The Hard Lessons of the Dismal Science
by Dennis Walikainen '92, '09
Economic Meltdown as a Teaching Moment
Dean Johnson has just spent the last two days giving his finance students a primer on America's two greatest economic crises: the 1929 stock market crash and the 2008 implosion of the housing market. "The particulars are different," says the associate professor of finance. "But the basics are familiar to us."
Both the housing and stock market bubbles were driven by debt–"buying on margin"–and fueled by the false expectation that values would always rise. Borrowing, or purchasing assets on margin, creates leverage, Johnson says.
"Back in the 1920s, instead of paying 100 percent of the stock price, people would borrow as much as 90 percent, creating higher demand and higher stock prices," he says. "Back then it was stock markets and buying on margin, whereas now it is homebuyers and mortgages."
Borrowing also fueled consumer spending. The once-popular practice of taking out second and third mortgages to finance big-ticket purchases was a classic example. Borrow $50,000 against the equity on your home, buy a boat. Watch the value of your home skyrocket, borrow another $50,000, and send your kid to college.
"Americans enjoyed the extra cash from refinancing or putting down a small amount on a home purchase," Johnson says. They spent the extra money, and that helped the economy.
"But when the bubble breaks . . ."
. . . the value of your home collapses. You are saddled with paying back loans worth more than your house. Defaulting becomes an option.
"There was way too much leverage in the housing and banking markets," Johnson says. "One little blip and everything started to unwind."
Complicating matters, connections weakened between the lender and the borrower. With Fannie Mae and Freddie Mac buying mortgages from financial institutions, and loan officers earning big commissions for generating loans, there was less concern about the homeowners' ability to repay.
Johnson says there's plenty of blame to go around: banks, Fannie Mae and Freddie Mac, and politicians who, seeing increased homeownership as good, did nothing.
"And there's no easy fix," he says. "We have to take our medicine. It took twenty years to create the over- leverage, and it will take time to undo that. The most important thing a fix can provide is to restore faith in the business and finance system. Human psychology is important. If people are cautious and not spending money, the government and financial industry must take action that will push capital liquidity." "The economy is based on trust," he says, "and people want to know that there is credit available in the financial and business segments."
The federal government did some "right things": allowing lots of credit, loans, and bank mergers; and putting capital into financial institutions. However, the government must not be afraid to allow new companies to emerge out of the bankruptcies of existing companies.
Johnson's role as advisor to the Applied Portfolio Management Program (APMP) has offered another teaching moment, as his students have watched their The student teams manage an asset portfolio on behalf of the Michigan Tech Fund, using donations from a variety of sources. In better times, they made lots of money, won national competitions, and learned about the finer points of finance.
"This year, they are also learning how to pres ent bad news to their advisory board," Johnson smiles. "It's just like having to deliver a presenta- tion with bad news as a CEO would do to a board of directors."
The APMP Advisory Board was meeting over Winter Carnival weekend. Before a run-through of the presentation, the two teams discussed what was bad ("commodities and financial"), good ("health care and utilities usually, but it was hard to escape the bad"), and their strategy for the future ("hope and pray").
Senior Zack Martin of the Black Team said the market also affords lots of opportunities for investors willing to look beyond the horizon. "The scope is huge. We are buying things long-term, and we have significant cash positions," he says. "Investing in this type of a market happens only once in a lifetime." Don Murray, a fourth-year student in finance and accounting, was on the Gold Team, and he said they were "staying with their fundamental philosophy and staying in for long term."
They also had the last laugh. They had to loan the Black Team some money when they had no cash their portfolio. Murray smiles: "It was a bailout."