Some timely student questions...

A student e-mailed some interesting questions last week. You do not need to agree, but I thought I would share the thoughts on our blog.

1.) How important is finance to the U.S./the world?

Very important. With the decline of defined benefit pension plans and the increase in defined contribution retirement plans, most people are relying on the financial markets for their retirement and general financial security. For most of us, how we manage our retirement investments and the return on these investment will dictate the quality of life we will have during retirement (or even if we can afford to retire).


2.) Has financed changed much over the years? How have events like the Iraq war and Sept. 11 changed finance?

Regarding your question about Sept 11 and the Iraq war, I am amazed at how well the financial markets stood up and bounced back from the September 11, 2001 terrorist attaches, especially considering the physical damage to Wall Street itself. I believe this is a sign of the strength and level of sophistication of the US financial markets. However, there are serious challenges today. Maybe even more challenging than the recovery from 911.

Finance has evolved and change tremendously over the decades. Take for example, residential real estate finance. The old model of residential real estate finance was depicted in the movie, It's a Wonderful Life, the Christmas classic starting James Stewart as George Bailey. George Bailey's job was managing a Savings and Loan (S & L). The original S & L financial institutions simply collected deposits from a local community and made residential mortgage loans to that same community. These old time S & L held the mortgages in-house and therefore needed to make 'good' loans or live with 'bad' loans.

Today we have a sophisticated secondary mortgage market that has its advantages, but also some disadvantages. Very quickly, the new model of real estate finance provides tremendous liquidity to the mortgage markets. Primary lenders, such as the remaining Savings and Loans and many other types now, can sell their mortgages to secondary market, most likely to Fannie Mae (FNMA). FNMA creates large mortgage 'pools' from primary lenders from across the country. FNMA thensecuritizes these mortgages making nice diversified mortgage investments for investors from around the world. Quiet different from the simple Bailey S & L model.

However, we are currently realizing some problems with this modern system. Because primary lenders are most often selling mortgages to the secondary mortgage market, and not holding these mortgage long term, primary lenders now have a big incentive to generate fees from mortgage originations and shift the risk of mortgage default (bad loans) to secondary mortgage market investors. We have originated a lot of bad loan over the last 10 to 20 years and we are paying the price. With changes and innovations comes new challenges.

I am concerned with the financial responsibilities that the US tax payers are taking on by bailing-out some of these companies, such as Bear Sterns, Fannie Mae, and Freddie Mac [nowAIG too]. These bailouts will be a tremendous financial burden, present and future. Also, I am worried about the signals these decisions send. If we keep bailing out people who make bad investments or companies that make bad choices, there is no incentive to stop making bad investments and decisions. Do a deal, makes some money off fees, and if the deal goes well, everyone is happy. If the deal goes bad, not a problem-you get bailed out.

The Iraq War is also a financial strain on our economy but there could be future benefits, including economic, if there are improvements in this region. If chaos breakout in Iraq, we will loose the investment that we have already made and might be forced to reinvest here again in the future. Unfortunately, this issue is such a political hot button it is difficulty for most people to think about this objectively. From a financial perspective, I think we need to do the best that we can here. Especially considering the economic burdens we are taking on at home, I don't think we have a choice.

As opposed to Iraq, there are no foreseeable benefits to these bad loans and mortgage market bailouts, except for some managers, debt holders, and even some stockholders of these bailed-out companies (for example, FNMA preferred stockholders have not been bailed out yet but some are speculating that they will be in the future).

It is a shame. Despite the transparency, sophistication, and strength (especially in times of crisis like 911) of the US financial markets, it seems like we cannot avoid a major self-inflicted financial crisis about every 10-years or so. I attribute this perpetual problem to moral hazards and a little bit of human nature.