over the last half-decade, the investment banks drafted heavily leveraged positions with complicated payout structures, including positions on so-called "toxic waste" mortgages. When the housing market began to decline two years ago, so did the value of these positions, and the firms and banks suddenly found themselves holding huge amounts of debt without enough liquid assets to pay them off.

Under normal conditions, said Andolina, investment banks would borrow cash for the near term from commercial banks and other lenders through short-term money markets. But, because lenders found it difficult to estimate the value of their mortgage assets as housing market trends changed, banks and money markets quickly became wary of lending cash to firms carrying massive debt and holding assets of unknown value.

When Bear Sterns and Lehman Brothers collapsed, banks, gripped by the spreading fear that other firms may be carrying unknown debt, stopped lending money at all, even to otherwise healthy companies outside the financial industry.

And because investment firms hold each other's contracts and insurance, "risk [was] highly correlated," said Andolina. This, he said, has generated a chaotic mentality that now grips the credit markets and is cascading way beyond Wall Street.

Small businesses -- which make up 50 percent of the U.S. productivity -- now find it harder to secure loans they need to manage their businesses. Banks are hoarding cash reserves (at 100 times their normal level) to protect against potential bank runs, Andolina said. State and local governments, he pointed out, can't find buyers for bonds to finance municipal debt, resulting in cutbacks on government projects. As mortgages get harder to obtain and their rates rise, the demand for houses will fall, lowering their prices and eroding confidence further, he said.

Panelist David Easley, professor of economics, called the bailout a "dramatic" and "probably necessary" attempt to restore confidence and trust.. But if trends continue, he said, "it gets very hard to turn things around quickly. There really is an urgency to get something done to give [economists] a chance to think about what ... to do for the long term."

Any bailout must accurately value the worth of "toxic waste" assets that the government would have to buy under the Congressional plan. But the details for valuation in the bailout are very vague, warned Andolina: "If the government can buy these mortgages for 50 cents on the dollar and they're actually worth 65 cents in the final analysis, we the taxpayers will make money."

Easley added later: "It's very clear that even if we do this [the bailout], it won't be the end of the story."

The panelists also discussed how the decades-long trend of both Republicans and Democrats focusing on financial deregulation was the backdrop for the crisis. Professor of government Elizabeth Sanders said the crisis is the result of "people making decisions within a situation that was so fluid and without boundaries and transparency that they were led quite rationally to do things that led in the aggregate to be disastrous."

But acting hastily and adding regulations as a knee-jerk reaction to the crisis could be detrimental, the panelists agreed, particularly as the United States competes for the center of the global financial markets.

Said Sanders, "We should be asking [the presidential candidates] 'Who are your economic advisers going to be?' Who are your brains trusts going to be?"

Graduate student David Bernat is a writer intern at the Cornell Chronicle.

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