The dark night is now past. Or is it? One year after the global financial-services firm Lehman Brothers Holdings, Inc. filed for Chapter 11 bankruptcy protection on September 15, 2008 and set the world atilt, IIT Magazine asked Michael Gorham, Industry Professor of Finance and director of the Center for Financial Markets at IIT Stuart School of Business, his impressions on the collapse and what can be done to safeguard the country’s financial situation today.
One year after the Lehman collapse, what are some of the lessons that Americans can learn from the experience?
We are still learning. One lesson was learned immediately and that was, given the market reaction to Lehman, the government couldn’t allow another big institution to go under; so a few days later, the Treasury and Fed decided that AIG would get bailed out. There is still a debate about whether Lehman was too big or too interconnected to fail. For example, on the day of its bankruptcy, it had 1.2 million derivatives transactions, with 6,500 trading partners in the United States alone. Most of these were terminated by their trading partners, but there are some 300 Lehman estate people sorting through the remaining contracts.
What series of events caused the chain reaction—Lehman collapse, AIG rescue, and the world financial markets breakdown—to occur?
Coming off the 2000 tech crash and 2001 recession, the Fed lowered interest rates to stimulate the economy. This made mortgages cheaper, attracting homebuyers, but also got international investors interested in mortgage-backed securities that paid higher interest rates than T-bills. The mortgage origination business went into overdrive, pushed also by government policy to bring more people into the American home-owning dream. This, combined with a poorly regulated mortgage market, resulted in a decline in credit worthiness standards and fraudulent sales practices, putting lots of people into mortgages that they would never be able to pay. These sub-prime mortgages, many poorly documented, got packaged and thrown into pools, and mortgage-backed securities were issued based on these pools. The credit rating agencies didn’t do their job well and gave high ratings to mortgage-related instruments, which they really didn’t always understand and that soon dropped in value and had to be downgraded. Too many people felt that a continued rise in housing prices would cover up all sins, mistakes, and fraud. But prices stopped rising, the housing bubble popped, and the world came undone.
While many saw the government bailout as being a lifesaver, it did have its share of critics. Would you have recommended a different approach?
Nope. I’m not smart enough.
How important are government incentives in the reestablishment of a strong economy?
Huge. The government is a major player in the economy by what it does on the spending side as well as what it does on the money-supply side. Had the government behaved differently in 1929 and the early 1930s, we might not have had the Great Depression.
Housing prices peaked as far back as May 2006, and six months after the Lehman collapse, they dropped 34 percent. Many mortgage-holding homeowners are still on the verge of losing their homes, and the housing market is not yet out of the woods. What reforms are necessary to ensure a more firm housing foundation, thereby decreasing the chances of repeated bubble and burst cycles?
There are some wonderful things that the government has done historically to encourage home ownership in the United States. There are many countries in which acquiring a home involves getting some land, then each year buying as many bricks as your savings allows and building a piece of a wall, acquiring some more bricks and building more wall next year, and then after maybe five or 10 years, you have a home; mortgages don’t exist.
In the early years of the United States, when mortgages began, they were often interest-only with a balloon payment at the end, so people would often never gain title to the home they were paying on. With the development of the modern, standardized 30-year mortgage and the creation of Fannie Mae and Freddie Mac, which purchased and pooled these standardized mortgages creating and selling securities backed by these mortgage pools, much more money came available for home buyers. Our mortgage market became the envy of the world.
One change I would make is to better regulate the mortgage origination business, that Wild West, fee-driven arena in which salesmen talked too many people into mortgages they weren’t qualified for, mortgages that were too expensive and impossible to pay off. This created great harm to the borrowers who ultimately went into foreclosure, to the neighborhoods with tons of vacant houses, and to those who invested in these mortgages.
What recommendations do you have for strengthening the financial marketplace?
Make sure that knowledgeable, thoughtful, and pragmatic people are managing the Federal Reserve System, the Department of the Treasury, the Securities and Exchange Commission, the Commodity Futures Trading Commission, the Office of the Comptroller of the Currency, and the FDIC. Have some group, whether a committee of agency heads or a single agency like the Fed, charged with the responsibility of watching for the development of systemic risks in the financial system.
Should the investing public place its trust in the stock market again?
They shouldn’t have gotten out. The stock market is incredibly difficult to predict. There are a few people who appear to be good at it, who seem to do well over the long haul by moving in and moving out, but those people devote most of their time to the market. Most people who get in and out do worse than those who just stay. For most of us mortals, the best strategy is probably consistency. Put your money in a diversified portfolio of stocks, a mutual fund, or an exchange-traded fund, and stop worrying about it.
How would you rate the health of global markets at this one-year anniversary?
So much better than they might have been.