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Professors explain how Wall Street affects Main Street

September 25, 2008

With $700 billion of taxpayer money on the line, Americans really want to understand what their money is being used to accomplish. With Congress now considering a massive plan to bail out key companies on Wall Street, people on Main Street are asking for answers about how this will impact them.

“For the man on the street, you’d better hope this works,” says Professor Anthony Sanders of the W. P. Carey School of Business at Arizona State University, former director and head of asset-backed and mortgage-backed securities research for Deutsche Bank in New York and an expert who has testified about Fannie Mae and Freddie Mac to the U.S. Senate Banking Committee. “If this doesn’t work, it could mean grave consequences for remaining banks and will eventually trickle down to layoffs.”

Sanders says that without this help, the housing market would likely fall further, and mortgages would be very expensive and limited to those with great credit. He says that’s why this bailout package is vital for the average American.

Professor Herbert Kaufman, a former economist with Fannie Mae in Washington, agrees with his W. P. Carey School of Business colleague.

“It’s impossible for all of this Wall Street disruption not to spill over into commercial and regular business markets, stifling some economic activity,” says Kaufman, who has consulted for the New York Stock Exchange, commercial banks, savings and loan associations, and government agencies, including the U.S. Treasury, the World Bank and the Congressional Budget Office. “If we don’t act, then we’re in for fallout into the real sector of the economy, which could exacerbate the current slowdown and make it last longer.”

Both professors agree that if Fannie Mae and Freddie Mac had not been saved, then the mortgage business -- and therefore the housing sector -- would be in much worse trouble right now. Sanders adds the AIG bailout had to be carried out, too, because the company’s failure would have triggered other major financial problems.

“This was a systemic risk issue,” Sanders says. “I disagree with bailouts in principle, but we can’t sit here and do nothing and have a massive meltdown of the financial system. They had already tried infusing capital into the system and tried taking over Fannie and Freddie, and they still needed to stabilize the market.”

Both Sanders and Kaufman agree one major reason for the recent problems is that too much credit was extended.

“What Main Street has to recognize is that the reason normal folks had so much access to credit on good terms over the last several years is because of this aggressive activity by banks and the financial structure,” Kaufman says. “Although lower interest rates and easier credit were beneficial at the time, excesses built up and created the basis for the ultimate collapse now. The actions by investment banks have now led to difficult borrowing conditions. We can expect slower economic growth and a longer, deeper recession.”

Kaufman says to also expect greater scrutiny of auto loans, credit card applications, mortgages, small business loans and more.

Sanders says that, in addition to the bailouts, more needs to be done to prevent this from ever happening again. New regulations have to be put into place, and some current legislation needs to be changed.

“We need to put politics aside and get rid of some popular legislation like the Community Reinvestment Act, which was created under President Carter and strengthened during the Clinton administration,” Sanders says. “This measure was aimed at encouraging subprime loans in underserved neighborhoods. However, giving loans to those who couldn’t afford them is part of the problem, and this measure isn’t really needed anymore. Less than 1 percent of homes in the U.S. are at a substandard level, and home ownership is at a record high level.”

Sanders says Congress needs to learn from this situation and start better oversight of Wall Street. However, it’s imperative that lawmakers not interfere too much with the free-market system that America was built on.

“Even in a football game, we have referees to determine what’s fair, but not to determine the outcome of the game, so regulation should not be used as a weapon to remove competition, but to protect the free market and make sure one side or the other doesn’t get an advantage in the game.”

W. P. Carey School of Business Dean Robert Mittelstaedt, Jr., says that overall, this problem is not just about bailouts and regulation, but also about the need to stop the new American culture of risk. He has written a book about companies repeating mistakes to their detriment and believes that huge amounts of risk-taking led both America’s financial system and American individuals to this point.

He says, “We have now put our economic freedom and standard of living at risk with unrealistic and dangerously under-regulated risk-taking that has become a societal disease. Corporate behavior is a reflection of our broader culture and societal norms, and individuals have become more risk-prone, as well. Consumer debt levels have reached new highs as we are consumed with the desire to risk it all for an affluent lifestyle.”

This is the type of risk-taking that all Americans will likely now pay for, in the form of $700 billion in bailouts.