Monday, December 20, 2010
When I first learned who had been appointed to the Financial Crisis Inquiry Commission ("FCIC"), which Congress set up in 2009 to investigate and report on the causes of the 2008 financial crisis, I thought there would likely be a majority and minority report. The reason for my doubts that there would be a unanimous report was that I knew something about two of the members, Brooksley Born and Peter Wallison. Ms. Born, the former Chairman of the CFTC, has been basking in the accolades thrown her way because she is viewed by many as having been right about the dangers of OTC derivatives. Mr. Wallison, who was General Counsel of the Treasury Department during the Reagan Administration, has been a fixture at the American Enterprise Institute, a conservative think tank in Washington, DC, for quite some time. One of his main preoccupations has been the dangers posed by Fannie Mae and Freddie Mac. I thought that Ms. Born would likely see much of the cause of the financial crisis to be due to OTC derivatives and Mr. Wallison would heap the blame on the two GSEs.
I was consequently pleasantly surprised in April, when I watched a FCIC hearing, that the members seemed to be getting along well, though I subsequently heard a rumor that they had all agreed to play nice in public, since it would not help any of them to engage in public disputes. I also was surprised at the tone of some of the questions asked by Vice Chairman Thomas of witnesses, which had more of a populist tone than one would expect from the former Republican Chairman of the House Ways and Means Committee.
Now the harmonious illusion has been shattered by the publication on December 15 of a short "Financial Crisis Primer" signed by all four Republican commissioners. It is easy to find criticisms of this paper on the web. For example, both Bethany McLean (in Slate) and Joe Nocera (in his New York Times column), whose recent book I commented on in the previous post, have provided devastating critiques of the "Primer." I agree with their comments.
It seems that the Primer was issued prior to the FCIC's report being finalized for political reasons. The Republicans want to head off any efforts at restrictive regulations, which the majority might recommend, while pushing their agenda to end the role of the GSEs and to combat the deficit, presumably by decreasing social spending. They are not wrong that the government played a role in the crisis, but they ignore the major role of private actors, including financial institutions ("Wall Street") and the rating agencies.
As for the GSEs, there has long been a Treasury view that these entities should probably never have been created and, in any case, never been allowed to get so big. Antipathy to Fannie Mae and Freddie Mac has been common to both Democratic and Republican administrations. The institutional view of Treasury has been that Fannie Mae was wrong in saying that the GSE model was one that worked. When I was at Treasury, we saw the dangers of mixing private profit incentives with a government backstop ("the implicit guarantee"). However, the GSEs were latecomers to the subprime mortgage party. Putting the degree of blame on them that the Primer does is a distortion of what happened.
Nevertheless, it is clear that something has to be done about Fannie and Freddie. The FCIC members do not need to exaggerate to make sure that this issue continues to be part of the Congressional agenda.
The concern expressed in the Primer about the budget deficit seems to be tacked on. The current fiscal situation cannot be said to have caused the crisis that took place more than two years ago. Why this is in the paper is not at all clear, since it will likely have no effect in the coming debates about taxes and spending.
What is a shame is that the Primer could have been written without any of the investigation that FCIC has undertaken. It was not written by people with an open mind, and it will probably have little effect except to minimize the impact of the FCIC's report. That may be the intent. Of course, that report, while probably presenting much useful and interesting information, may have its own exaggerations, but of course it is not possible now to tell how good or bad it will be. The signatories to the Primer, though, should hope that it is quickly forgotten, and they should strive to have something more thoughtful to say when the final FCIC report is issued.
Book Review: All the Devils Are Here: The Hidden History of the Financial Crisis by Bethany McLean and Joe Nocera
While I have some criticisms of Bethany McLean and Joe Nocera's new book, All the Devils Are Here: The Hidden History of the Financial Crisis, I would put it on the required reading list for anyone seeking to understand the financial crisis. Its focus is on the financing of the housing bubble, and it assigns blame widely. Mortgage originators, Wall Street firms, rating agencies, regulators, and government sponsored enterprises all played a role.
There have been a large number of books about the financial crisis. Many of these books are interesting and shed light on specific events. For the most part, they have been written by reporters who covered the story as it was happening. A common shortcoming to most of these books is their narrow focus and lack of analysis. For example, Andrew Ross Sorkin's book, Too Big to Fail, focuses on the actions and meetings of some key top Wall Street executives and government officials during the crisis. This is interesting, but it does not tell the larger story of the crisis to which these top people were reacting.
One of the best books to come out of the financial crisis is Gillian Tett's Fool's Gold: The Inside Story of J.P. Morgan an How Wall Street Greed Corrupted its Bold Dream and Created a Financial Catastrophe. This book, too, is narrow in scope, but it provides interesting history and analysis of the development and use of credit default swaps and collateralized debt obligations. For those seeking to understand this aspect of the crisis, this book should also be on the required reading list.
