"The Current Financial Crisis: Why did it happen and what is being done?"

Look at a typical investment bank's balance sheet and you can understand how the collapse of housing prices took down those banks. 

That's the message I took away from "The Current Financial Crisis: Why did it happen and what is being done?",  an April 16 presentation by John Haigh, executive dean of the Harvard Kennedy School, to the Boston Security Analysts Society. Haigh said it didn't take much to explode the investment banks' model of highly leveraged balance sheets with lots of short-term debt.

I liked his simple diagram of the progress of the financial crisis.
"Home prices fall -->mortgages reset --> delinquencies --> foreclosures --> prices fall further --> mortgage equity withdrawals decrease --> consumer spend falls --> job market erodes --> recession"

Haigh made several statements that stuck with me.
* People are wrong about the rating agencies. "These are such fundamentally new financial instruments tht they don't know how to rate them." That's because ratings agencies typically rely on historical data--which didn't exist for the new financial instruments--to build models for rating.
* There's a "hot potato theory" that investment banks tossed the hot potatoes off to pension funds. But, in fact, pension funds that got AAA notes got the better assets. Investment banks were left holding the worst assets. They thought they had insured against losses in those assets through credit default swaps. That turned out to be wrong. "That why they went overnight from being investment banks to being commercial banks." Given their exposure, they needed the liquidity and support of the federal government.
* People tell me credit default swaps are like Las Vegas, except Las Vegas is regulated and credit default swaps aren't.


To fix the near-term crisis, Haigh said, we must
1. Recapitalize banks
2. Restart interbank lending
3. Absorb "toxic" assets
4. Prevent bank runs

More regulation of financial services is coming. Haigh is concerned that the pendulum may swing from too little regulation to too much. He referred to an April 6 presentation by Barney Frank at the Kennedy School that discussed regulation.  However, Haigh said, "You have very smart, thoughtful people in the Obama administration. I don't think you'll get insane regulation unless Congress gets out of control." 

You can email John Haigh for a copy of his slides, if you'd like to learn more.

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Susan B. Weiner, CFA
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