Winter 2009

The Future of the Economy

Five Haas experts propose solutions for the current crisis

Robert Edelstein: A Long-term US Strategic Plan
John Quigley: Aligning Incentives in the Mortgage Business
David Vogel: Rethinking Corporate Social Responsibility
Andrew Rose: Reigning in US Borrowing
Ken Rosen: Fixes for the Housing Crisis

Robert Edelstein

A Long-term US Strategic Plan

The United States is confronting a set of challenges that require a multifaceted, coordinated approach to restore economic growth as well as domestic and international economic and political stability. While specific monetary and fiscal policy measures are already being deployed to achieve economic stability, the US also must develop and embark on a strategic plan to address longer-term national and international stability. Crucial components of the plan should include:

Universal Public Service

Every able man and woman — regardless of socio- ethno-economic background — should dedicate two years of public service to their country, such as military service, teaching in the inner-city, the Peace Corps, as well as the building and engineering of public facilities. This will engender an esprit de corps and solidify morale in the US. Universal public service would typically commence after high school, but could be deferred to age 26 for school or other legitimate reasons.

In the 21st century, it is imperative to have a well-trained labor force. Part of universal public service would provide on-the-job education to enhance each participant’s skills and ability to perform public service.

Military Rebuild

A strong military is a necessary social and political asset for the US. It serves as a deterrent yet is most successful when it does not have to be deployed. Its future use must be more carefully exercised than in the recent past. Universal Public Service can be an integral part of "re-staffing" the ranks.

International Globalized World Family

The US should nurture the economic development of less fortunate countries and peoples. Diplomatic (versus military) power combined with national generosity is needed to attain the moral high ground in this world and to restore the US to its rightful position of international leadership.

Two other components of the strategic plan already have been proposed by the Obama administration: energy independence and a national universal health care system.

An energy independence program includes economic incentives for the development and implementation of technology to reduce energy consumption and dependence on foreign oil. One important feature should be added: The US would share our new technological knowledge with other countries, particularly China and India, because global pollution control requires improved energy efficiency worldwide.

An important complement to universal health care, meanwhile, would be a functioning Social Security retirement system, which would provide real income stability and security for the elderly and retirees. While this agenda may seem daunting in scope and cost, elements can be phased in according to economic circumstances. With the restoration of US and global growth, the agenda’s costs will become feasible. Ultimately, the agenda would foster and promote international economic and political stability, benefiting us all.


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John Quigley

Aligning Incentives in the Mortgage Business

The global financial crisis began with a series of innovations in the mortgage business that led to fast-paced specialization. Unfortunately, each specialized party to the mortgage had fee-based compensation that motivated a large volume of transactions with little or no responsibility for the performance of the mortgages. Reform should focus on the compensation structure in the mortgage business and on accountability standards similar to those imposed on stockbrokers.

Bad compensation structures

The incomes and fees in the mortgage business are all transactions-based, with payments made when the transaction is recorded. The loan originator, typically a mortgage broker, is paid between 0.5 percent and 3.0 percent of the loan at the time the contract is signed. The mortgage lender earns between 0.5 percent and 2.5 percent upon selling the mortgage. The bond issuer is typically paid 0.2 percent to 1.5 percent when the bond is issued. All these fees are paid in full within six to eight months after the mortgage contract is signed by the borrower.

No party to the mortgage transaction — other than the borrower — has any economic stake in the performance of the underlying loan. With this structure of incentives, it is not hard to understand why many risky loans were originated, financed, sold, and securitized, especially with house prices rising rapidly from 1999 through 2006. There were certainly enough unscrupulous lenders and predatory borrowers, but the incentives faced by decent people made their behavior much less sensitive to the underlying risks.


