Next president faces great challenges

October 10, 2008
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Strap on your seatbelts folks: We’re in for a rough ride.

The U.S. financial system — and most of the rest of the world’s — is now non-functioning: It’s frozen. It will take real leaders to pull the country out of this economic and financial funk, leaders who can rebuild the people’s trust in the financial system and restore their confidence in it, financial commentator William Seidman told a packed house at Grand Valley State University’s Seidman College of Business Breakfast Series Thursday. 

In Seidman’s opinion, neither of the presidential candidates has defined an economic program in a way that’s very memorable, let alone in a way that addresses the consequences of the Federal Reserve’s $700 billion rescue efforts of the past month.

“We have clearly gone into the worse financial panic since the Great Depression. In some ways it’s worse because it’s much more complicated,” Seidman said. “This is the start of increased unemployment and home foreclosures. The financial disturbance is going to hit the economy very hard, and the longer we’re in this condition, the harder it’s going to be.”

Seidman is currently chief financial commentator for CNBC. He was an economic advisor to Presidents Gerald Ford and Ronald Reagan and served as chairman of the Federal Deposit Insurance Corp. under Reagan and George H.W. Bush. He was also founding chairman of GVSU’s Board of Trustees. 

Seidman wishes both presidential candidates had more experience in the real world of the private sector. Fortunately, he said, they are both highly qualified, but neither of them have ever been in business nor do they have any experience that can help guide them in terms of the problems with the private sector. One candidate is a fighter pilot and the other a community organizer, which are both very reputable careers, but not particularly useful in preparing them for the kind of situation they will step into as president, Seidman observed.

“That will clearly be the challenge of the century,” he said. “So when deciding which candidate you want to vote for, you’d better look hard at who’s advising him.” 

Seidman shared his theory on how the country got into this financial crisis. The country enjoyed great prosperity headed by a housing boom fueled by subprime mortgages made to people with less-than-perfect credit. The subprime mortgage market grew in a way that was almost impossible to believe, Seidman said: There were nearly 2 million subprime loans written within a period of 18 months.

Seidman said most of the subprime mortgages were written by mortgage brokers, who passed them to banks and systematic investment plans, which resold them. Unfortunately, nobody who had anything to do with putting the whole thing together had an interest in whether they paid off or not, he noted.

But the biggest purveyors of the crisis were the investment banks, he said. In 2004, the investment banks went to the Securities and Exchange Commission, which regulates the amount of capital they can have — the amount of leverage. At the time, the investment banks could not have more than $12 in loans for every $1 of capital, Seidman explained. The banks told the SEC that the system was antiquated and they could determine the amount of capital they should have based on their history.

“Bottom line is that from 2004 until today, the investment banks went from 12 times leverage to 30 to 35 times leverage,” Seidman pointed out. “The more they borrowed, the more they made. I think the lesson of that was very clear: Self-regulation unsupervised does not work.”

The vehicle used to market the subprime mortgages was tranche credit-rated securitization, which means a bunch of mortgages are put into a trust and the trust is divided up into sections. As Seidman explained it, all the mortgages support payment of interest on the first section, and after they’re paid, all the mortgages support payment of interest on the second section, and after they’re paid, all mortgages are used to pay the interest off of the third section. Then there is a residual section. Pieces of those tranches were sold all over the world, spreading the risk, Seidman pointed out.

“That’s why the world blames the whole financial crisis on us,” he added. “Subprime mortgages were not a known quantity, and the credit raters really didn’t know how to rate them, so they just used other mortgages. The problem was that when we added up all the pieces, they came out to a higher value than the underlying assets.”

Reality set in, and mortgages started being foreclosed on because many of the people who had taken out a mortgage didn’t have sufficient funds to pay for the houses they’d purchased.

In the past several weeks, the Federal Reserve has stepped in to try to replace the private sector and provide money so people can borrow. Seidman said the Fed is attempting to keep the financial system going, but every time the Fed steps in, people fear things must be worse than they thought, and then the market slides further down, he said.

“If there ever was a real panic, we’re in it today. The greatest challenge is to get out of this panic.” Seidman said. “We’re in real trouble, but that doesn’t mean we can’t get out of it.”

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