The economic crisis: The Babcock School’s Bruce Resnick and Charu Raheja explain the credit crunch driving the proposed $700 billion bailout plan

10.3.2008 Article, General, School News

Bruce Resnick is the Babcock Graduate School of Management's Joseph M. Bryan Jr. Professor of Banking and Finance and the co-author of the book, "International Financial Management." Assistant Professor of Management Charu Raheja teaches courses in corporate finance, financial management, and corporate and asset evaluation.

What is the bailout plan meant to accomplish?

The purpose of the bailout is to authorize the government to buy mortgage-related securities from banks. By making these purchases, the government will establish a value on these securities and replace the mortgages sitting on balance sheets with cash so banks can resume lending. In normal market conditions, banks would sell these mortgages themselves, but with today's credit market crisis, they can't because there's no market.

Can you give us a quick primer on the bailout plan?

First it is important to understand the situation right now. Credit has essentially dried up. Currently lenders are not willing to lend to some borrowers with whom they have had a long relationship. The plan will likely buy home mortgages, mortgage-backed securities (MBS), and investments comprised of MBS from banks. The $700 billion is an educated guess as to how much will be needed to clean up bank balance sheets and restore confidence in financial institutions and create willingness among bankers and investors to lend. It is perhaps too much, but likely large enough that it will not require more.

Is it really necessary?

Some economists do not believe anything needs to be done. They believe that the operation of markets got us into this mess and their natural operation will correct the problems. Perhaps they are correct. Personally, we favor some form of a bailout plan. A plan that allows the banks to clean up their balance sheets and restores the incentive to lend is necessary. However, one concern is that these bailed out banks will just find new ways to get themselves into trouble.

Will taxpayers eventually recoup some of the costs of the bailout?

It depends on the exact structure of the plan. If the bailout plan buys the bank assets at below their fair value and can sell them for more, then the government (taxpayers) will profit. If they are bought at fair value and liquidated at the same price, then the government will only recoup its money. If the government pays too much it will obviously lose money in reselling the assets.

Can executive compensation be limited?

This is a tough one. The general public does not want the executives of these troubled banks and financial institutions to profit at taxpayer expense, but exactly how one could limit this is not clear. There is a competitive market for executive talent and to buy this talent requires paying the market price.

Is there a simple explanation for why the first bailout plan failed in the House?

The plan needed refinement; $700 billion is an astronomical sum. We would not have expected it to pass just on the opinion of the Treasury Secretary, Fed Chairman and even the president. All these people have recently said that the economy is fundamentally in good condition! No reasonable politician would have passed the bailout plan without more study and conversation with their constituents.

We were told last week that this had to be passed immediately, or the economy would grind to a half. Does the chance of its passage decrease as more time goes by?

Possibly it is the belief that a reasonable bailout plan will soon be offered that is keeping the market in check. But let's not forget that the market fell 777 points on Monday, only to recover by about 500 on Tuesday when it appeared that coordinated international efforts among many of the major central banks were in the making.

How does this affect the person without much consumer debt?

You are in good shape. If a credit freeze continues, perhaps merchants you shop with will not be able to borrow to purchase seasonal inventory, meet payroll or refinance a mortgage. A lengthy credit freeze may cause some marginal businesses to go out of business. If you're a student, it will most likely be much more difficult and expensive to obtain student loans in the immediate future.

What happens if no plan passes?

We believe this is an unlikely situation. If no plan passes, we will find ourselves in the midst of an enormous free-market experiment. If a credit freeze continues, a lot of unnecessary damage could happen to creditworthy individuals and financially sound business firms.

Why can't we continue to wait and let market-forces play out, like Citigroup taking over Wachovia?

Wachovia hoped that a bailout plan would be passed in time to save it. When it wasn't, Wachovia put itself up for sale to save what was left. In fact, Fed regulators intervened early Monday to tell Wachovia executives that the bank's deteriorating condition posed a threat to the economy and that a sale was necessary. [Editor's note: In an abrupt change of course, Wachovia Corp. said Friday morning that it will be acquired by Wells Fargo & Co. in a $15.1 billion all-stock deal, wiping out Wachovia's previous plan to sell its banking operations to Citigroup.]

Speaking of Wachovia, a week ago Wachovia appeared to be solid, so what happened?

Wachovia has been worrisome since Ken Thompson was removed in June. This is when the general public became aware that a serious problem might exist at Wachovia. Recently, some people in town we know withdrew CD deposits from Wachovia in excess of the FDIC limit. We find it amusing that Morgan Stanley (an investment bank that has fallen out of favor as a viable form of financial institution) and Wachovia had recently contemplated a merger. How did it ever make sense that two weak firms could expect to create one strong firm by combining?

What do you expect the fallout of the Wachovia deal to mean for Winston-Salem and Charlotte?

Nothing good for either city. It will perhaps have a more negative impact on employment in Winston-Salem than Charlotte. Winston-Salem has 2,000 to 3,000 Wachovia employees, primarily in wealth management. Unfortunately, this function may be merged into Citigroup's wealth management in New York.

There is a proliferation of small community banks around Winston-Salem; are there too many banks?

Lots of cities have small banks. Some small banks may actually be in better shape than the large ones that got wound up in the subprime mortgage mess and lending to unqualified borrowers. BB&T, not a small bank, but nevertheless a locally headquartered one, is in very good shape.