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Economy chat with Peter Cohan

September 19, 2008
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Peter Cohan, a management professor at Babson College, took readers' questions about the economy, stock market, and turmoil in the banking industry. Here's a transcript of the discussion.

Normal View TitleBoston_com_Moderator: In response to developments in the banking industry and economy this week, we're holding a special chat today. I would like to welcome Babson professor Peter Cohan. Thanks for joining us, Peter.

T_S___Guest_: How is anyone supposed to know what to invest in in this situation? Is everything insecure?

Peter_Cohan: It is an honor to be here. In this situation there are varying levels of insecurity. I think that depositing money in accounts under $100,000 with a highly profitable FDIC-insured bank is a good bet for preserving your money.

Peter_Cohan: Some people will make out well taking a risk on buying financial stocks that have tumbled in recent months. But that is a far riskier option.

Risox__Guest_: Hi Mr. Cohan, thanks. While the current credit and banking issues on Wall Street are obviously bad, other than the employees of these firms, are average Americans really getting substantially "injured" if they are forced to shut down? Investments managed through these co's are insured through SIPC and investors in these companies surely aren't guaranteed anything. Seems they should be left to fail and it will strengthen the industry long term. Thoughts?

Peter_Cohan: The answer to that is a big unknown. The problem is that the government has not been following a clear set of criteria for deciding which institution to bail out and which to let fail. We really don't have much of a say in what the government is doing -- but it seems financial institutions can fail without causing a financial catastrophe while others will bring down the global financial system if they cease to operate.

Peter_Cohan: If the government's estimate of the damage is right, then perhaps it did the right thing when it decided to bailout AIG, Fannie and Freddie.

Peter_Cohan: But there is no way of knowing whether it would have been better for the government to let them fail as Lehman did.

deborahsue88__Guest_: as long as all my bank account are "FDIC" insured, do I have anything to worry about? As long as I keep less than $100k in each account there should be no problem, right?

Peter_Cohan: There is no problem as long as the FDIC fund remains solvent. It has about $45 billion and some have suggested that more banks will fail. If enough fail, then the FDIC will need to find a way to replenish that fund.

Peter_Cohan: So if you have an account under $100,000 and the bank is profitable, then it is less likely to fail and it won't need a bailout.

Peter_Cohan: So check to see how your bank is doing financially and if it's profitable, you have little to worry about.

kevin_2__Guest_: Peter, after reading all the reports about this, I only really have one question. How is the government paying for all this? Is the US just borrowing more money to add to the national debt? If so it seems like we adding to the inevitable amount we will need to pay back.

Peter_Cohan: The government is paying for this by issuing more government bonds. This will cause the national debt to increase dramatically. It was $5 trillion in 2000 and it is now close to $10 trillion. That figure will probably increase by around $2 trillion.

Peter_Cohan: We are creating a temporary delay in dealing with the problem. To put this in some perspective, the Resolution Trust Company was established by the first president Bush to bail out the S&L industry. It bought $225 billion worth of its bad assets and sold them for $140 billion. The net cost to taxpayers was $85 billion.

Peter_Cohan: This is the kind of thing the government is trying to do now.

T_S___Guest_: Thanks for your answer. But do you really mean a person who has savings should just put it in a bank account now rather than investing it....everyone has been saying invest in diversified stuff and stocks are for the long haul. Has that changed?

Peter_Cohan: I can't give you financial advice but if you are concerned about not losing your money, I think there is a case to be made for putting it in the safest place you can find until it becomes clearer where the bottom is with this financial situation.

Peter_Cohan: Some people will pick the bottom and ride it up -- but I am not smart enough to know where that is.

ACG__Guest_: Should people who have steady jobs spend money to go on vacations and so forth? I'm concerned that if the economy tanks, they may get laid off and find themselves wishing they had not gone on the trip because they need the money. I'm a software engineer, and although I feel pretty secure there's always the threat of being outsourced to India at a moment's notice.

Peter_Cohan: I think people should try to build up their savings at this point. There is a chance that companies will have more trouble borrowing money thanks to this credit crunch. And that could force companies to cut costs. If a person gets laid off from a job, it is good to have at least six months and probably 12 months worth of savings.

Peter_Cohan: So cutting back on discretionary expenses makes sense.

Richard__Guest_: Call me crazy, but why doesn't it seem stupid that the government is the lender of last resort and that the taxpayer is essentially lenging their money to people that banks won't lend to otherwise?

