I’m shocked. I’m outraged. I’m going to throw a rock.
As I’m writing this, thousands of protestors in London are venting their anger at the world’s financiers, hanging effigies of besuited bankers and smashing bank windows. While the Metropolitan Police will undoubtedly do their best to quell the violence, no one is expecting any G-20 leader to offer up a defense of the world’s bankers.
Indeed, last week U.S. legislators seemed positively eager to stoke the fires of populist rage, as they strained to out-do each other in expressing anger over AIG’s $165 million bonus pool. Given AIG’s starring role in the current crisis, the proposed payouts were gross and unwarranted. The feeble defense offered by AIG’s chief, Edward Liddy—that the bonuses were necessary to retain employees who “knew the contracts”—seems tantamount to blackmail.
Yet Washington’s froth-flecked indignation has about it the stink of hypocrisy. However reprehensible their conduct may have been, Wall Street’s wizards weren’t the ones responsible for protecting the U.S. economy from systemic financial risks. That burden rested on the shoulders of policy-makers at key federal agencies and members of the relevant Congressional banking and finance committees. Blame deflection is an instinctual competence among Washington’s political classes, so we shouldn’t be surprised when regulators and legislators attempt to hide their culpability for the banking crisis behind a smokescreen of populist fury. But make no mistake: the bomb that blew up America’s economy may have been detonated on Wall Street, but it was built in Washington.
Predictably, the crisis has spawned calls for drastic reforms—from the repeal of the Gramm-Leach-Bliley Financial Modernization Act, to a vastly enlarged role for the Fed as an uber-risk manager. Undoubtedly, some of the recently mooted ideas have merit. But taxpayers and voters should be wary: the credit crunch has provided an opening for all those who are eager to expand the state’s role in the economy and thereby their own spheres of influence. We would be unwise to let them exploit that window without first compelling them to come clean about the government’s role in precipitating the worst economic downturn in 80 years.
Our elected representatives and their appointees have failed us on at least five counts.
1. We expected the government to protect the economy from unsustainable booms.
Instead, it provided the fuel for an unprecedented asset price bubble.
You can’t have a bubble—like the one that inflated house prices —without the complicity of the central bank. In his eagerness to protect the economy from a downturn after the dot-com flameout, Alan Greenspan kept interest rates too low for too long. In doing so, he paved the road for all the follies that followed. Sure, nobody at the Fed put a gun to the heads of consumers and said, “borrow or your life” but easy money and the prospect of a quick return in the property market was a temptation too great for many to resist. Adding impetus to the risk-taking was a widely-held belief, correct as it turns out, that when asset prices did inevitably collapse, the Fed would pull out all the stops to quickly reflate the economy.
Of course there were other forces at work. A savings surplus in export-led economies helped keep long-term interest rates low. But a determined tightening of short-term rates by the Fed would have sent a strong signal to lenders and borrowers alike that easy credit couldn’t be taken for granted.
2. We expected the government to avoid creating perverse economic incentives.
Instead, it aggressively subsidized subprime mortgages.
It was the determination of congressional legislators to expand the market for “affordable housing” that set the subprime crisis in motion. In the years leading up to the bust, Fannie Mae and Freddie Mac, government-sponsored entities that answer to congressional masters, bought billions of dollars of subprime mortgage loans from originators such as Countrywide Financial Corp. Fannie and Freddie were given aggressive quotas in building their portfolios: their mandate was to buy loans made to individuals with below-average incomes—and banks across the country were happy to supply them with the necessary product. So great was the impact of Fannie and Freddie in dumbing down the mortgage business that by 2006, one-fifth of all home mortgages were of the subprime sort.
With the implicit backing of the U.S. government, Fannie and Freddie were able to borrow at preferential rates and ultimately assembled a $1.4 trillion portfolio of mortgage-backed securities, as the New York Times noted here. Despite congressional disavowals to the contrary, the investors who bought Fannie and Freddie securities did so in the belief that U.S. taxpayers would cover any losses—again, a bet that has turned out to be in the money, as taxpayers are now on the hook for a $240 billion rescue of the GSEs.
There were those who sought to put the brakes on Fannie and Freddie. In 2005, the Republicans on the Senate Banking Committee introduced a bill that would have severely curtailed the pell mell growth of their loan portfolios. But the bill failed to attract the support of a single Committee Democrat and never reached the floor of the Senate. In the House, Barney Frank, chair of the Financial Services Committee, took every opportunity to defend the GSEs, and in recent years saw off several attempts at reform.
3. We expected the government to enforce prudent banking practices.
Instead, it allowed investment banks to dangerously over-extend themselves.
Enforcing capital adequacy standards is the first responsibility of any bank regulator, but here again, U.S. taxpayers and investors were poorly served by those who had a duty to protect their interests.
