Lessons of the Great Credit Crunch

By Richard DeKaser
Senior Vice President, Chief Economist
National City Corporation
NABE Board Member

Among other distinctions, this Oct. 6 session surely won the award for most timely.  As participants took to the dais the Dow Jones Industrial Average had just eclipsed a 500 point daily decline, the Treasury-Eurodollar spread hit an all-time record, and the moderator, Chris Varvares, Marcoeconomic Advisers and the new NABE president, acknowledged that he was anticipating word of an inter-meeting rate cut by the Federal Reserve. 

Though the rate cut never happened that day, the speakers provided a superb overview of what went wrong. William Poole, the Cato Institute and former president of the Federal Reserve Bank of St. Louis, began by identifying “credit quality” as the essence of woe, though he emphasized how it was amplified through capital inadequacies and a vicious interplay between the collateral posted by investment banks to key counterparties and the role this had on liquidity—by borrowing short in wholesale funding markets, but posting long-term securities as collateral, access to credit unwound violently once the securities’ integrity became dubious.

Martin Baily, Brookings Institution, agreed with the Poole diagnosis, but elaborated on precursors, especially the intoxicating effects that steadily rising house prices had on underwriting standards.  As prices subsequently collapsed, not only was poor underwriting exposed, but also asset quality swiftly eroded as loan collateral evaporated.  While acknowledging the important role of aggressive capital flows into the United States in depressing mortgage interest rates, Baily also believed the Fed had erred by keeping the federal funds rate too low for too long during 2003 and 2004.   He believed there was at least enough evidence of an emerging housing imbalance to prompt the Fed to “lean against the wind.”

Robert Dugger, Tudor Investment Corporation, also focused on the importance of foreign investment, both as an accelerant to the housing boom and—after smarting up to the inferior quality of the debt they acquired—amplifying the decline with its sudden departure from the secondary market.  He spoke about how insufficient domestic savings contributed to this exposure to foreign capital flows and then took a prescriptive tack, explaining how dangerous this excessive reliance had become and arguing for more conservative fiscal policies going forward. 

When asked about prospects for salvation from the recent “Emergency Economic Stabilization Act,” the presenters were mostly skeptical.  Poole was concerned about a possible challenge to fair-value accounting, and Dugger lamented the lack of a re-capitalization plan.  Baily, however, claimed to ultimately support the legislation, albeit only while “holding my nose.”
For copies of the speakers’ presentations, go to the annual meeting session page.