[DEBATE] : Siegel in WSJ - The Resilience of American Finance

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The Resilience of American Finance
By JEREMY J. SIEGEL


The turmoil in the financial markets will reorganize the financial  
landscape. But this does not mean the financial industry will shrink  
dramatically. In fact the current crisis could well lead to an  
increase in the demand for financial services, as the world grapples  
with the need for new financial instruments, new risk management  
techniques, and the increasing complexity of the financial world.
[The Resilience of American Finance] Getty Images

There is no doubt that some of the most hallowed names in the  
industry, such as Bear Stearns, Merrill, Lehman and others will  
disappear as separate entities. Their demise was caused by bad risk  
management, and a failure to understand the high risks of an  
overheated real-estate market, the root cause of our current problems.

We can argue about who was responsible for the overleveraging of the  
financial industry and the poor to nonexistent credit standards that  
prevailed in real estate. Certainly the regulatory agencies, including  
the Federal Reserve, should have sounded a warning. But the lion's  
share of the blame must go to the heads of the financial firms that  
issued and held these flawed credit instruments and then, in many  
cases, "doubled down" by buying more when their price was falling.

Overleveraging has been the cause of many past financial crises, and  
will undoubtedly be the cause of those in the future. It was the cause  
of the 1998 blowup of Long Term Capital Management, where the Fed also  
intervened to prevent a crisis. Then two years later the tech and  
Internet boom burst. If banks would have been allowed to buy on  
leverage these stocks during the bubble, they would have been in even  
more trouble than now.

But few were willing to admit that subprime real-estate loans could be  
as risky as stocks. It was just too profitable to issue these  
mortgages. So eyes were closed and the money kept pouring in.  
Groupthink prevailed. To paraphrase John Maynard Keynes, it is much  
easier for a man to fail conventionally than to stand against the  
crowd and speak the truth.

There is no doubt in my mind that if we didn't have a proactive  
Federal Reserve and deposit insurance, we would have been following  
the same course as we did in the 1930s, when the bursting of the stock  
bubble and fear of loan defaults led to thousands of bank failures and  
ushered in the Great Depression.

That will not happen this time. The rapid provisions of liquidity by  
the Fed will prevent any full scale downturn. In fact, I take it as a  
mark of confidence in our financial system that the Fed did not feel  
compelled to bail out Lehman Brothers as they did last March when they  
folded Bear Stearns into J.P. Morgan. Certainly politics played a role  
in this election year, as critics (and some Congressmen) criticized  
the government for bailing out the big boys, while letting homeowners  
twist in the wind.

Despite the recent turmoil, there is good evidence that the worst is  
over, especially for the commercial banks with access to Federal  
Reserve credit. Despite yesterday's severe sell-off, most are  
significantly higher than their July 15 low, and some such as Wells  
Fargo and UBS are up over 50%.

Nevertheless, the current crisis will change the financial landscape.  
Certainly Bear, Merrill, Lehman and others will disappear as separate  
corporate entitles. But other institutions, specifically the  
commercial banks that absorb these firms, and who have direct access  
to Federal Reserve credit, will become larger.

The demand for financial services will in no way disappear as the  
automobile pushed out the horse and buggy a century ago. Although  
unemployment on Wall Street will undoubtedly rise, many workers will  
be reabsorbed elsewhere in the industry. The current financial crisis  
calls out for new products and services as well as more, not less,  
information about what is safe and profitable in the future environment.

It is easy to be pessimistic about the future of financial services in  
the current climate. But objective facts indicate that the future  
demand for these services will be high. Looking beyond past losses,  
the demand for financial services, especially internationally, has  
been strong. The growth of the developing countries, combined with the  
aging in the developed countries, will lead to huge international  
capital flows that will be facilitated by new and existing financial  
intermediaries.

It is shocking that firms that withstood the Great Depression are now  
failing in what economists might not even call a recession. But their  
failure was not caused by lack of demand for their services. It was  
caused by management's unwillingness to understand and face the risks  
of the investments they made. The names of the players will change,  
but the future growth of the financial services industry is assured.

Mr. Siegel, a professor of finance at the University of Pennsylvania's  
Wharton School, is the author of "Stocks for the Long Run," now in its  
4th edition from McGraw-Hill.