This Too Shall Pass

Dungan explained that the differences between the financial and real economies are important, as they frequently display differing behaviour. While both are subject to cycles, he said, financial cycles are becoming more volatile and real economic cycles are trending downwards in length and scope.

The real question, according to Dungan, relates to the severity of the credit crunch. He suggested that the problem lies in the space between lenders and borrowers, especially home buyers and small businesses. He insisted there are many willing borrowers and lenders who are only suffering from a lack of credit, which makes him optimistic about a recovery.

“I am confident that within a few quarters, the financial system will work its way out of this,” he said, adding that both the U.S. Federal Reserve and Bank of Canada are on the case.

Professor of finance John Hull offered his take on the mechanics of the derivatives which lie at the heart of the crisis, and said that the securitization market requires a rebirth through a new attitude towards accountability.

Explaining that the lenders who sold these securities were “only out to make a quick buck,” Hull suggested that originators of assets that are to be securitized should be required to keep a certain percentage of all the tranches, not just the equity tranche.

“What we want to do is align the interests of originators with investors,” he said. “Otherwise, the securitization market will never get going again.”

Hull said the current compensation structure in most financial institutions requires revisiting, and pointed to the myopia that dominated the industry in 2006 when lenders continued to sell subprime mortgage-based securities despite the imminent bursting of the real estate bubble. “Why? Because you were just interested in your bonus at the end of year 2006,” he said. “As long as the market didn’t blow up in 2006, you were OK.”

An alternative, according to Hull, is eliminating short-term performance bonuses and creating new goals. He suggested five-year performance plans, which would create longer-term horizons for decision-making.

He also advocated for improved risk management, pointing out that during good economic times, people tend to ignore this aspect of the business. He described two risk managers at Merrill Lynch who tried to raise the alarm about that firm’s exposure to the real estate market. “Those two were very vociferous in talking about the risk inherent in Merrill’s portfolio,” he said. “Nobody listened to them.”

To comment on this story, email jody.white@rci.rogers.com.