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Waller explains financial crisis

Kaitlynn Riely | Friday, December 5, 2008

The Montgomery Auditorium in LaFortune was filled to the brim Thursday night with people interested to hear Notre Dame economics professor Christopher Waller explain the subprime mortgage mess and financial crisis or, as he wrote on a PowerPoint slide, “what in the hell just happened.”

Waller, the Gilbert F. Schaefer Chair in Economics, will be joining the Federal Reserve in St. Louis as senior vice president and director of research next summer. He spoke for nearly an hour, and he ended by saying that the current financial crisis is going to take a long time to figure out completely.

“It’s going to take months and years to fully understand the ramifications, the impacts and the cost of this,” Waller said.

But to begin to understand what happened, Waller went all the way back in time to before the Great Depression, referencing the Jimmy Stewart film, “It’s a Wonderful Life.”

Prior to the 1930s, if someone wanted to buy a home, he would go to a bank, and the bank would give a loan for five years. The person receiving the loan would pay off interest and pay off the principal. At the end of the five years, the person would ask for another five-year period, and the bank would roll the loan over.

This works well if everything is stable, Waller said.

But if the markets become unstable, a bank might be unable to keep up the loan. If one bank goes under, it can inspire a run on other banks.

This is a phenomenon unique to financial firms, Waller said.

“If McDonalds is going to go under, nobody says, ‘I’m not going to eat at Burger King anymore,'” he said.

A systemic collapse in the financial services system can lead to a social housing disaster, and so in the Great Depression, 40 percent of homes were foreclosed on.

In the United States currently, only about three percent of homes are foreclosed on, Waller said.

After the 1930s financial crisis, the government asked banks to give longer maturity loans of 15 to 30 years. To help the banks do this and remain solvent, the government says it will buy mortgages from banks in a credit crunch, and so the government became a “buyer of last resort.”

And so Fannie Mae was created.

“They created a very well-functioning secondary mortgage market, meaning you are buying used mortgages,” Waller said.

But this created a moral hazard, he said, because when you provide insurance for something, it also provides protection for bad actions. A famous example, he said, is seatbelts. With a seatbelt, someone may feel he is protected from an accident, consequently there is an incentive to drive faster or more recklessly.

“If you really wanted to get the people to drive safely, you put a big metal spike in the middle of the steering wheel,” Waller said. “That’s how you get people to drive safely.”

Banks had the incentive to dump bad loans on Fannie Mae, so Fannie said they would only buy prime mortgages, or those with credit scores over 650, with a low credit risk. Anyone below 650 was thought to be risky.

The secondary mortgage market was running smoothly in the 1960s, but the government worried that Fannie was becoming a monopoly, so they created Freddie Mac. Both were privatized and sold off to investors, but classified as government sponsored enterprises.

“It basically meant that we have a special relationship with these firms and we are very concerned if they get into trouble,” Waller said.

Waller then skipped ahead to the 1990s, when hedge funds and investment banks started issuing mortgage-backed securities backed by subprime mortgages. These performed “reasonably well,” Waller said, so early success led to high ratings from ratings agencies.

Firms like Goldman Sachs bought insurance against default from the company American International Group (AIG).

Changes in government housing policies in 1992 meant Fannie and Freddie had to use funds to serve poor households, and by 2005, they had to dedicate over half of their lending to low-income families.

“That may be a socially laudable goal, but you might start thinking, ‘I’m giving a lot of loans to very low-income people,'” Waller said.

In 2000, there were around 200,000 subprime mortgages issued, and by 2005, there were 2.25 million subprime mortgages issued.

In 2005-2006, the home ownership rate hit about 70 percent, and it was “lauded as a great social achievement,” Waller said.

But it would lead to the housing bubble, as house prices doubled in less than seven years. Mortgage payments increased as housing prices increased, and homeowners were left with little equity to weather downturns in the market, he said.

So investment banks took big bets on mortgage-backed securities due to their perceived profitability and low default probability.

But the banks highly leveraged themselves, and so, when the housing bubble burst, they were wiped out.

“There was a time we had an industry called investment banks, and they don’t exist anymore,” Waller quipped.

Prices fell for homes and interest rates of mortgages rose, and soon low, middle and high-income homeowners were defaulting.

In July 2007, two Bear Stearns hedge funds imploded from subprime losses, and this set off a financial panic. Housing prices plummeted as did the value of mortgage-backed assets.

Fannie and Freddie, which held $5 trillion in mortgages, suffered huge losses and became insolvent.

They were then taken over the by the government in September.

The investment bank industry collapsed, and in mid-September the credit markets began to crumble.

“We call this a massive flight to safety,” Waller said. “Creditors only want to hold U.S. government debt. They don’t trust anyone else.”

Treasury Secretary Henry Paulson asked for the largest bailout of the financial markets in American history on Sept. 19.

“The idea was hopefully this would restore confidence and trust in the credit markets and it would reverse the flight to safety,” Waller said.

The government then decided to recapitalize the banks. But now banks who were not in a subprime mortgage crisis have the government as a competitor, so it is not a fair fight for those companies, he said.

Waller said he does not know what is coming next for the economy.

“Things change, day by day,” he said. But he said things are better off with the government intervention.

The Student Senate University Affairs committee organized the speaking engagement after seeing from their October mock election results that students overwhelmingly voted the economy as the most important issue for them, committee chair Ashlee Wright said.