Peter_Cohan: You're not crazy. But government can print money and no other institution can. The simple reality is that it is too late for good solutions -- there is only a choice between terrible and catastrophic. Our government seems to be choosing terrible.

Worried__Guest_: Hi Peter, how do you think all these bailouts and mergers are going to affect companies in Boston? I'm starting to worry that our weakening presence in the financial industry will get weaker.

Peter_Cohan: The situation in the financial services industry could get bad for employees. For instance Putnam just closed down a money market fund yesterday. The mergers of investment banks is likely to reduce demand for financial services workers and throw more of them on the street in search of employment. If the government measures restore confidence in the markets, then the problems will be short-lived.

Peter_Cohan: Otherwise, we could see a weakening in our financial industry.

chat__Guest_: Is any of this mess effect money market funds? I understand I understand there is no federal insurance around them

Peter_Cohan: The government announced today a $50 billion fund to back stop money market funds. This means that if a firm's money market fund experienced big withdrawals, the government would step in. There is $3.4 trillion in money market funds so that $50 billion is a tiny percent. I hope it will be enough. But it depends on the number of funds that owned debt from firms like Lehman that went bankrupt.

JP__Guest_: How is the government rationalizing that a hedge fund's short position on a company is driving the market down?

Peter_Cohan: The government banned shorting for 10 days because it thinks that this practice has been forcing investment banks to merge or go bankrupt. Some hedge funds have been pulling their money out of these investment banks -- which hurts their business -- and then shorting their stocks. This has contributed to their weakness and the government has shut them down.

wanttoknow__Guest_: I would like to know the "primary" reason for the mortage meltdown, backed by facts if possible: Is it mainly due to bankers overselling to lower qualified folks of their own volition, or is it government's insistence on lenders lending to people with higher-risk profiles on the grounds that to do otherwise would be racially prejudiced?

Peter_Cohan: The primary reason is that banks lent money to people who could not afford to pay it back. For starters, $1.3 trillion worth of subprime mortgages were issued and at least half of those were so-called no documentation loans. That means that people could overstate their income to get the loan. The lenders figured that if the borrower defaulted, they could sell the house at a profit and get their money back.

Peter_Cohan: These subprime mortgages were bundled together in packages -- called mortgage backed securities -- by investment banks. The investment banks paid ratings agencies to give those MBSs AAA ratings. This made them seem safe to investors around the world.

Peter_Cohan: But those investors borrowed way too much money to buy the MBSs -- for every $32 dollars worth of MBSs they had only $1 worth of capital and they borrowed the rest. When the market for MBSs dried up, their capital was wiped out by the drop in value of the MBSs.

jitters__Guest_: In reference to your point about taking money out of stocks and move to bank account or under the mattress, doesn;t that futher impact the situation?

Peter_Cohan: I am not necessarily advising to sell all your stocks. I do think that if you have any extra money, I would put it in a bank account rather than stocks at the moment.

Peter_Cohan: If everyone sold their stocks, that would make the situation worse.

wanttoknow__Guest_: Based on your answer to another question "government can print money" - will this either necessarily or likely lead to higher inflation?

Peter_Cohan: Yes it is likely to lead to more inflation. But Ben Bernanke, who is a Great Depression scholar, no doubt believes that the Great Depression was made worse by the lack of money supply. He is erring on the side of providing too much money. But the simple fact is that there is a good chance that having all that extra currency will devalue it.

Erica_L___Guest_: What do you see needs to be done to turn the crisis around? Do you think this will clean itself up as the markets did after the 1987 and 2001 crashes? Or do you think we have a larger issue on our hands where the downturn will be harder to recover than in the past?

Peter_Cohan: We have a much larger issue on our hands than the dot-com bubble. That's because the dot-come was primarily an equity bubble and this is a debt one. Debt it more costly to the economy because it has to be paid back, at least in part. Nobody had to pay back the people who lost value in their Internet stocks.

Chad__Guest_: Hi Peter. I am looking to purchase a multi-family home within the next year or so and I was wondering what yourmarket outlook is as far as ral estate prices are concerned. Obviously it is a buyers market currently, but I was wondering if you think real estate prices will continue to fall and how long this drop in prices will continue. Essentially, I am looking to buy when real estate prices are at there lowest point. Thanks.

Peter_Cohan: I don't know where real estate prices will bottom out. I remember buying at a peak in 1986 and the prices kept dropping for six years -- finally coming back around nine years later.

