Financial Crisis Inquiry Commission: A Comment on Three Members' Dissenting Statement

The Financial Crisis Inquiry Commission released its final report this morning. I have briefly looked at it but have not had a chance to read all of it. I have, however, read the Dissenting Statement of Keith Hennessey, Douglas Holtz-Eakin, and Bill Thomas. The fourth Republican on the Commission, Peter Wallison, did not join in this statement, but rather appended a 96-page dissenting statement of his own, which I have not yet read. (Apparently, the full dissenting statements will not be reproduced in the commercially published version of the report. Each statement there will be limited to nine pages. That would seem to be an avoidable mistake of the majority. The full dissenting statements are included in the more expensive version published by the Government Printing Office and for free on the web.)

I am pleased that the Dissenting Statement of the three Commissioners is much better than the "Financial Crisis Primer" the four Republican Commissioners issued last month. (My negative review of that release can be found here.)

The dissenters are right to make the point that the U.S. was not the only country to experience a credit and housing bubble nor to experience problems with financial firms. They consequently conclude that it cannot just be domestic U.S. failures that need to be looked at in evaluating the causes of the crisis.

With respect to monetary policy, the Dissenting Statement is weaker. They appear to be correct in saying that "the Commission should have focused more time and energy on exploring ... questions about global capital flows, risk repricing, and monetary policy." The dissenters, though, conclude that "global capital flows and risk repricing caused the credit bubble ..." and that "U.S. monetary policy may have been an amplifying factor, but it did not by itself cause the credit bubble, nor was it essential to causing the crisis." This is an interesting assertion; unfortunately, the dissenters do not provide much in the way of analysis to support it.

There is more to the dissent, and it is all interesting. They do not go easy on Wall Street firms and do not lay all the blame, just some of it, on Fannie Mae and Freddie Mac. Unlike the primer, the dissent does not read like a partisan or ideological tract, and I give the authors credit for furthering the debate on the issues in an intelligent way.

The State of the Union Proposal to Reorganize the Government: Implications for the Treasury Department?

When hearing President Obama yesterday evening in his State of the Union address propose reorganizing the federal government in a more sensible fashion, I wondered what the effect might be on my former employer, the U.S. Treasury Department. The last major reorganization of the government occurred when the Department of Homeland Security was created. In terms of turf, the Treasury was a big loser then. It lost Customs and the Secret Service to Homeland Security and much of the Bureau of Alcohol, Tobacco, and Firearms to the Justice Department.

The Treasury did retain the Office of Foreign Assets Control (OFAC) and the Financial Crimes Enforcement Network (FinCen). OFAC in particular could plausibly be placed in other agencies, such as the State Department, Homeland Security, the Justice Department, or even the Commerce Department. The argument for keeping it in Treasury is that a large part of what it does involves banks, but certainly many of its activities are much broader in scope than banking transactions. Moreover, OFAC carries out both an enforcement and foreign policy function. It is not a neat fit anywhere. In Treasury, there is tension between OFAC, whose activities by necessity make financial transactions more difficult to carry out, and the Treasury's institutional predisposition to the free flow of capital and belief in the efficacy of financial markets. One hopes this tension leads to a good balance between competing objectives.

The Treasury also retains authority on wine labeling, as this function of ATF did not go to Justice. That could plausibly be housed elsewhere. For example, there was a controversy during the Clinton Administration over whether the wine industry could refer on wine labels to the potential health benefits of drinking wine in moderation. Senator Strom Thurmond strongly objected to this and prevailed. I suspect that most senior Departmental officials, including most Secretaries, would rather not have to get involved in this type of issue.

The Treasury has over the years lost many functions, including drug enforcement, formulating budget policy, and managing the Coast Guard. In recent years, it has gained regulatory authority by getting the Office of Thrift Supervision as one of the pieces of the Federal Home Loan Bank Board that was abolished and split up due to the S&L crisis. The OTS is to be merged with the OCC, but both bureaus have a great deal of independence from the Secretary. Dodd-Frank gives the Treasury more authority in the financial regulatory sphere, but the organizational structure of financial regulation continues to be overly complex and fragmented. The Administration will probably not want to tackle this right now, having recently made its policy and political judgments in the process leading to the enactment of the Dodd-Frank legislation.

One of the criticisms that could be levied against former Treasury Secretary Paul O'Neill is that he did not fight the loss of Treasury functions when the Department of Homeland Security was created or insist on something in return. He undoubtedly thought that the functions Treasury was losing were not central to Treasury's primary responsibilities. On the other hand, others would argue that the more responsibilities an agency has, the more respect private sector actors will accord that agency. Moreover, some think that losing the Secret Service was a big loss; in addition to protecting the President, the Secret Service has the responsibility to battle counterfeiting, which arguably is related to Treasury's core functions.