In most cases, the solution is a matter of better aligning the economic incentives in this industry. Loan originators could be paid fees over the course of a two-year period after the transaction. Similarly, other actors could be paid a significant part of their fee after the loan performance is observed. And a clawback provision for fees advanced on nonperforming loans could be mandated. Finally, part of the fee to the rating agency could be paid in shares of the bond being issued — with a prohibition against sale for a reasonable period of time.

In addition, originators and lenders should be held to a “suitability standard” that requires them to take into account borrowers’ ability to repay the loan, similar to how the National Association of Securities dealers holds stock brokers responsible for recommending financially suitable investments for their customers. Stock brokerage firms that sell securities that are unsuitable for clients can face lawsuits and sanctions.

The Federal Reserve adopted rules in July that included a suitability standard for subprime mortgages, but they will not take effect until October 2009. More immediate straightforward changes to financial incentives in the mortgage industry would go a long way toward improving the efficiency in the market for mortgages and mortgage-backed securities.


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David Vogel

Rethinking Corporate Social Responsibility

The meltdown of financial markets has hit socially responsible investors particularly hard. Impressed by the social and environmental initiatives of firms such as Goldman Sachs, Wells Fargo, AIG, Bank of America, and Citigroup, socially responsible mutual funds held a disproportionate amount of the shares of these and other financial institutions. Unfortunately, the business practices that ethical funds so valued turned out to be of much less financial importance than the ones they overlooked. Perhaps economist Milton Friedman was right after all; maybe the most important social responsibility of companies is to advance the interests of their shareholders. Measured by this criteria, many financial institutions behaved extremely irresponsibly, making investment decisions that exposed their shareholders to unreasonable risks — and also harmed all of us.

There is an important, albeit rather expensive, lesson to be learned from the financial crisis: Firms can behave irresponsibly in ways never imagined by even the most critical student of corporate social responsibility (CSR). Moreover, the negative social impacts of financially irresponsible decisions have turned out to be much more substantial and far-reaching than those of even the most socially or environmental “irresponsible” firms or industries. Clearly, what is urgently needed is a broader definition of CSR that includes a major focus on how well a firm performs its basic mission of maintaining and creating wealth. Combating climate change and promoting community development in poor countries are well and good, but they cannot be a substitute for managing shareholder resources prudently.

What I find most striking about the financial meltdown was the unwillingness of virtually all financial institutions to take advantage of the highly sophisticated instruments for assessing and hedging risks that so many smart and sophisticated scholars and practioners had developed. Such firms may not have behaved unethically in the narrow sense of violating any law. But their managers proved to be vulnerable to three of the most common causes of unethical behavior:

1. Herd mentality: If everyone else is doing it and getting rich from it, why shouldn’t we also give subprime mortgages to people regardless of their credit risk and then leverage our assets to purchase as much debt as possible?

2. Compensation schemes that reward executives — in this case traders and other financial managers — for short-term gains, leaving others to pay the price if their decisions turn out disastrously.

3. Lack of accountability due to a diffusion of responsibility: The original mortgage lenders were not accountable for the risks they spread throughout the financial system.

The financial crisis should challenge us to rethink the ways we teach CSR and ethics. We now need to include cases and material on financial risk management to make students understand what it means to be a responsible steward of other people’s money and how easily managers can be blindsided. We need to teach students why it is both socially and financially irresponsible to sell products to people who cannot afford them. And we need to alert students to the moral hazards of developing, buying, and selling financial instruments that are almost impossible to understand.


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Andrew Rose

Reigning in US Borrowing

While US lawmakers are now rightfully focused on pulling the economy out of a recession, another potential financial crisis looms longer-term if the government and consumers do not change their behavior.

The US has amassed an unsustainably large current account deficit — a huge gap between exports and imports that results in larger amounts of capital flowing into the US than capital flowing out. Sooner or later these American borrowings will have to be returned, with interest. The US cannot continue living unsustainably vis-à-vis the rest of the world.

Only an increase in savings among US consumers and the government, combined with a depreciation of the dollar, will close out the current account deficit and avert a future crisis.