Bethany McLean and Joe Nocera's new book on the financial crisis does attempt to provide both history and analysis of the developments leading to the financial crisis. It focuses its attention on the mortgage industry, which is appropriate since the crisis was the result of the inevitable end of a housing bubble. The book puts a large measure of blame on Wall Street with it insatiable demand for badly underwritten mortgages with high interest rates which could be transformed into high yielding securities with AAA ratings conferred by the rating agencies. The rating agencies are singled out especially for their utter failure to manage the conflict of interest inherent in their business model – being paid by issuers to rate their securities.
The appetite for bad mortgages encouraged mortgage originators, some notable ones wanting to grow quickly, in reducing their underwriting standards in order to supply product to Wall Street. Some mortgage lenders convinced borrowers to get into riskier products, such as option ARMs, because there were greater profits for the originators in these types of loans. The underlying assumption was that housing prices always go up.
While this was all going on, the regulators did very little. Federal Reserve Chairman Alan Greenspan had faith in market discipline correcting any problems and, consequently, the Fed did not use its authority to curtail problems in the mortgage industry. The Office of the Comptroller of the Currency ("OCC") steered national banks from originating many bad loans, but its state law preemption policies, the authors argue, contributed to the problem, since the Office of Thrift Supervision ("OTS"), in competition with OCC, followed the OCC lead and was a weaker regulator. In addition, states were reluctant to impose tougher requirements on state-chartered institutions than those applicable to federally-chartered competitors supervised by the OTS. The authors do, though, credit John Dugan, then the Comptroller of the Currency, with "fretting to other regulators about the growth in nontraditional – i.e., subprime – mortgages…" in 2006. The authors, referencing an unnamed Treasury official, state that Main Treasury did not take the Comptroller's warning that seriously. The economists working on housing issues and the staff working on financial markets did not talk on a regular basis. (From personal experience, I can attest that communication and coordination between various parts of Main Treasury is less than optimal and that this "silo" problem is very resistant to attempts to address it.) In addition, Treasury officials were inclined, according to a "former Treasury official" to be relaxed about increased leverage. The authors quote the official as saying: "It was a gradual process that got us to where we were … So you'd think it would be a gradual process that got us out." The authors comment – "In this assumption, however, they could not have been more wrong." (Disclosure: I worked for eight months at the OCC on detail from Main Treasury in 2007, an assignment I requested and was facilitated by Mr. Dugan. In 2006, I was not working in the Domestic Finance section of Treasury nor was I working on issues related to the housing crisis or problems in financial markets, which is another way of saying I have never had any contact with either author. I do not know whom they spoke to at the Treasury Department.)
The authors also discuss Fannie Mae and Freddie Mac. Some observers, with perhaps an ideological perspective, would like to assign the lion's share of the blame for the crisis on the two major housing government sponsored enterprises; the authors have a more balanced view – the two GSEs had major problems, but they followed the private sector into subprime.
As with the Gillian Tett book, this book is invaluable for those seeking to understand what happened. The book, though, is not without flaws.
I wish the authors had discussed in their book the analysis Bethany McLean offered as to the cause of the financial crisis in one of the interviews of the authors as they made the rounds to promote their book. She said that while incomes except for the very wealthy stagnated, the way the economy was able to continue to grow and for corporations to be profitable was for consumers to use their houses as ATMs. They refinanced their houses in order to borrow more, and kept consumption up with this borrowed money. This was made possible by the housing bubble and relaxed lending standards. Of course, this could not continue indefinitely. Others have made this point, but it would have been helpful if the authors had discussed more fully this process of maintaining consumer demand with borrowed money while incomes stagnated. Perhaps they considered income stagnation beyond the scope of the book, but it would not seem to have been difficult to find various economists and others willing to give their analysis of this subject.
The authors assign some blame, as is fashionable, to Secretary Rubin's opposition to CFTC Chairman Brooksley Born's attempt to regulate the OTC derivatives market. (I have written posts about this here, here, and here.) While the authors are fairer to Rubin than many have been, they missed that Brooksley Born rejected his proposal outright that the President's Working Group on Financial Market's ask the questions posed by the draft CFTC's concept release rather than having the CFTC do it. The reason for Rubin's proposal was that it would not have implied that the CFTC might consider some existing OTC derivatives, such as total return swaps based on equity securities, to be illegal, and hence unenforceable, futures contracts. The authors also do not mention that the statement of the Secretary Rubin, Chairman Greenspan, and SEC Chairman Arthur Levitt criticizing the CFTC concept release was issued because of concern of market reaction to the CFTC's implying that some OTC derivatives contracts were unenforceable.
Moreover, at the time of the meeting in 1998, the market for credit default swaps, which would prove to be so troublesome later on, had not yet taken off to any significant extent nor had synthetic CDOs. The major contracts people were focused on at the time, such as interest rate, foreign currency, and total return swaps, were not implicated in the 2008 crisis, though, admittedly, some of the variations on these contracts were extremely complex and made pricing these contracts an issue of legitimate concern.