In any case, it is not clear what President Obama intends by proposing government reorganization nor whether there are any plans to add responsibilities or to subtract them from Treasury.

Too Big to Fail: The Wall Street Journal, Simon Johnson, and Neil Barofsky (SIGTARP)

Neil M. Barofsky, the Special Inspector General for the Troubled Asset Relief Program ("SIGTARP") released an "audit report" earlier this month entitled "Extraordinary Financial Assistance Provided to Citigroup, Inc." The report provides useful and interesting information about the use of TARP funds to help out Citigroup, but there are no surprising revelations. Policymakers were responding as best they could to a difficult situation under enormous time pressure.

I was, though, struck that both the Wall Street Journal editorial page and Simon Johnson, who offers frequent comments on the blog "The Baseline Scenario," used the report to comment on the issue of "too big to fail." The two come to this from different perspectives—Simon Johnson is a former chief economist of the IMF who favors making the largest banks smaller and the WSJ editorial perspectives on a myriad of subjects are well-known enough that it is unnecessary for me to characterize them.

Both the WSJ editorial, "The Ruling Ad-Hocracy" (subscription required), and Simon Johnson's Bloomberg article, "'Citi Weekend' Shows Too-Big-to-Fail Endures," mention Treasury Secretary Geithner's admission in the SIGTARP report that he could not rule out taking similar actions again if there were a comparable shock to the financial system. The WSJ editorial page and Simon Johnson are also both skeptical concerning the Dodd-Frank legislation's efficacy for making improvised bailouts in the future less likely.

Johnson has the more developed argument of the two. He focuses on the "big" in "too big to fail," advocating that a problem that should be addressed is the vast size of the biggest banks. He also believes, with some justification, that the resolution authority granted to the FDIC by the Dodd-Frank legislation will not work for these huge international financial institutions because of the global operations of these entities.

The point that the WSJ editorial page is trying to make beyond carping that the regulators have not done away with "too big to fail" and that they have not produced objective criteria as to what constitutes a systemically important institution is harder to discern. On the one hand, the editorial argues that "the time to tighten the rules on too-big-to-fail firms is when the market is calm, not amid a panic," which is a somewhat surprising statement from the editorial page editors given their usual anti-regulatory stance. They return to form at the end of the editorial in saying: "Any Republicans tempted to accept Dodd-Frank as settled law should dig into the details and work to restore the freedom to fail in American finance."

If it were possible to minimize the collateral damage from the failure of a financial institution, I would agree with that last sentiment. But that's the problem. Who can doubt that a sudden failure of Citigroup to meet its obligations would not have adversely impacted all of us? The failure experiment was run with the much smaller Lehman Brothers, and no one liked the results.

It is this issue that Johnson is trying to address by his tireless advocacy on his blog and in the book he coauthored with James Kwak, Thirteen Bankers, of limiting the size of financial institutions. While I think Johnson's ideas should be considered more seriously by policymakers than they have been, I would also point out that it does not solve all problems. Limiting the size of financial institutions does not necessarily get the government off the hook; for example, consider the savings and loan crisis of the 1980s and 1990s. To put it somewhat simply, the S&Ls ran into trouble because their business model of borrowing short and lending long could not survive a large increase in interest rates. Their regulator, the Federal Home Loan Bank Board, tried to paper over the problem by allowing S&Ls to pretend they were solvent by substituting "regulatory accepted accounting principles" for GAAP. The S&Ls could not grow out of their problem, and the George H.W. Bush Administration decided that, once and for all, they had to resolve this problem which had developed during the previous Reagan Administration.

(As an aside, Fannie Mae ran into the same problem as the S&Ls in the 1980s. Fannie was able, though, to grow out of its financial difficulties. A new management decided to embrace mortgage-backed securities, for which Fannie retained the credit risk but not the interest rate risk. This strategy, along with a better matching of the duration of liabilities with the duration of assets, worked. Also, of course, Fannie's strategy relied on its continuing access to capital markets due to the implicit federal government guarantee of its securities. After Fannie got a new regulator, the not very effective Office of Federal Housing Enterprise Oversight, its interest rate risk increased, but that is not what did it in. Fannie had no way of shedding the credit risk on mortgages it either had securitized or held in its portfolio. Freddie Mac ran into the same problem in the recent crisis, but in the 1980s it had a very small portfolio and minimal interest rate risk.)

As readers of this blog know, I have been concerned about the regulatory capture problem. Whatever structure we have for our financial institutions and markets and however the government is organized to regulate and supervise these institutions and markets, there will be heavy reliance on the quality of government regulation. There were regulatory failures that exacerbated the financial crisis; we need further thought on how to avoid such failures in the future. It is not an easy problem.

