Spatt predicts future of the U.S. economy

Chester Spatt, a Tepper School of Business professor and, incidentally, one of the few people to have paid David Tepper $5 an hour (when Tepper was his TA), returned to Carnegie Mellon after a three-year term as chief economist of the federal Securities and Exchange Commission. At a lecture Wednesday, Spatt spoke on systemic risk and the economy in a presentation to the Undergraduate Finance Association.

The last several months have been chaotic in the stock market.

The Dow Jones Industrial Average, one stock market indicator, rose to a record 14,000 points and beyond in July. Friday, the Dow closed at 13,176.79. Two hedge funds, owned by the venerated investment bank Bear Stearns, collapsed. According to a Bloomberg article, Bear Stearns injected $1.6 billion into one of the funds, the largest hedge fund bailout in nearly a decade.

Many universities, Carnegie Mellon among them, invest their endowments.

Information about Carnegie Mellon’s investing strategies can be found at (http://www.cmu.edu/giving/planned/q_and_a.shtml#5). Eighty percent of the endowment is aimed toward growth, while 20 percent is invested in fixed-income investments. Of the 80 percent, half of that is invested in American equities (stocks) and 15 percent is invested in international stocks.

Edward Grefenstette, Carnegie Mellon’s treasurer and chief investment officer who took office in April 2007, said, “Notwithstanding the recent market turbulence, the endowment has also posted positive gains during the first four months of the current fiscal year [beginning in July], again showing the benefits of a well-diversified portfolio.”

According to the university’s website, “Strong performance in some markets often helps to offset weakness in other markets. The limited degree of performance correlation among markets stabilizes the overall return of the endowment.”

For the fiscal year that ended June 30, Carnegie Mellon’s investments returned 20.4 percent.

The National Association of College and University Business Officers ranks endowments and compares growth rates each year, but has not released the 2007 figures yet. In 2006, Carnegie Mellon had a 12.2-percent increase in its endowment, compared to 13.5 percent and 18.4 percent for Harvard and Yale, respectively. MIT at number six posted one of the largest increases at 24.7 percent.
When companies have poor profits in a quarter, they often tighten their belts and cut their sponsorship of the arts and special projects.

“A corporation’s first obligation is, of course, to their shareholders and their employees,” said Ellen Sheppard, director of external relations for the Pittsburgh Opera. "In prosperous times, corporations are inclined to share their good fortune with the community through increased support of community organizations; conversely, in challenging economic times, we should be sensitive to any belt-tightening in the corporate world and adjust our expectations accordingly.”

In his lecture, Spatt spoke about systemic risk and how hedge funds — and banks — got themselves into trouble and triggered the summer credit crunch.

Spatt said that markets currently are illiquid, meaning lots of banks and investors have lots of money in assets that have lost value and that they cannot sell without losing a bundle. In fact, illiquid markets became even more illiquid as banks sold off the assets that were easy to sell rather than the assets that were difficult to sell.

The effect of the illiquid market was that credit dried up over the summer and loans were difficult to get, even for people with good (prime) credit.

Many of these assets that lost value are subprime and variable-rate (in which the rate starts out low and then jumps later) mortgages. Millions of Americans with poor credit received mortgages from companies like Washington Mutual and Countrywide Financial.

“From what I’ve heard, it’s basically like a very slow downfall that’s occurring,” said senior business administration major Jyoti Joshi. “Even though this thing started a few months ago, people are just beginning to default on their mortgages now, and many more will default in the next few months.”

The credit ratings of these people and many companies’ non-discriminatory lending practices failed to reflect the riskiness of these mortgages.

“While painful, some of the mispricing in the credit markets had to be corrected at some point, which means that, going forward, there should be more logical pricing of risk,” Grefenstette said.
Grefenstette’s remarks echo those of Federal Reserve Chairman Ben Bernanke, who told Congress Nov. 8, “To be sure, the recent developments may well lead to a healthier financial system in the medium to long term.”

Those who predicted Americans wouldn’t be able to pay their mortgages, though, prospered.

According to Forbes magazine, “Money manager John Paulson joins the list [of American billionaires] after pocketing more than $1 billion short-selling subprime credit this summer.”

Also, the falling value of homes has hurt Americans and companies alike.

New York’s attorney general is going after firms that appraised homes above their actual value at the urging of Washington Mutual.

Many hedge funds and banks ate up the subprime credit, a risky move.

Spatt said that those who actually bear this risk are obscured by hedge funds. Banks use portions of customers’ deposits to give loans to individuals and businesses. Hedge funds were known to make the big money (billions of dollars) but take larger risks.

However, many banks funded hedge funds, and so when hedge funds gambled and lost, so did banks like Citigroup, Bank of America, and JP Morgan Chase. “Channeling transactions to hedge funds reduces transparency of risk bearing,” Spatt said.

The credit troubles have spilled into the general economy.

“While it was widely believed during the summer that this credit crisis might be relatively contained, it has, in fact, spilled over into other markets, both in the U.S. and abroad,” Grefenstette said.
Bernanke predicted that the economy will slow due to the credit problems, among other reasons.

“Overall, the committee expected that the growth of economic activity would slow noticeably in the fourth quarter from its third-quarter rate,” he said. “Growth was seen as remaining sluggish during the first part of next year, then strengthening as the effects of tighter credit and the housing correction began to wane.”

Many investors clamor for more Federal Reserve cuts, but Spatt thinks that “downside protection” encourages risky behavior.