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Setting National Priorities: Financial Challenges Facing the Obama AdministrationAuthor(s): Marc R. ReinganumSource: Financial Analysts Journal, Vol. 65, No. 2 (Mar. - Apr., 2009), pp. 32-35Published by: CFA InstituteStable URL: http://www.jstor.org/stable/40390350 .

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FINANCIAL ANALYSTS JOULRN AL

Setting National Priorities: Financial Challenges Facing the Obama Administration Marc R. Reinganum

If a company is "too big to fail," it is probably

too big.

2008, the U.S. financial system experienced extreme stress and came close to paralysis. In medical terms, it suffered what might best be described as a severe heart attack. The economic and financial doctors in charge of

government policy are vigorously applying a variety of triage tech- niques to make sure the patient survives the night, but the economy's arteries are clogged and its valves are damaged. Assuming the econ- omy survives this heart attack, significant lifestyle changes will be required to restore and maintain the economy's health. Another trip to the emergency room cannot be risked.

The symptoms of this economic heart attack are clear. The S&P 500 Index declined from a high of 1565.15 on 9 October 2007 to 752.44 on 20 November 2008 - a retrenchment of -51.9 percent. The S&P 500 financial stocks, the worst performing sector, had total returns of -72.97 percent.1 The five largest Wall Street investment banks disappeared.2 Some of the biggest commercial banks and thrifts became insolvent and were taken over. The equity values of AIG (American International Group) - the largest U.S. insurer - and of Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Association) - government- sponsored mortgage lenders - have declined by about 99 percent since the middle of 2007. Interest rate credit spreads are near peak levels. Unemployment is rising, and the National Bureau of Eco- nomic Research officially declared that the current recession began in December 2007. Clearly, the Obama administration faces finan- cial challenges not witnessed for generations.

What created this economic emergency, and more importantly, what can be done to ensure that the economy does not return to the emergency room?

The ostensible catalyst of the current crisis was falling home prices. From July 2006 through November 2008, the S&P/Case- Shiller Home Price Index dropped by 25.1 percent. Many of the more recent securitized mortgage obligations had minimal equity requirements, or cushions. If home prices had kept rising, they might not have posed a big problem - but they didn't. The "canary in the coal mine" was mortgage insurers, whose stock prices began to collapse in the summer of 2007. Falling home prices meant that

Marc R. Reinganum is director of quantitative research and senior portfolio manager at OppenheimerFunds, Inc., New York City. Note: This article is based on a speech given by the author in November 2008 at Oberlin College for a symposium titled "Setting National Priorities: Economic Challenges Facing the New Administration/' The views expressed in this article are the author's alone and do not necessarily reflect those of OppenheimerFunds, Inc.

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FINANCIAL ANALYSTS JOURNAL

many mortgages were not fully collateralized and the values of mortgage-backed securities were too high. Financial institutions started to write down the values of the securities they held, which led to a loss of both capital and the ability to lend (i.e., delever aging and credit contraction). Home fore- closures and diminished credit led to further downward pressure on home prices and thus began a vicious cycle. The economic doctors in Washington, DC, are debating whether this cycle can be broken by policies that either make credit more easily available or arrest the decline in home prices - or some combination of the two.

The negative feedback between the real estate and mortgage-backed securities markets spilled over into other markets. Financial institutions lost confidence and trust in their counterparties' ability to repay debt obligations. This contagion created an unwillingness to lend and froze a variety of markets, including those for student loans, com- mercial paper, and auction rate securities. Only U.S. Treasury securities remained a vital market, and the demand for these safe havens drove their yields close to zero. Financial networks began to implode and crash, and the contagion spread to real economic activity as well.

The current economic and political consensus seems to be that the U.S. economy needs massive government spending to stimulate aggregate demand. In an op-ed column on the return of depression economics, Paul Krugman, the 2008 Nobel laureate in economics, urged the new admin- istration to offer a huge stimulus package.4 Even if such measures would enable us to get through the current crisis, the long-term health of the U.S. econ- omy requires more than a higher level of govern- ment spending, targeted Treasury bailouts, and unprecedented lending by the Fed. It requires the adoption of healthy lifestyle changes that will make our markets work better. Reforms are needed to regain and maintain long-term economic health.

Following are four reforms recommended to help mitigate the current problems in the finan- cial system. 1. The long-term health of the U.S. economy

requires changes in the structure of the market for trading derivative and credit instruments. No longer should derivative and credit instruments be traded like used cars - that is, as completely private transac- tions between two parties. The market for trad- ing derivative and credit instruments must

include a clearinghouse - that is, a third party that acts as an intermediary between the buyer and the seller. Essentially, a clearinghouse acts as a counterparty to both the buyer and the seller and requires each to honor its commit- ments. A clearinghouse, in conjunction with the regulators who oversee it, would determine the necessary rules and capital requirements to ensure a well-functioning market - one that would not need bailouts from taxpayers.

