Question & Answer Session

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Response to Questions that Time Did not Permit Panel Responses

1. Is this issue not a matter of fundamental saving v. spending? Americans should be more financially responsible. If we were more responsible, would the crisis not be lessened, or eliminated?

If the citizens in the U.S. were slightly more patient and frugal the impetus that drove the excessive leverage would certainly have been much less powerful. No money down or interest only loans, coupled with lowered underwriting standards were the response by Fannie Mae and Freddie Mack to political pressures (by both parties) to expand home ownership. The use of excessive leverage or minimal equity to spread the wealth combined with a failure to recognize the realities of the real estate market created a perfect storm for housing and the resulting financial crisis.

2. With regard to Samwick’s Law, does Wal-Mart fall under this category?

I do not believe that Wal-Mart falls into this category. The difference is that financial institutions are very integrated into all aspects of the economy and especially among themselves. Once people believe correctly or incorrectly that an institution, or worse the entire banking system, is in trouble they can move their deposits to another institution. If a retail business gets into trouble and fails they can simply shop elsewhere without otherwise affecting the economy.

3. Why are so many companies financially plummeting even after the Sarbanes-Oxley Act was passed in 2002? Obviously these companies were “cooking the books” to a certain extent since they are going bankrupt or went bankrupt in a relative short period (Wachovia, Merrill Lynch, Enron, Fannie Mae, etc.). Since the economy is doing bad, is it a good time to invest in secured loans (federal, state, city, etc.)?

The Sarbanes-Oxley requirements were phased in over time and much of the activity related to subprime loans and questionable lending practices had been going on for a number of years. It is not a question of the companies “cooking the books”, except in the Freddie and Fannie cases, it was a case of a failure to manage or mitigate risk (to the extent that they recognized its existence) associated with real estate and other retail debt instruments properly. This question is an excellent one in that it begs for an answer to what were the audit firms and the Boards of Directors doing while the risks mounted and the leverage increased? While it is tempting to pull your money out of other investments and put them in US Treasuries or other state or municipal debt instruments there are a few things to consider. If everyone does that then the economy will go rapidly from recession to depression and the state and local governments will have difficulty meeting their payment obligations as their revenues fall. Also the market value of these investments will decrease as the demand increases, meaning that in order to get your money back you will need to hold them to maturity.

4. Speaking of contagion of our crisis to foreign banks, how, in comparison to our methods, do they plan to emerge from the problem? Every experienced and knowledgeable economist I have spoken with have agreed that the “bailout” was a bad decision. With this being said, why would the government go against knowledge like this in their decision?

The evidence is fairly clear at this point that foreign governments have adopted the policy of injecting capital directly into financial institutions to promote inter-bank and retail and commercial lending again. While I agree that the structure of the federal Government’s program could have been better thought out, and the structure has changed over the last week or so in response to the comments of the economists you refer to and others. Remember that there was a very real sense of urgency to “do something” to calm markets and restore confidence. To a material extent that has happened and the structure of the program is being modified as we move forward and deal with actual market responses.

5. As part of restoring public confidence in the financial community, what measures are available (cultural or legal) to overcome the obscene salaries of top executives?

There are a lot of legal measures available that could address this issue. Laws we could change include increasing marginal tax rates to 70% or greater on incomes above $1 million or making salaries of executives that exceed $1 million not deductable. There are two problems with addressing this problem with new laws.

First, compensation for many executives is tied to stock ownership, not just salaries. Manager-owners should and do have strong incentive to enrich stockholders and create healthy businesses. Second, some executives are worth a lot. Managing a large corporation is at least as challenging and should be as rewarding as being able to hit a baseball a long way.

That leaves cultural measures, and this one is more promising. Executive officers are “managed” by Boards of Directors. These Boards remain largely made up of older white men. Only about 15% of the Directors of Fortune 500 companies are women. African-Americans, Hispanics, and Asians remain under-represented. The older white men who sit on Boards often attended the same schools and have family connections that go back for generations. They also often select executives from among those they know and value.

That’s why we have to value and demand cultural diversity. Forgetting the ethical issues, companies that don’t adequately manage diversity make mistakes. Sometimes these mistakes include overpaying executives.

6. Would you say the lowering of fuel prices would help increase spending or saving? Why?

Lowering fuel prices will make only a very small difference in the savings rate, because those families most affected by higher fuel costs have a difficult time meeting expenses, much less saving. Most of our nation’s saving and investment comes from wealthy families, for whom fuel costs have much less impact.

That does not mean that we all don’t need to save more. Increasing our saving rate is critically important if we want to remain competitive.

