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Understanding the Current Financial Crisis: Dr. Richard Marston

Volatility in the stock market can spark panicked sellouts, but in a conference call on October 6, 2008, Dr. Richard Marston examined the current financial crisis and advised individual investors to stay focused on their long-term goals. Marston, a widely recognized authority on international finance, teaches at the University of Pennsylvania’s Wharton School of Business.

Titling his talk: “Where Do We Stand?” Marston first reviewed the causes of the present crisis. Traditionally banks held loans until they matured or were paid off. Starting in the 1970s—through a process known as securitization—banks began bundling mortgages into bonds and selling these bonds so they could extend more loans. But the mortgage market has been poorly regulated: Congress allowed Fannie Mae and Freddie Mac (government-sponsored companies that facilitate mortgage-lending) to take undue risks, and many people who couldn’t afford houses received mortgages. As rising numbers of homeowners defaulted on their mortgages, the mortgage-backed bonds lost value, and banks and other institutions that held these securities suffered severe losses.

Banks play a crucial role in the economy because they lend funds to businesses, which need loans to expand and to make payroll. Now banks have cut off credit, because they don’t have enough money or can’t afford the risk. This “credit crunch”—one of the key factors slowing down our economy—could lead to mass layoffs and widespread unemployment as well as stock market plummets and other symptoms of recession.

The Federal Reserve has three roles in a crisis: lowering interest rates, lending to distressed banks, and bailing out banks whose failure would threaten the overall health of the economy. The Fed has never revealed how it decides which banks are “too big to fail” because it wants all banks to exercise caution.

In this crisis, the Fed hasn’t simply bailed out commercial banks. In September, it helped J.P. Morgan buy Bear Stearns (an investment bank overseen by the FDIC, not the Fed), and it rescued the insurance company A.I.G., because A.I.G. was so heavily involved in securities markets that its failure could threaten the whole system. This shows how much the financial markets have changed: securitization has replaced the traditional banking model. It’s clear that old rules no longer apply. The next president will have to rewrite financial market regulation.

The Emergency Economic Stabilization Act of 2008 (a.k.a. $700 billion bailout) aims to support the market for mortgage-backed bonds, so that banks can sell these securities and start lending again. The bailout is meant to help Main Street by making it easier for small businesses to obtain loans, but there will still be a credit crunch, and some banks will still fail. Marston warns that bankruptcies have not yet peaked.

Studying the last nine recessions since 1950, Marston found that in each recession the Standard & Poor rebounded more than 30% in the first twelve months after it reached bottom. In eight of the nine cases, the market started rising three to eight months before the recession ended: investors saw that the economy was recovering and anticipated an upswing. But the timing of stock market turnarounds is uncertain. The last recession ended in fall 2001, but the market hit bottom twelve months later.

According to Marston, the economy will probably rebound before the housing market, which may be down for more than six years as it was in the early 1990s. He warns individual investors to avoid extra risks in the bond market and in cash, to have well-diversified portfolios, including large- and small-cap U.S. stocks, foreign equities, and a relatively small percentage of emerging market stocks, and not to make major changes in overall allocation.

Jeff Applegate, Chief Investment Officer of Citi Global Wealth Management, hosted this conference call.

Lisa Montanarelli is a freelance writer based in New York City. Visit her at www.LisaNY.com. She recently revised and updated The First Year–Hepatitis C (Marlowe 2007) with co-author Cara Bruce.

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