Ask an Economist: Breaking Down the Financial Crisis

 

It has been a jarring September for Wall Street. It is just the middle of the month and some largest financial institutions have met an unflattering demise. Bernard Anderson, Professor at the Wharton School of Business in Philadelphia and a member of the Black Enterprise board of economists weighs in on the crisis, the economy, and which candidate is best prepared to rescue Wall Street.

 

BlackEnterprise.com: In March, securities institution Bear Stearns was purchased by J.P. Morgan Chase. Just last week the government took over loan giants Fannie Mae and Freddie Mac, and yesterday the federal government agreed to loan AIG $85 billion. Today Lehman Brothers was acquired by Barclays and on Monday Merrill Lynch was acquired by Bank of America. There’s a lot of flux in the financial services industry, what’s causing these financial institutions to flounder?

 

Bernard Anderson: There was a common problem with each of the financial institutions, and that was rooted in their heavy investment in financial instruments called collateralized debt obligations. A CDO is a debt instrument that companies invest in with the expectation that instrument will generate quarterly revenue. In this case they were mortgage backed securities. Now when you write off the value of those securities in order to balance in

your portfolio, you have to raise more capital. Banks raise capital by selling shares, but in this case no one wants to buy the shares. The share price of the companies plummet, which means they face a capital shortage. They are running out of money to meet their financial obligations and that drives them near bankruptcy.

 

Fannie Mae and Freddie Mac were taken over by the government, how will this affect the way these companies will run now?

 

You will have government appointed officials running the companies. Those officials will technically be political appointees, but will have extensive experience in the private sector. They will be able to reorganize Fannie Mae and Freddie Mac and bring them back online as successful mortgage companies. Fannie Mae and Freddie Mac will be subject to far greater regulatory scrutiny. The federal government, probably through the Federal Reserve Board, will have new authority to regulate. Also, the treasury will have new authority to regulate and will be more attentive to regulating Fannie Mae and Freddie Mac. I doubt very seriously whether it will revert back to its previous form, but that’s a question that will await the new administration in Washington.

 

How do these government bailouts affect taxpayers? How will the financial crisis affect average Americans?

 

Preserving those institutions will protect small investors. It won’t cost tax payers anything unless the strategy fails. If the company cannot be turned around, if it cannot begin to generate revenue and pay its bills, then federal government will come in and pay the bills. That will increase the federal deficit. It will put greater pressure on the economy because federal money that would otherwise be used for building highways, or supporting education, would now be used to pay debt holders of the private corporations.

 

What type of ripple affect will the current bailouts have for the job market and other parts of the economy? What part of the economy will be most affected?

 

We have two problems; we have a liquidity crisis and a credit crunch. Begin with the assumption the businesses run on credit. If the business cannot barrow money to operate, that business will have to cut costs —they cut production, they layoff people, they put people on part-time schedules. If that happens, then what you will see is a decline in consumer spending. If Wall Street begins to affect the American economy to greater degree then we’ll move from slow growth into a recession.

 

 

Will the events of the last week and a half affect the way J.P. Morgan Chase, Goldman Sachs, and other large financial institutions operate?

 

I would suggest there’s a danger because as a result of the adjustment to this crisis, we’re getting fewer financial institutions. That leaves far fewer financial institutions on Wall Street, I’m not sure that’s a good thing. Competition is good, consolidation and a move toward monopoly or oligopoly, I don’t think is good. I would be concerned about the drift of events which would lead to the further reduction in the number of financial institutions that are competing on Wall Street.

 

Sens. Barack Obama and John McCain have both proposed increasing the regulation of financial services companies, and investment banks, how will these efforts help fix the current crisis? Whose economic plan is more viable in helping the economy get back on track? Whose plan is more lip service?

 

I am a member of the economic advisory team for Sen. Obama. He understands the importance of regulation of financial sectors, and has called for more regulation and transparency in our government approach to private sector. Sen. McCain does not support more regulation. Obama has indicated the kind of regulation that would be helpful in correcting the current problems in

the financial market. He wants to create greater transparency in their reporting to the federal government on their activities. He also wants to increase the regulation of investment banks. At the present time only commercial banks are regulated. The McCain-Republican approach is a trickle down approach, and it’s the same approach Republicans have had for the last 40 years.

 

On Tuesday in Florida, McCain said he’d establish “comprehensive regulations” on the financial sector, which runs in opposition to his small government antiregulation stance, why do you think he’s changed his position on the issue?

 

He’s changed his position because he knows he’s vulnerable. One of the reasons we’re in the position now is because of lax regulation on the part of the republican administration. Republicans fight government regulation. The forces behind the Republican party would not allow a republican president to be a strong regulator. I don’t buy Sen. McCain’s death-bed conversion to regulation.

Renita Burns is the editorial assistant for BlackEnterprise.com