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Financial Crisis Caution

Leverage, Transparency, Liquidity

Dean Jay Light began his introductory remarks by characterizing the crisis and collapse of housing prices as a test that has exposed how fragile the recently evolved U.S. financial system is. “Leverage, transparency, and liquidity lie at the heart of much of what’s going on. The system has proven to be unexpectedly fragile in a way that I think nobody I know really understood,” Light said.

To illustrate his point about the interlocking nature of housing and the U.S. financial system, Light said that for decades beginning in the 1930s, the ratio of median home prices to median income remained relatively stable, about 3 to 1. Over the last 20 years, however, the financial markets that financed the housing system in the United States changed remarkably. Local markets once dominated by tightly regulated savings and loans—a simple system of buy and hold—evolved into something much more complicated due in part to the development of mortgage brokers. The new system fueled a bevy of mortgage backed securities and derivatives that were terribly difficult for experts to comprehend, he said.

Too much leverage combined with too little transparency meant that the markets froze. Liquidity vanished. Similar to mortgage-backed securities, highly leveraged loans and other transactions were characterized by a lack of transparency. “When one looked at an institution, it was very hard to understand who had what risk. In a world like that, liquidity disappears. So too does the liquidity of institutions. … That in fact is where we are today,” Light said.

Just as a hospital treats patients by focusing on three tasks, so too should we remedy financial turmoil, he said. First, stabilize the patient, in this case the markets. Second, fix the problem through either surgery or other medical care. Finally, prepare long-term rehabilitation. Those three tasks must be accomplished in order.

As for the $700 billion proposal described as a bailout by Treasury Secretary Henry Paulson, it is deliberately void of many details that would be hard to pre-specify, Light said. “It isn’t clear it’s a bailout at all. … It may in fact be a very profitable investment. And at what price are the assets to be purchased? You see, it’s actually needn’t be a bailout proposal at all. It’s in fact a proposal to try to re-liquefy markets by reducing leverage, by increasing transparency, and by increasing liquidity by establishing a set of pricing processes that involve the private market as well as whatever this public entity is.