The authors, though, do make a reasonable point that Secretary Rubin could have worked harder to regulate OTC derivatives in some way, if he was concerned about the risks, regardless of his personal animus to Chairman Born. However, with respect to the failure of the hedge fund, Long-Term Capital Management ("LTCM"), the authors imply that this episode vindicated Born's concerns. What they fail to mention is that a regulatory initiative to address excessive leverage at hedge funds need not focus on particular instruments but on hedge funds themselves. For instance, in LTCM's case, the use of OTC derivatives was only one of a set of trading strategies the fund used. Since the institutions that pose systemic risk issues with respect to OTC derivatives are also involved in other types of speculative activities and investments, whether to key regulation off the players or the instruments is a policy issue that needs to be analyzed. Doing both, and assigning responsibility to different regulators, as the Dodd-Frank legislation does, is likely to lead some regulatory dysfunction. (A previous post addresses this topic.)
Also, even if Chairman Born had been successful in regulating OTC derivatives, it is not at all clear that this would have prevented the crisis, which as the authors rightly argue started with a housing bubble and extremely relaxed underwriting standards. Regulating interest rate swaps or foreign currency swaps or forcing these products on to exchanges would have done nothing to prevent the crisis. What the CFTC would have done, if it had the authority, if anything, about credit default swaps is unknown. Would they have caught the concentration of risk at AIG any better than the OTS, and, if they had, what would they have done about it? How would the inevitable clashes with the bank regulators and the SEC have played out? After all, the regulatory failure associated with the financial crisis was not due to a shortage of regulatory authority but to existing authority not being used. Maybe the CFTC would have done something, but perhaps not. It is a small agency and would have been operating in the same environment and under similar pressures as the other regulators.
Moreover, when it comes to unregulated OTC derivatives, the authors sometimes confuse these instruments with securities. For example, they cite Orange County's bankruptcy as the result of its investment in derivatives, when in fact much of the problem was caused by Orange County's investment in structured securities which was a way to bet on interest rates. While structured securities can be used to speculate as can OTC derivatives, the important point is that securities are regulated by the SEC, and this regulation did not prevent some big problems. I would also note that CDOs and synthetic CDOs, which had in them credit default swap positions, were subject to SEC jurisdiction. This did not prevent problems with these securities.
While the authors are critical of Secretary Paulson for missing the housing problem, they praise him for "a hugely ambitious project to revamp the regulatory system." What the authors fail to mention is that the exercise to reform the regulatory system began as an effort to lighten up on regulation.
There was the idea before the crisis hit that New York was losing business to London because of the lighter touch of the U.K.'s Financial Services Authority. Senator Charles Schumer and New York Mayor Michael Bloomberg commissioned a report by McKinsey & Company which was released in January 2007 – Sustaining New York's and the US' Global Financial Services Leadership. As an example of the tone of this report, its Executive Summary says about derivatives: "'The US is running the risk of being marginalized' in derivatives, to quote one business leader, because of its business climate, not its location. The more amenable and collaborative regulatory environment in London in particular makes businesses more comfortable about creating new derivative products and structures there than in the US." Another more interesting paper – Interim Report of the Committee on Capital Markets Regulation (November 2006) – also argued that the U.S. should adopt a lighter touch. This study, by prominent industry leaders and academics, was influential at the time. Both studies provided support for Secretary Paulson's initial efforts to lighten regulation ("principles-based" rather than "rules-based").
Of course, by the time The Department of the Treasury Blueprint for a Modernized Financial Regulatory Structure was published in March 2008, the situation had of course changed, and the report was recast as one advocating regulatory reform rather than focusing on a lighter regulatory touch. The report is not one of Treasury's best efforts, and it is incidentally not that easy to find on Treasury's recently redesigned website. However, Secretary Paulson should not be given a pass on what his real agenda had been, but his spinning of this to date has been remarkably successful.
Finally, while the book does an excellent job of tracing the roots of the financial crisis to the housing bubble and the associated lowering of underwriting standards, it is U.S. centric. There were, and continue to be, problems in Europe. For example, there was a housing bubble in the U.K., and one of the early signs of trouble was the classic bank run, with account holders lining up in the street to get their money out, on Northern Rock in 2007. The institutional arrangements for financing housing in the U.K. and its regulation are of course different than in the U.S., but still there was a housing bubble there. On the other hand, the major banks of Canada, a country which obviously cannot insulate itself from economic developments in the U.S., did not experience the financial difficulties experienced by U.S. banks. Putting the U.S. crisis into an international context would have been a much more ambitious project than the authors attempted, though more mention of the international problems would have been appropriate. The international crisis and its causes have yet to be analyzed or understood to any great extent.
Nevertheless, in spite of these criticisms, there is much to recommend about this book. It is one of the better accounts of the financial crisis in the U.S. and its assignment of blame for the most part is not reflexive but based on solid reporting. It deserves the accolades it has been receiving.