Peter_Cohan: I don't know if history will be any guide here but I suspect it will be worse than that this time.

Peter_Cohan: Having said that, all real estate is local and the local conditions for that property will have alot to do with where the bottom is.

Wizard__Guest_: Mr. Cohan: The way the market reacted over the last 2 days you'd think: "Happy Days are Here Again." If it is so easy for the Government to step in and cure the problem, why hasn't it done so in the past? Also, isn't the nationalization of Fanny and Freddy, AIG and banking bad debt something that would be done by Chavez in Venezuala?

Peter_Cohan: The market's reaction in the last two days may be due to short covering.

Peter_Cohan: When a trader shorts a stock, he or she must borrow the shares to sell them at the then-current market price. Eventually the short seller must repay the stock loan by buying the shares back -- hopefully at a lower price.

Peter_Cohan: But when the SEC banned short selling this morning, this probably forced many short sellers to go into the market and buy in a big hurry to close out their positions. This creates a buying panic as the rising prices force more and more shorts into the market to cover their positions.

Beaver__Guest_: How would you compare today's market tribulations to those of the early 80's? What are the similiarities and differences?

Peter_Cohan: The early 1980s were the beginning of an 18 year bull market that lasted from 1982 to 2000. Now we are in a period of extended contraction -- but it is very hard to know how bad it will be at this point.

Babson2006grad__Guest_: What is causing the break down of money market funds in your opionion? Should we move cash away from these in our retirement packages?

Peter_Cohan: One money market fund broke down because at least one that I know of had invested in Lehman Brothers bonds that it determined were worthless.

Richard__Guest_: I have not read anything to the contrary but I am assuming that one can still buy Put options or sell Call Options if you have a negative outlook on a company or for whatever purpose you might have. Is that right?

Peter_Cohan: Yes -- it is still possible to buy puts or sell calls.

clicks__Guest_: Are local banks more solvent then the "big banks"? How are they tied into the larger banking system?

Peter_Cohan: It makes sense to look at a bank's financial statements. See if it's profitable, whether it has a big cushion of capital, whether it is maintaining a low level of chargeoffs and so on.

Peter_Cohan: In general small banks have been more conservative than big ones. But there are some small banks that took big risks getting into construction loans and they are in trouble.

Peter_Cohan: So being big does not necessarily mean trouble and being small does not necessarily mean safe.

BHO__Guest_: Do you see moral hazard with the government insuring money markets? Doesn't this benefit investors / managers who took excessive risk chasing yields? Could the gov't have preserved confidence in the system while still leaving these investors (not taxpayers!) on the hook for at least some of the losses?

Peter_Cohan: There is certainly moral hazard in any government bailout. But it is hard to see what kind of bad behavior on the part of a money market investor that the government is rewarding by bailing out money markets.

Peter_Cohan: The bailout is being done because withdrawing funds from money markets causes banks to stop lending to each other and that puts the global capital markets into freeze mode.

Domenic__Guest_: Do you think Lehman and Bear Stearns would have been saved if the SEC had acted sooner to restrict naked short selling?

Peter_Cohan: I think the cause of Bear Stearns' failure was that overnight lenders refused to renew its loans. The short sellers certainly profited from this but they did not cause it. They were withdrawing their money from Bear before shorting the stock.

Peter_Cohan: Lehman certainly could have managed itself better than it did -- the shorts may have done something similar there as well.

gooch__Guest_: As the old saying goes"Buy when there's blood on the streets!" Where are the greatest opportunites to invest in this market?

Peter_Cohan: I think there might be opportunities in financial stocks. But it is russian roulette. If you bought 10 financial stocks now, a bunch of them would go bankrupt. The ones that survive this might go down even further before recovering and going way way up from there.

Peter_Cohan: But I am not smart enough to pick the bottom.

TexCat__Guest_: Are FDIC insured credit unions a better place to put savings than banks at this time?

Peter_Cohan: Credit unions may well be safer in general -- I have not looked at their financial statements. But my hunch is that they are often set up for a company's employees and therefore the company has an incentive to make them very safe. So I would imagine that generally they would be better places. The definitive answer would come from analyzing their financial statements.

Boston_com_Moderator: We've run out of time today. I would like to thank Peter Cohan for agreeing to chat. Also, if you're concerned about how the economy might affect your investments, the Globe would like to talk to you. E-mail Jenn Abelson at abelson@globe.com to share your story.

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