There will be a next time. One thing I learned from following these issues for over 30 years is that problems and crises in financial markets happen with a disturbing frequency. I don't think that can be prevented. The goal should be to minimize the severity of crises and particularly to limit the fallout. I am skeptical, as are the WSJ editorial page and Simon Johnson, about the efficacy of Dodd-Frank. It makes some improvements, but one does get the sense that what is happening now is a political process where the Treasury and the regulators are trying to address some issues while not offending financial institutions too much.

As far as when the next time will be, I have no idea. But if one wants something to worry about, one need only think about the continuing decrease in housing prices, the foreclosure mess, the high unemployment rate, the economic problems in Europe, the potential for Middle East conflicts, the increase in food and energy prices, the financial condition of state and local governments, etc. That is not an inclusive list. One can only hope that the optimism expressed by the stock market and the improved GDP growth rate are more important.

More Bank Foreclosure Woes – The Ibanez Case

There is more news concerning banks and foreclosures. First, though it is not clear what this signifies, R.K. Arnold, the former CEO of MERS, has retired. Also, and the subject of this post, is an important Massachusetts court case which definitely has implications in that state for the foreclosure process going forward. It also appears to provide grounds in Massachusetts for anyone who has lost a house because of a foreclosure action to bring suit if there is reason to believe that the financial institution involved did not clearly hold the mortgage at the time of the foreclosure. It may also have implications for foreclosures in other states as other state courts consider the opinion of the Massachusetts Supreme Judicial Court.

U.S. Bank and Wells Fargo lost in their appeals to the Massachusetts Supreme Court of a lower court's ruling that the foreclosure sales of houses were invalid. The banks were the only bidders for the foreclosed properties; the two cases had been combined since they raised similar legal issues. The lower court ruled, and the Massachusetts Supreme Court agreed, that the foreclosures were improper because the banks could not show that they held the mortgages at the time of the foreclosures. These two cases, which do not appear to involve MERS, indicate that the paperwork problems of the banks will have real effects.

It is impossible to read the various filings in this case and not be appalled at the extraordinary sloppiness of the two banks with respect to these two home mortgage loans. The details of these cases and the arguments surrounding the issue are to be found in these filings. A list of them with links can be found at this blog post of "foreclosuresblues."

With respect to the sloppy paperwork, the brief filed for Ibanez quotes a lawyer for U.S. Bank telling the lower court in reply to a question concerning the legality of holding a foreclosure sale in the absence of an assignment of the mortgage as saying: "It was really never identified as a problem…admittedly, it's their own fault, the securitized industry, you know, has been caught with their 'pants down' so to speak…" Further, the lawyer for U.S. Bank is quoted as saying: "I tell you for our law firm we do just what you say, we have changed our practice…and we don't start the Notice of Sale process until we do the assignment and get it on record." (p.3 of Ibanez brief.)

The Attorney General of Massachusetts filed an amicus brief opposed to the banks. At the end of the brief, there is this observation: "As the Land Court points out, the banks were the only bidders at the foreclosure sales and they purchased these properties for less than the market values stated in their own appraisals, an advantage they may have gained because of the defects in their notices…This was particularly damaging to Mr. Ibanez, as U.S Bank bid for and purchased the Ibanez property for some $16,000 less than the amount of the outstanding loan, leaving a significant deficiency…Thus, the plaintiffs profited from the risks they took, at the expense of each of the borrowers. Having reaped the benefits of their casual attitude toward ensuring they possessed valid assignments of the mortgages, it is not unjust that plaintiffs should now bear the costs of their errors." (Martha Coakley is the Attorney General of Massachusetts. She lost an election to the U.S. Senate to Scott Brown for the seat held for years by Ted Kennedy.)

Felix Salmon of Reuters is wringing his hands over this decision in a January 7 post. He notes that the decision is retroactive, which may well prompt litigation in Massachusetts, and, while the decision only applies to that state, it will be looked at by the courts of other states. Salmon writes: "If a similar decision comes down in California, which is a non-recourse state, the resulting chaos could be massive. People who are current on their mortgage and perfectly capable of paying it could simply make the strategic decision to default, if and when they find out or suspect that the chain of title is broken somewhere. They would take a ding to their credit rating, but millions of people will happily accept a lower credit rating if they get a free house as part of the bargain."

It is not clear whether that is true. Presumably, even if the note and the mortgage have been separated, some entity does own the note, which may now be an unsecured loan. The ability of a creditor to compel payment on this note outside of bankruptcy probably differs from state to state; and, in bankruptcy, I would guess that the bankruptcy judge would have some latitude about how to deal with this.

