Iowa State University
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News Service

News Service:

Annette Hacker, director,
(515) 294-3720

Office: (515) 294-4777

09-24-08

Contacts:

Roger Stover, Finance, (515) 294-8114, rstover@iastate.edu

Rick Carter, Finance, (515) 294-9438, rbcarter@iastate.edu

Burt Porter, Finance, rbporter@iastate.edu

Dan Ryan, College of Business, (515) 294-5800, djr@iastate.edu

Mike Ferlazzo, News Service, (515) 294-8986, ferlazzo@iastate.edu

Iowa State finance professors try to make sense of current economic crisis

AMES, Iowa -- The U.S. government put Fannie Mae and Freddie Mac into a conservatorship. Lehman Brothers filed for bankruptcy and is being sold off in pieces. Merrill Lynch has been taken over by Bank of America and the government effectively seized control of the insurance company American International Group. And now the Bush Administration is trying to fast-track its $700-billion bailout plan to rescue the country's staggering financial markets.

There's certainly been a lot of troubling financial news lately, making investors and home owners understandably nervous. But what does it all mean? Three Iowa State University finance professors say at this stage, one can only take an educated guess.

"Once we take a breather from the events of the past couple of weeks, the real question is whether this meltdown in the financial sector of the economy will affect the nonfinancial sector," said Burt Porter, assistant professor of finance at ISU.

"We are already seeing banks making it more difficult for borrowers with less than perfect credit to get a loan and charging higher interest rates to all borrowers regardless of credit rating," he said. "This is true for loans ranging from automobile to business. Individuals and companies that had thought they had no exposure to the mortgage-backed securities market have found it difficult to borrow to purchase houses and finance operations, respectively."

Roger Stover, a professor of finance and the Iowa Bankers Fellow in Finance at Iowa State, says the current crisis has become more interesting given the decision by the Federal Reserve to allow two investment banks to become bank holding companies.

"My real issue with all this is that we are given no real impact analysis of all these decisions," Stover said. "For example, if we allow any of these institutions to 'fail,' who will be harmed? I think we have some idea of this. But more importantly, how much will they be harmed? We need regulators to give some estimate of the magnitude and timing of the impact no matter how difficult that estimate may be.

"My analogy is the prospect of dropping a brick on someone's toe," he said. "Given all the information that is available on the impact of that act, will it break the toe? Will the toe bleed profusely but not break? Will it just bleed a little? If we are going to commit such a volume of capital potentially to this problem, we need more information."

Regardless of the problem's solution, the ISU professors point to greed as a contributing factor to causing it.

"This greed has ranged from individuals buying more house than they can afford to businesses taking advantage of cheap credit to borrow excessively," Stover said. "At least we can now better understand the costs associated with this compulsion."

The professors report there is evidence that reduced availability and higher cost of credit may slow the country's expected economic recovery. But they say there is also evidence that businesses were anticipating such a crisis by increasing their cash balances and improving their capital structures to weather the storm. They point out that Congress, the Treasury Department and the Federal Reserve have also been taking action to lessen these risks.

"Even though the nonfinancial sector outside of housing and autos appears quite robust, only time will tell whether the financial sector meltdown will have an impact on the rest of the economy," said Porter.

And from a long-term perspective, the troubling economic events may actually have a "silver lining."

"We are already seeing government agencies moving to insure greater transparency in the investment vehicles employed by financial institutions," said Rick Carter, professor of finance. "Furthermore, individuals may now take a more prudent stance when faced with investment options and the amount of debt they can realistically handle."

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Carter

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Porter

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Stover

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Quick look

Three Iowa State finance professors -- Rick Carter, Burt Porter and Roger Stover -- try and make sense of the country's widening economic crisis.

Quote

"My real issue with all this is that we are given no real impact analysis of all these decisions. For example, if we allow any of these institutions to 'fail,' who will be harmed? I think we have some idea of this. But more importantly, how much will they be harmed? We need regulators to give some estimate of the magnitude and timing of the impact no matter how difficult that estimate may be."

Roger Stover