When the financial crisis erupted last summer, the US current account deficit totaled more than 5 percent of Gross Domestic Product — significantly surpassing the 3 percent threshold widely viewed as acceptable by economists.

Before the crisis, the current account deficit was slowly narrowing as the dollar depreciated, making imports more expensive and exports more attractive overseas. However, last fall, the financial crisis triggered a surprising rise in the US dollar as investors flocked to US Treasurys as a safe haven, which in turn widened the current account deficit.

In fact, a huge infusion of overseas capital into the US was one major contributor to the financial crisis in the first place. Asian countries such as China and Gulf states such as Saudi Arabia invested trillions of dollars in the US, helping to drive down interest rates and fueling a so-called "hunt for yield" that led to mortgage-backed derivatives and the housing bubble.

After the economy has started to recover — whether in six months or two years — the dollar inevitably must depreciate in order to close the current account deficit. We need to spur our export growth and slow imports; the easiest way for the market to do that is for the dollar to depreciate. But that's going to be painful because Americans like to consume imports, whether they're plasma TVs from China or clothing from India.

US consumers and the government alike also will have to start saving more to bring the current account to a sustainable level.

These days, the idea of the US government saving may sound unfathomable, but it’s not unheard of. During the last four years of the Clinton administration, the government was actually saving money and the US had a budget surplus. But when Clinton raised taxes in 1993, a recovery had already been under way for a year. We must wait for a recovery before taking such actions to address the current account deficit.

Similarly, we don’t want US consumers to start saving all of a sudden because that would deepen the recession. During the housing boom, however, consumers confidently believed they didn’t need to save at all because their houses and stock values were going up. Now that they have suffered painful losses, consumers are already realizing they must, in fact, save more. Their futures, and their retirements, depend on it. And so does the future economic strength of our country.


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Ken Rosen

Fixes for the Housing Crisis

An economic recovery hinges on solving the housing crisis. Housing has led the economy out of every recession since World War II and can do so again through the following three policy initiatives:

These initiatives would address three interconnected problems in the housing and mortgage markets: 1) rising foreclosure and delinquency rates on poorly structured mortgages given to high credit risk borrowers; 2) continuing house price declines in the 20 percent range nationally; and 3) a collapse in new house construction, a sharp decline in existing home sales, and a large inventory of unsold homes.

To address these problems, our economic stimulus policy must focus on the housing consumer.

First, we must declare a six-month moratorium on owner-occupied foreclosures while a new comprehensive federal plan is put in place. Second, all borrowers who are facing foreclosure or are 90 days delinquent on their loans must be allowed to refinance into a new 4.5 percent fixed-rate mortgage funded by Fannie Mae, the Federal Home Loan Mortgage Corp., or the Federal Housing Administration.

Homeowners who still cannot afford such lower payments must be offered other options, including an extended mortgage term, a graduated payment fixed-rate mortgage, or the ability to give up ownership and rent their house with the option to repurchase it in a set period of time.

When a home’s value has fallen substantially below the amount of the mortgage, the mortgage amount might be reduced and a shared-appreciation second mortgage added, in which the bank or government would share on a 50/50 basis any house price appreciation above the new mortgage amount.

To stimulate consumer demand for housing, 5 percent to 10 percent down-payment loans, which require private mortgage insurance, must be more widely available. Each of the five biggest private mortgage insurance companies could issue $1 billion of convertible preferred stock to the US Treasury to insure $250 billion in new low down-payment loans.

Finally, a 10 percent tax credit, up to a maximum of $22,500, should be created for buyers of a new or foreclosed home for owner occupancy or any first-time home buyer in 2009. Such a tax credit combined with a mortgage buy-down plan successfully stimulated a housing market recovery in the 1974–1975 recession.

In addition to enabling millions of Americans to avoid losing their homes and jump-starting new home construction, these proposals will prevent further meltdown of our financial markets.



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The Future of the Economy



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