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Finance expert discusses crisis in banking industry

The sub-prime mortgage crisis has sent the banking and financial services industry into a downturn that has caused the collapse of some of Wall Street’s perennial heavyweights and the subsequent $700 million government bailout of the nation’s financial markets.

To provide some insight into the state of the banking industry Knowledge Link sat down with banking expert G. Andrew Karolyi, the Charles R. Webb Designated Professor of Finance.

KL: What are some of the key initiatives that need to be implemented to turn the industry around and get the bad securities off the books of these institutions?

Karolyi: First and foremost they have to get an accurate evaluation of the non-performing loans and troubled assets that are on their books. Once they have a clear sense of the intrinsic value of these assets then they can decide strategically how to dispose of them. Clearly in a distressed form they are going to have to make some concessions.

Then, the banks can strategically dispose of them and write them down or absorb them into other entities. In the next 12 to 18 months, there maybe some form of consolidation in a lot of banks, especially those with regional footprints. Part of the asset disposable process will swallow them up into other entities where some banks will buy other banks as well as buying other assets.

KL: What effect will the government bailout of Freddie Mac and Fannie Mae have on investors?

Karolyi: The bailout plan was an extraordinary rescue package that will likely go down as one of the most expensive bailouts in United States financial history. The markets have been waiting and wondering for some time about the extent to which the implicit “too big to fail” promise for Fannie and Freddie was good. On Sept. 8, we saw a positive resolution of uncertainty, especially among financials.

With $5.5 trillion worth of U.S. mortgages on the line, it is hard to have imagined any other course of action. But, my worry is there will be a sober hangover from the euphoria when we learn to what extent this is going to burden taxpayers in the long run. I am also curious as to what will happen when the two institutions start tapping freely into their respective $100 billion facilities and the next wave, if any, of mortgage-related write-downs arrive on our doorsteps.

KL: Private equity firms and hedge funds have been very active while banks have been hurting financially, how will this change these corporations?

Karolyi: That is an interesting dynamic, because we do not always know who these investors are. We are seeing private equity investors identify really interesting opportunities that are almost potentially taking advantage of the fears and anxiety a lot of investors have in these banks. They are seeing an opportunity to step in and take large positions where they would not otherwise. You wonder how much this is going to change the face of these organizational structures. The fact that these large potentially active private equity investors are trying to exert some control on these banks is something that we really haven’t experienced and don’t really know what kind of dynamic will stem from that.

KL: In the end, what effect will this crisis have on consumers and firms who want to borrow money?

Karolyi: One of the counter-arguments to consolidation is it creates scale economies that lower the cost of providing services. Many customers fear that services will not be provided as effectively as they would otherwise because it is a way to save money or that certain regions will not be accommodated. I think that there is too much competitive pressure in this industry for the services to fall off too far.

Banks retrench in down phases to prepare themselves for the up phase in the economy. If you can image seeing through the downstage of the economic cycle we are in now, try to imagine for an intermediate term what the consequences will be for consumers and depositors of banks. I don’t see that they are going to suffer from any of this consolidation or the terms and conditions in which loans are being extended.