In 2004, with the housing boom well under way, America’s big investment banks were chafing under SEC restrictions that limited their debt levels. Eager to boost the returns by taking on more debt, Wall Street’s leading banks joined forces to lobby for regulatory relief. Up against the united front of the nation’s biggest investment banks, the SEC capitulated. Like X-Game athletes juiced up on Red Bull, the bankers went for big air. Traditional leverage ratios were doubled, and then tripled. When Bear Stearns collapsed, its ratio of debt to equity was 33:1. At that level, a 3% decline in asset values wipes out a firm.
In return for the SEC’s accommodating stance, the banks agreed to let the agency monitor their activities and restrict any practices that seemed particularly risky. Yet in the critical period between March 2007 and October 2008, the SEC failed to conduct a single audit, the Times reported. Some have argued that the SEC was out-gunned in smarts and personnel. Maybe so, but you don’t have to be a rocket scientist to stop one—you simply have to interrupt the supply of rocket fuel. In the banking world, this means enforcing, rather than scrapping, capital adequacy rules. Yes, the bankers were idiots, but the real culprits were lackadaisical SEC regulators. Neutered by a belief in the omniscience of millionaire bankers, and blinded by their faith in industry self-regulation, they failed to prevent a financial Katrina.
4. We expected the government to ensure transparent and orderly markets.
Instead, it abdicated its responsibility to create a regulatory framework for credit default swaps and other derivative products.
How in the heck did the world end up with more than $60 trillion dollars worth of credit default swaps and no overarching regulatory control? Some have claimed that the current crisis is an example of “market failure,” but you can’t have a market failure without a market—and until recently, there was no clearinghouse for collateralized debt obligations and credit default swaps. In the absence of a well-functioning market, it was virtually impossible for anyone to know what these complex instruments were worth—a fact that worked to the advantage of the banks that were packaging subprime loans into mortgage-backed securities, and to the disadvantage of virtually everyone else.
Efficient markets flatten margins—so if you’re a banker, complexity is your friend. It creates the illusion of value and cloaks porcine fee structures. Thus it’s hardly surprising that bankers worked to kill a bill introduced in the late 1990s that would have regulated swaps, or in 2000 helped to engineer the passage of the Commodity Futures Modernization Act, a bill that effectively removed derivative products from the supervisory net of the Commodity Futures Trading Commission. Thanks to derelict legislators, the world got a $60 trillion market for credit default swaps that was less well organized than eBay’s market for bric-a-brac and baubles.
While financial derivatives can be useful tools for hedging uncertainties, the volume of credit default swaps created over the last nine years vastly exceeded what might have been required for that purpose—by a factor of 10. Indeed, a recent UN report on the banking crisis concluded that the majority of credit default swaps were gambling devices devoid of social value. Nevertheless, over the last few years those instruments created a lot of value for fee-hungry bankers.
The failure to regulate swaps and the lack of a transparent market contributed mightily to the banking crisis and to the costs of cleaning it up. It has made it virtually impossible for banks to “mark to market,” and has enormously complicated the job of valuing, and thus selling, “toxic assets.” The cost to taxpayers for this regulatory lacuna? At least $170 billion. That’s the cost, thus far, of bailing out AIG, the insurance company that somehow became the world’s largest factory for credit default swaps.
5. We expected the government to indemnify taxpayers against bank failures.
Instead, it mortgaged the country’s future to rescue banks that were too big to fail.
Banking is a mature industry. Before the invention of the subprime scam, the only way to grow was to acquire your competitors. In the 1990s, the banking industry led all others in terms of merger activity, thanks in part to the Riegle-Neal Act of 1994, a bill that abolished long-standing restrictions on interstate banking. Suddenly, little bank CEOs could dream of becoming big bank CEOs, and by the end of the decade, Sandy Weill (Citicorp), Hugh McColl (NationsBank) and William Harrison (JP Morgan) had laid the groundwork for America’s first trillion-dollar banks (as measured by asset size). By 2004, 74% of US bank deposits were controlled by just 1% of America’s banks. For the first time since the Great Depression, America had banks that were, indeed, too big too fail.
Undoubtedly aware of their privileged status, executives in these new mega-banks took big risks, confident in the knowledge that any catastrophic losses would be backstopped by the federal government—a classic case of moral hazard. As any prudent investor knows, it’s important to diversify risks. Yet America’s regulators stood by while a small cadre of imperially-minded bankers consolidated their hold on America’s financial system.
So what do our “public servants” have to say in their defense? Not much. In congressional testimony and press interviews they have staked their innocence on two claims: first, that the financial crisis was a global, systemic problem, the product of macroeconomic imbalances and supra-national forces beyond their control; and second, that regulatory gaps and jurisdictional voids created space for risky new banking strategies. Their proposed cure: more global coordination and expanded regulatory powers.
In my next post, I’ll dig deeper into the political factors that led to these failings, but first I’d like to hear from you.
Readers, as you think about the current financial crisis, are there other ways in which our political leaders failed us—other things they should have done but didn’t? In your opinion, what accounts for these lapses in judgment and policy?