7. From a psychological standpoint, would you say that this “economic scare” is necessary to help permanently imbue the desire to do good business within the generation of yesterday, today and tomorrow? Note: Strong emotions help a person remember something longer if not permanently.

Money has a short memory. Free markets and free people remain the best way to manage economic and political power. I think the scare will convince investors that there is more risk in markets than we thought. This means we will make more cautious and conservative decisions, until we have another good decade. Then, we’ll go wild again.

8. What is the good news?

There is some very good news. Young people are interested. As an “older white man” who has seen apathetic eighteen to twenty-two year olds for a full generation, I’m very excited that students today care. I think baby boomers have made a contribution to the world, but I think it’s time that our focus on material goods and wealth is tempered by a broader world view that includes the informed opinions of young people.

9. In 2006, the US had a negative savings rate – the lowest since 1933. Given the importance of saving, what can the federal government do to encourage saving, particularly in short-term funds like a savings account or CD?

I’ll answer this from the investment side. As Dean Johnson mentioned, we need to change the policies that have made home ownership so attractive relative to other investments. Allowing other loan payments to be tax deductible and creating a maximum mortgage interest deduction would do that

Second, all barriers to long-term savings should be eliminated. Right now, the most common vehicle we have for tax-free investments is our retirement plans. Other long-term savings should have tax rewards.

Changes in short-term funds probably won’t make much difference. We could make them tax exempt, but that probably wouldn’t do much to incentivize them. We also want to encourage longer term investment and ownership.

10. What is money? When I get paid by direct deposit, a truck does not drive up to the bank and put anything into it. So what is money?

Money is anything that a society chooses to recognize as a mechanism to exchange goods and services. Western societies have consistently moved away from using physical conventions, gold coins and paper, toward electronic notations of bank account balances that can be turned into a physical convention when desired.

11. What things are similar, if any, to the Great Depression years ago?

At the height of the Great Depression, unemployment was 25% vs. 6% now, the Dow was down 91% vs. 40% now and industrial production was down 50% vs. 3% now. Thus one has to realistically say that the only current similarity to the Great Depression is the public loss in confidence in financial institutions.

The current situation remains much more similar to conditions during the recession in the 1980’s.

12. I’m still not clear on what a CDO is. What is commercial paper? Why do businesses “have to” run on credit? Can’t they just pay cash? Isn’t it safer in the long run not to run on credit? What’s a “non-bank” bank?

CDO: A CDO (Collateralized Debt Obligation) is a Bond for which the funds for repayment come a variety of different source types bundled together. In contrast to MBS (Mortgage Backed Securities) where the funds for repayment only derive from principle and interest payments of multiple mortgages bundled together. CDO sources types typically include high-yield corporate bonds, often called junk bonds, other corporate debt, credit-card debt, subprime mortgages, and other CDOs.

Non-Bank Bank: Many financial firms that are not legally classified as Banks, Freddie Mac, provide credit services to their customers that are indistinguishable to credit services provides by Banks, Wells Fargo. As a result, their impact on providing credit to the economy is identical to a Bank; however, these firms operate within a different set of restrictions on capital assets.

Corporate Paper is a loan made to a corporation without any form of collateral being pledged to insure repayment of the loan.

Businesses utilize credit for everyday operating expenses because it is more profitable to invest their funds in their own business. Typical interest rates are currently in the range of 4% and business profits are more in the range of >15%.

Safer is a relative term since history teaches us that every corporation fails at some point. Certainly in the current environment, a profitable corporation with low short-term debt is less likely to fail than competitors with more debt. In more normal environments, that same company might well be less profitable than its competitors and more likely to fail.

13. What caused the housing bubble collapse in 2007?

Home price appreciation in the United States has been substantially above its historical rate for over 30 years and during the period 1995 to 2005 substantially outpaced every economic fundamental, especially real wage growth. As Herbert Stein famously said “something that cannot continue forever will stop,” and we tend to look for that one event or factor that caused it to stop.

In the current case, I think that a number of factors such as over-building, hurricanes in Florida, subprime lending and defaults, slowing wage growth, financial engineering, that alone would not have caused a market price collapse, have combined to produce a backlog of homes for sale that cannot be absorbed by the normal population-driven growth in home demand. Now that we have a large backlog, tighter credit standards, and a slowing economy, home prices will likely continue to fall for many months to come.

14. Inflation wise, how do you think that inflation will go in the next couple of months, when the fed increasing aggregate money in the economy so much?

I personally expect inflation over the next few months to remain low as commodity prices especially oil prices fall and GDP growth slows or falls, and current results for the CPI (Consumer Price Index) and bond markets are consistent with that view.

In the longer term, money supply increases will certainly be a factor tending to increase inflation rates.