Making sense of the financial crisisupdated October 8, 2008
On Thursday, September 25, 2008—the day Congress proposed a $700 billion rescue of the U.S. financial system—Calvin business professor Leonard Van Drunen and economics professor Scott Vander Linde sat down with communication and marketing's senior writer Myrna Anderson for a conversation about the crisis. Van Drunen worked in various roles at JP Morgan before coming to Calvin, and Vander Linde has taught at Calvin for 24 years.
How did the current financial crisis come about?
Van Drunen: In short, Americans have borrowed way too much money in the last 10 years, way more than they can ever pay back, borrowed on the premise that housing prices will keep going up. Therefore, many Americans are not able to pay their debt.
Can you explain the role of subprime mortgages in this crisis?
Vander Linde: A subprime mortgage is basically a mortgage that has a high risk of default, meaning that the borrower is unlikely to be able to pay back the loan. Many mortgages became subprime in recent years because lenders were very lenient in the mortgage application process—didn't require enough collateral or income behind the loan and required little or no down payment. In the past, credit markets were more restrictive and didn’t allow people to take mortgages without substantial proof of being able to pay the lender back. On the lender side recently, any kind of mortgage sold was desirable as the lender received commissions on whatever mortgages it sold, regardless of risk of default. The risk was shifted by an almost immediate re-sale of the mortgage to some of the financial institutions that are now in trouble. There was great desire in world financial markets for financial instruments backed by U.S. mortgages fueling this whole borrowing and lending culture.
Van Drunen: There’s some good news and bad news with that. The good news is that many Americans have been more able to afford housing. The bad news is that, when times are tough, people lose their jobs—and they can’t pay their loans, and they get kicked out of their houses. So, that’s the backdrop in America. In America, there’s a strong public policy and a private philosophy that home ownership is important. That’s a great thing—but now we’re paying for that.
Why didn’t regulations on mortgagers prevent this from happening?
Van Drunen: The basic philosophy of regulation in the U.S. is to let the market regulate itself. There are some regulations, right? You’re not allowed to lie. You’re not allowed to steal. You have to disclose information. But in America, we’re allowed to do stupid things. People are going to look back at this financial crisis and say, “The government’s at fault.” I don’t buy that. The government isn’t in existence to protect people and private companies from making bad decisions. You’ll read it in the newspapers that some little old lady really didn’t know what she was getting into, and some unscrupulous mortgage broker fooled her into this. Some of that happened, but that’s not the main problem. I think what is really going on is that everybody thought housing prices would keep going up, and the banks lent more than they could ever get back, and homeowners borrowed more money than they could ever repay.
Vander Linde: And this is a piece that I think is being missed in the media somehow. Not only was this mess built on the premise that housing would always continue to rise in value, but it was also premised on a historical trend in the mortgage re-selling market—that only a relatively small percentage of mortgages ever default. But because of the change in the culture of lending and borrowing, we end up with a 30-to-40 or more percent default rate on mortgages in some of the mortgage investment packages. This can cause a big drop in the value of some of the assets held by Wall Street firms.
Why are American taxpayers responsible to pay for this gigantic bailout?
Van Drunen: Because the overall economic system is closed. If the American financial system has lent a lot of money to the American people, and it doesn’t get paid back, that leaves a big hole. Someone has got to plug it. If it becomes too big, it comes back to the general population. On the whole it’s fair. But you drill down a little bit. Why should a guy like me—who has never defaulted on a loan, never borrowed too much money—why should I have to pay this much? As an individual, it doesn’t feel very good.
Vander Linde: The markets need a clear signal that there’s a plan to clean up the financial crisis. If financial markets continue downward, not only will wealth decline, but spending by consumers and businesses could stagnate greatly; that will mean a lot of lost jobs as well as lost wealth. So, my point of view as a macroeconomist is to buoy financial markets to stop an economic slide. I resonate with one thing President Bush said in his speech the other night, “It’s not about pointing fingers at this point. We need some pretty significant action right now.”
What kinds of restrictions would you like to see on this bailout?
Van Drunen: If I’m going to spend $700 billion, I want to make sure it doesn’t go to the managers and the shareholders of these institutions…
Vander Linde: And I don’t want the money going to the borrowers who were looking for their own little golden parachutes.
Van Drunen: That’s what Congress is debating. For instance, when the government bailed out AIG, their condition was that senior executives had to retire without parachutes.
What are the implications of this crisis and the bailout—and the bailouts perhaps yet to come—on students who are just graduating from college and starting their lives?
Van Drunen: I’m more worried about the 70-year-old who is retired and has money in the stock market, and it’s gone way down.
Vander Linde: Even with a bailout, the economy’s growth will be very slow for at least a year or more as it is bordering on recession now. That’s a tough market to graduate into. Over the longer haul, the economy and the financial markets will recover, but without help, I believe we could experience something much worse than we care to think about. We will be fine if action is taken. I’m not painting any rosy picture of the future.
Van Drunen: I’m glad I’m not retiring this year.
Vander Linde: It would give one pause.
Van Drunen: In an ideal world, this would never have happened.