Indeed, in late December 2008, both the U.S. Securities and Exchange Commission and the Commodity Futures Trading Commission sig- naled their intent to approve organizations that clear the $54 trillion credit default swap mar- ket.5 This action is certainly a start. Clearing- houses must have both sufficient capital to credibly guarantee counterparty contracts and the authority to impose conditions (e.g., margin or reserve requirements) on firms that trade in these markets. Furthermore, clearinghouses should be established for any credit and deriv- atives market that finances significant eco- nomic activity - not merely credit default swaps. More generally, mechanisms and regu- lations must be fashioned to track financial mar- kets so that yet-to-be-created contracts cannot become widespread without a clearinghouse. After all, the goal is to avoid a future crisis. Clearinghouses have worked exceedingly well in publicly traded equity and futures markets. The time has come for their establishment in markets for derivative and credit instruments, as well as other financial markets that may affect economic activity systemically

2. Markets for derivative and credit instruments must also take the lead of the equity and futures markets and become public, transparent markets in which the prices, quantities, and identities of the traded securities are reported and avail- able in real time. Public, transparent credit markets will aid the economy in the process of "price discovery" for credit and risk. They will also help ensure that the buyers and sellers of credit and derivative instruments each receive the best price for execution. The evolution of the NASDAQ stock market has shown that multiple-dealer markets work. Of course, this type of public market structure means that standardized, simplified credit securities will need to be developed - securities that must be well understood by both the buyers and the

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FINANCIAL ANALYSTS JOURNAL

sellers. Public, transparent markets would probably not work with myriad customized contracts. But after the current debacle with financially engineered and structured instru- ments, simpler, easier-to-understand, stan- dardized, and transparent securities will likely gain market acceptance.

This suggestion is not to imply that econ- omies can do without customized financial instruments completely. Rather, bespoke instruments cannot be allowed to become the dominant securities financing economic activity. Securities that underlie the financing of much economic activity (including deriva- tive and credit instruments) must be traded in public, transparent markets that can be supervised and observed.

3. If a company is "too big to fail," it is probably too big. The proper functioning of competitive markets requires that companies be allowed to fail because failure directs society's scarce resources away from inefficient activities and toward successful, innovative ones. The stan- dard economic model assumes that companies are atomistic entities whose existence has no systemic influence over prices or other attri- butes of the marketplace. As has long been recognized, however, not all companies fall into this standard paradigm. Antitrust law was developed to protect consumers against companies that might become "too big" and extract monopolistic profits. Even natural monopolies - with cost savings arising from economies of scale - are highly regulated. But in most economic writings, "too big" is associ- ated with "too profitable and successful." Linking the concept of too big with failure is somewhat oxymoronic.

Too big to fail is more an idea associated with financial networks as opposed to monop- olistic institutions. Policies must be developed that will prevent the failure of any investment firm in the financial network from spreading and widely infecting other firms in the net- work. The establishment of a clearinghouse in conjunction with public, transparent markets for major derivative and credit securities will partially reduce the probability of failure. Additional backstop policies, however, may be necessary. These policies might be directed toward limiting the size of financial institu- tions in the network. Alternatively, if financial

institutions are allowed to become large "nodes" in the network, the oversight and reg- ulation of such firms must prevent them from engaging in activities that threaten the net- work's well-being. If some firms choose to become large nodes, short-term firm profitabil- ity may need to be sacrificed for long-term network safety. Innovation may become more concentrated in smaller financial firms because such institutions will not cause network fail- ures if their risky strategies fail. In short, new policies should strive to make sure that no investment firm is too big to fail by either limiting the size of firms or prohibiting activi- ties within a firm that can lead to failure - or some combination of the two. Without these changes, taxpayers and governments will always be liable for massive network failures caused by just a handful of firms.

4. In addressing the market's long-term health, these reforms must also incorporate solutions to the observed failures in financial agents' monitoring and in accounting practices. More stringent oversight and enforcement, as well as better risk-sharing arrangements, must be instituted in the loan origination /securitization process. Credit- rating agencies must be given proper incentives to eschew potential conflict-of-interest opinions and to make objective, realistic assessments. The compensation of financial executives must be tied to the time horizons of their investment decisions: Short-term, outsized payments should not be made for projects that have inter- mediate- or long-term horizons. On the accounting front, off-balance-sheet obligations need to be minimized. Transparency is para- mount to reestablishing trust and confidence in the markets; the regulatory and oversight gov- erning boards should make sure that all mar- kets have honest, fair, and investorcentric accounting rules. These reforms could well be incorporated into the changes required to estab- lish a clearinghouse and public markets for derivative and credit instruments. Short-term economic suffering seems unavoid-

able. The immediate policy concern facing the Obama administration is to alleviate this pain. To safeguard the U.S. economy's long-term health, however, we must treat the causes and not merely the symptoms of this financial crisis. The creation of both a clearinghouse and a public, transparent mar- ket for credit instruments and their derivatives will

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FINANCIAL ANALYSTS JOURNAL

correct a serious shortcoming in the current struc- ture of our financial markets. In addition, new pol- icies must ensure that no firm or small group of firms can cause systemic failure throughout the financial network.

The current financial crisis is not a failure of the free-market, capitalistic economic system, which has the flexibility to evolve, just as it has in previous financial crises. Although more oversight and more rational rules governing our financial infrastructure are appropriate and necessary,

these changes must not be so severe as to choke off innovation and creativity - the long-term drivers of economic growth and prosperity. Rather, inno- vation and creativity must be properly channeled and monitored so that "failed experiments" cannot recklessly destroy wealth and livelihoods. With appropriate reforms, the prognosis for a healthy and stable U.S. economy is excellent.

This article qualifies for 0.5 Πcredit

Notes 1 . This information was calculated using Factset Data Systems. 2. Lehman Brothers went bankrupt; Bear Stearns and Merrill

Lynch were absorbed into JPMorgan Chase & Co. and Bank of America, respectively; Goldman Sachs and Morgan Stanley were allowed to become commercial banks.

3. These institutions included Countrywide Financial, Wash- ington Mutual, Wachovia Corporation, and IndyMac Bank.

4. "Depression Economics Returns," Nezv York Times (14 November 2008):A33.

5. Doug Cameron and Kara Scannell, "Regulators Back System to Clear Credit Swaps," Wall Street Journal (24 December 2008):Cl.

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