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Charter Trustee Richard Bernstein '80, chief investment strategist at Merrill Lynch, detailed the anatomy of the credit bubble during a lecture on Sept. 27, organized by Professor of Economics Chris Georges. According to Bernstein, the fear of deflation at the turn of the century led central banks to provide record amounts of liquidity by decreasing key interest rates, namely the Fed funds rate. The latter, coupled with increased Fed transparency caused investors to become less risk-averse, a scenario which left no asset class starved for capital with the effect of reducing returns.

Then Bernstein explained the concept of leverage and its growing use in mergers and acquisitions, home sales and even private equities and swaps. According to him, the incentive is the increased availability of cash on the part of lenders with a bigger appetite for risk, and the decreasing rates of return to capital on the side of borrowers. Since returns are calculated on a cash-to-cash basis, investors can transform a 10 percent rate of return into a 100 percent return by using leverage.

Specifically, Bernstein commented on the use of subprime mortgages in an environment of low-perceived risk. Mortgage lenders would provide loans at low interest rates to relatively unqualified households to purchase a home they could not otherwise afford. Lenders would keep the origination fees and then combine a group of risky mortgage loans into a package with a low probability of default, and sell it to investment banks, which in turn pass it on to hedge funds. With the unassumed decline in home prices, households started failing to make their mortgage payments and eventually defaulted and faced foreclosure. Similarly, hedge funds exposed to mortgage-backed securities were hit by the low-probability high impact event of all bad loans defaulting at the same time, thus incurring substantial losses. 

Bernstein reiterated our moral commitment to expanded home ownership, adding that the answer is not that "everyone should own a home," rather "everyone should afford a home." He also expressed concern over the continued decline in home prices and the rise in home inventories, but remained confident that household unemployment is ultimately the determining factor behind the decision to hand in the keys.

At the macroeconomic level, Bernstein blamed irresponsible monitoring of fiscal policy along with the Chinese currency peg for the large budget and trade imbalances, without exonerating the low savings rate here at home. He dismissed claims that the trade deficit can be closed by following a strategy of weaker dollar, insisting that the U.S. has very little left to sell to foreign countries.

At the end of his talk, Bernstein predicted an increase in the risk premium on investments. If his prediction is correct, this would create a situation in which the performance in capital-intensive industries such as energy and consumer goods would be negatively affected. Chinese and other emerging economies that rely heavily on capital-intensive manufacturing and industrial infrastructure would also be hurt.

Finally, in answer to a question regarding the latest Fed easing of 0.5 percent,  Bernstein said it was a risky move that has already caused inflation expectations to rise. At the same time, it was well-grounded in the credit crunch and the decline in the housing market. He added that housing is the front of the economy, so a weakening in the housing sector is felt across many others such as furniture and home improvement through the multiplier effect. Ultimately, according to Bernstein, investors hope that we are not replaying 1989 when it took more than 18 months for asset values to pick up again after their slump. 

-- by Tamim Akiki '08

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