Don't understand the financial crisis? Q&A with Rob Catlett

Rob Catlett, assistant professor of economics, shared some of the background of how the current financial crisis began, how this crisis is different than the stock market crash of 1929, the purpose of the government bailout and the potential impact that the crisis could have on Emporia State.

How did the financial crisis start?

The financial crisis originated in the housing market. The secular or long-term trend in housing prices was in general upward drift. Bankers and other financial institutions recognized that it was wise to buy a house, sooner rather than later, because housing prices were going up at a steady pace.

How did people in the past get approved for loans?

It used to be that when people wanted to borrow money for a house, he or she would go to a bank, or to a saving and loan, and borrow the funds. There would be considerable scrutiny in checking out that individual, checking their credit history, their income levels – or their capacity to borrow and repay – their character and collateral. Usually, a home would be pretty good collateral because if the person couldn’t pay it back, the bank could repossess the house… the house generally appreciated in value.

What are some of the keys to finding out what led to the financial crisis?

I’m not going to blame this on the internet, but the internet is part of it and our fast-paced communication. We recognized that we could borrow money from anywhere – we don’t have to borrow it from a local bank. Banks didn’t have to be as careful as they recognized that housing prices generally drifted upward.

When somebody borrows money, they develop a contract between the lender and the borrower. That contract was worth however much that person, the borrower, was going to repay because it was a legal contract, the courts would enforce it and they could sell that asset to somebody else. Somebody can sell that mortgage to somebody else, it could be a financial institution, which is typical…. When we recognize that that loan agreement is something that can be sold, that’s the real key to this financial crisis.

What is the sub-prime market?

Sub prime means less than spectacular credit… It doesn’t have to be somebody who has mismanaged his or her finances in the past… People who are a bit older might be in that sub-prime market because they haven’t paid their credit cards on time, they may have bounced checks, they may have other sorts of issues where they haven’t kept their finances as well as someone in the prime market, where people who’ve been keeping track of their personal finances, always paying their bills on time, especially their credit cards and other sorts of things, they’re likely to be viewed as a pretty good credit risk because of their high levels of responsibility, so banks are eager to loan to people in that prime market.

In the past, what would people who were in the sub-prime market do to get a loan?

They would go to a loan shark. That was where the mafia or somebody might loan them the money, and if they don’t repay, they break their legs or do whatever else.

Do financial institutions loan to people in the sub-prime market now?

Banks and other financial institutions recognized that the sub-prime market is actually a fairly lucrative one… They end up in better shape if you default on a mortgage. Now, that sounds bizarre, but they’ve got (your) promise to repay $100,000 plus interest.

Let’s say you default after making several payments. They’ve got your payments and now they’ve got an asset that’s not worth $100,000, but it could be $120,000 or $130,000. Compared to that original $100,000, they’ve now got a 20-30 percent return in a single year in addition to your payments. That’s insulating them from a lot of that downside risk.

I’m reasonably certain that the people who analyzed the sub-prime market realized there were some really attractive financial gains from owning some of those mortgages. Financial institutions realized that they could sell those mortgages to others… they’re going to put them in a bundle of mortgages – a stack of loan agreements…. that other financial institutions, other banks or insurance companies can buy.

When insurance companies buy the loan agreements, what happens?

When the policy holders put in $100,000, they take and effectively invest those funds and have more than $100,000 and they make it so they don’t have to charge as much for premiums and they’re in a superior financial situation.

That can cause them some difficulties. They’re searching for ways not just to put those into home mortgages, they can put them into a wide array of instruments that may potentially increase in value.

So what happened when the housing prices went down?

As we watch those housing prices come down, you can imagine what happened to those people who put virtually no money down, are anticipating those prices going up in the future and if they can’t make the payments, they sell the house…. Now, those financial institutions have (bought mortgages) that aren’t worth what they thought they were worth. Our other challenge is finding out how much they are worth. We’re not talking about standard kinds of things. We’re not talking about a bond or a savings bond – we know what the government is going to pay on that savings bond…how do we price these dissimilar houses with these mortgage back securities in the sub-prime market?

If a bank is worried that they might loan to another bank, and that bank is going to go broke, then the bank that loaned it the money isn’t going to get its funds back. They’re reluctant to loan to each other right now because they’re afraid of what’s going to happen if one of those banks were to fail…That has caused the flow of credit to be diminished because most businesses borrow money… the other challenge that has put this into crisis mode is that banks are to fail, some people have more than $100,000 in their bank, many businesses do, so if they’re only insured to $100,000, they may lose significant amounts in excess of that.

That is perilous for our economy…We could see some major U.S. corporations failing and all of their workers being out of work…

How is this situation different that the Great Depression?

Deposits at banks and credit unions are insured up to $100,000 and that effectively insulates most of us from the panic that occurred during the Great Depression.

That’s really important for us to recognize – that we don’t need to go and get our funds out of the bank. Even if the bank were to fail, the FDIC would back those up. The Federal Reserve – which is independent from the government – controls our monetary system is effectively ensuring that banks are in good financial states… They are highly regulated, highly supervised… In the 1930s, we didn’t have these kinds of protections and runs on the bank were pretty common.

What’s the impact on ESU?

Obviously, businesses are going to struggle to some extent. That means that people are going to have troubles finding as many jobs. As the economy struggles with this and people get somewhat nervous, they’re going to probably slow down on some of their spending, which means we’re going to have few things purchased in the state, less sales tax collections, and it they slow down their purchases, every time spending takes place, it creates an identical amount of income. Incomes slow down.

As our incomes in Kansas potentially go down, it means there’s less Kansas income tax collected and less Kansas sales tax collected and local sales tax collected. So that our governmental entities have fewer funds coming in and one of the sources of funds for ESU is the government, the state of Kansas. That’s the biggest source of governmental funds that we’ve got.

But one of the things that puts ESU in better place than maybe 20 years ago is we’re getting far less of our funds from the state than we used to. A much bigger percentage of it is now coming from students in their tuition payments. So the potential challenges of ESU facing real serious financial problems is less than if we were getting virtually all of our funds from the state and the state can’t afford to pay it…

What is the purpose of the bailout?

Congress was trying to arrange that $700 billion line of credit for the treasury secretary to go and buy those mortgage back securities.

Do you think that the bailout is a good idea?

I don’t think we’ve got much choice…. If you do the arithmetic, you’re going to take $700 billion dollars with a population of 300 million people – you’re going to say ‘wow, that’s a lot of money per household,’ but they’re not just giving that money away. They’re buying houses and pieces of paper that effectively have people paying on their mortgages, and are not going to stop doing that.

It’s possible that the government could actually make a significant profit if housing prices went back up again – the government would end up with huge amounts of return on that.