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A financial crisis Q&A

Tuesday, September 30, 2008 | 10:47 p.m. CDT; updated 11:13 a.m. CST, Wednesday, February 11, 2009
Karen A. Schnatterly, assistant professor of management at MU's College of Business, said investment packages of subprime mortgages are an important cause of the ongoing financial crisis.

 

Karen A. Schnatterly, Ph.D.,  assistant professor of management at MU's College of Business, explains how the financial meltdown affects the average American, Washington's bailout plan and the causes behind the current economic crisis.

Q: How does this financial crisis impact me if I don't have a lot of money in the stock market?

A: When the credit markets restrict, no money flows.

It's going to be a lot harder and more expensive to get car loans, student loans, to get mortgages, your credit card rates are going to go up, your minimum payment is going to go up, the maximum you can charge is going to go down. Companies are going to suffer, we're all going to suffer.

Q: What about my job?

A: Companies will have a hard time making money. Where can they save money? Labor. We're going to see a large number of layoffs. Salaries may stay the same, some may rise. The rate of increase will not be as great as all of our overall cost of living.

Q: The bailout failed to pass in Congress. Is it a good idea?

A: Yes. There is lots I'm not fond of, including the fact that there is a large amount of unresolved conflict of interest for how the bailout would be implemented.

But I'm looking at bailout that I don't like, or no bailout, and I think we need bailout. It will help reassure the financial markets and today based on the hope of a bailout so the financial markets need that reassurance to reduce their validity and stop being crazy.

Q: How can a bailout help?

A: The bailout can help reassure banks that have bad assets.

That's going to help loosen up some credit, and that's going to help more positively as for small companies and consumers, cost of the credit we get, but that's going to take some time to trickle through.

Q: What doesn't it do?

A: What it doesn't address is the sinking housing market to the extent that it can reach reassure investors, individuals and banks, but the bailout doesn't reach into communities slow down foreclosures, or even allow bankruptcy judges to renegotiate the terms of their first mortgage.

Q: Were you surprised it failed to get through?

A: I was. The fact that a majority of the house voted "no" boggled my mind.

There's clearly more pressure now on lawmakers than there was before the vote on the bill. They've seen how the market crashed.

Q: Why didn't it pass?

A: I think part of it was there was a weak job done by Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke and everyone else who had a stake in the bill's passing for not explaining the link to Main Street as clearly as they should have.

Understandably, voters were upset, saying ‘You're bailing out Wall Street, and you're letting the people who got us here in the first place receive unbelievable compensation and giving them a get-out-of-your-mistakes-free card. That is so fundamentally unfair.'

And that's true, it's just that what's most important is how this is going to affect you and your pocketbook, your ability to buy holiday season presents, a car, a house. That link was made very poorly.

Q: Best-case scenario?

A: A lot of this relies on the housing market recovery, and nobody knows about that.  

One completely hypothetical outcome is that we've only spent $500 billion or $600 billion in buying the bad assets and we've held on for three or four years. By then, housing prices are going back up ... and the government could sell them back for one and a half what we paid for them. So we could, completely hypothetically, in a world of hope, spend $600 billion and get something like $800 billion back in 3 to 5 years.

Q: Worst-case scenario?

A: We pay our $700 billion and find out the housing market is worse than we thought, there are accelerating rates of foreclosure and all the assets are worth less than we paid. So, we're out $700 billion plus additional foreclosure costs, so 1 trillion, or 1.2 trillion. That's the absolute worst of all possible worlds. Then as taxpayers, we're on the hook for $700 billion to $1 trillion.

Q: What triggered this financial mess?

A: One of the biggest things underlying this is the housing market, led by the subprime problem.

Q: Then what happened?

A: When housing prices started going down. More mortgages became questionable mortgages.

When you get a mortgage your bank generally doesn't keep it, it sells it on to someone else to manage, basically. Subprime mortgages are riskier, and it's harder to sell them for a really good price.

Some really clever people decided that if you package a bunch of subprime mortgages together, say a hundred or a thousand, there's no way they can all fail at once. So instead of selling them individually, they were put together in bundles so they couldn't all fail at once. Then these bundles of subprime mortgages were insured by companies like AIG. These are called credit default swaps.

So now what you have is a bundle of risky mortgages that aren't great that are all insured and worth a lot more money.

Once you've put a hundred or a thousand subprime mortgages together, name it a new asset and divide up fractions of it to sell, banks can buy individual shares.

What they've done is buy shares in this virtual asset. In order to evaluate it correctly, we need to understand that underlying value of mortgages and the insurance.

Q: As the housing market declines, and there are more and more foreclosures, then what?

A: What the banks have bought looks investment-grade, but what's going on underneath is this big, difficult-to-value mess. The assets are not worth what you thought they were, but your ability to figure out what they are worth is much more difficult.

 


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