But it is true that this poses a big problem for the banks. While the federal regulators are no doubt trying to figure out what they can do about this, they are faced with an important constraint – it is state law, not federal, which is relevant in these cases.

Salmon concludes – "Maybe we'll muddle through this somehow – that's still probably the base-case scenario. But maybe we won't. And if we don't, the downside here, to the banking system and to the economy as a whole, could hardly be larger." I suspect that Salmon's worst case scenario of wholesale defaults on mortgages by perfectly solvent homeowners who nevertheless are able to retain title and remain in their homes will be avoided, but there is plenty to worry about. That is not to say that the court was wrong in its decision; banks cannot be above the law. One result of this decision if other state courts with laws similar to those in Massachusetts come to similar conclusions is that it may encourage banks to pursue loan modifications more actively.

Meanwhile, in another case, the Massachusetts Supreme Court is considering whether people who bought houses which have been sold by financial institutions which did not have the right to foreclose on the properties are in fact owners of the houses they thought they had purchased.

MERS In the Spotlight Again

The Washington Post published a long article on the Mortgage Electronic Registration Systems ("MERS") this Sunday – "First the electronic mortgage superhighway. Then, the pileup." (Previous online version here.) The spotlight on MERS must be increasingly uncomfortable for the parent firm's (MERSCORP) 45 employees (MERS itself has no employees) who work in Reston, Virginia (a suburb of Washington, DC). The article states that "MERS is facing lawsuits from across the country seeking unpaid county recording fees. Several state courts have rejected attempts by MERS to act on behalf of banks seeking to foreclose on delinquent mortgages. And Congress is weighing legislation that would bar home loan giant Fannie Mae from buying any mortgage listed in MERS, potentially a death knell for the registry."

I have written on this subject in two previous posts (here and here). The new Washington Post article will no doubt increase the attention played to the MERS controversy. Court decisions currently are mixed on MERS, but if a major court decision does not go MERS' way, financial institutions and markets could be in for some real trouble.

MERS seems to be modeled after the Depository Trust Company ("DTC"), which serves to "immobilize" securities held in street name and operate a book-entry system to transfer securities among member firms. The firms in turn mark their books and the last tier in this book-entry system indicates the beneficial owners of the securities. However, MERS was constructed on the cheap, and does not have anything similar to the large underground vault that DTC has in Manhattan filled with paper securities.

Also, the legal regime for real property differs from securities. One of the purposes of MERS is to avoid the fees and the work involved in filing with local authorities the transfers of mortgages. There is some question whether listing MERS with local authorities is sufficient. There are also questions concerning whether MERS serves to separate the notes, which set out the terms and conditions of the loans, and the mortgages, which give the right to the lenders to foreclose on property should the borrowers default. Case law dating from the 19^th Century indicates that a mortgage separated from the note is worthless. This also implies that a note without the mortgage is unsecured, which has important implications in a bankruptcy proceeding. Moreover, some claim that MERS serves to disrupt a clear record of the chain of ownership of the mortgage and the note.

Obviously, to the extent that fraud is involved, as it would seem to be in the case of "robo-signers," shredded and/or forged documents, improper notarizations, and so on, there is no argument that this does not pose a serious problem. The more troubling question is whether the MERS system itself works as a legal matter even without such clearly improper action. One can easily find some extremely heated discussion of MERS as itself a fraud. For example, see L. Randall Wray's three part series for The Huffington Post on MERS ("Anatomy of Mortgage Fraud") which begins here. At the end of the series, he writes: "Some might think I have used the 'F' word excessively and cavalierly throughout these three pieces. To be sure, fraud is something that must be proven in court and since it involves intent that is not easy. I am using the term in the common everyday sense of the term and I think it accurately describes the behaviors I have outlined--and I am not alone. Christopher Peterson, Associate Dean and Professor of Law at the University of Utah calls MERS "a deceptive and anti-democratic institution", a "shell company" with a structure that could 'arguably be considered fraudulent'."

Also, Yves Smith has written very critically of MERS on her blog naked capitalism. For example, see "Will MERS Exam Be a Whitewash?" and "Why MERS Needs to be Taken Out and Shot." (Incidentally, "Yves Smith" is a pseudonym. It is a clever pun based on the Book of Genesis and a famous Scottish economist.) A more dispassionate look at the legal challenges MERS faces can be found in this Reuters article. On the other side, for an argument that MERS will likely in the end fend off the legal challenges, see "MERS Prevails In The Show-Me State." The author, a lawyer who works for a "creditors' rights law firm," concludes her article with advice to those on her side of the issue: "In order to stay on the winning side, lenders need to continue to adapt their procedures and policies to timely provide foreclosure counsel with documents and information. Likewise, foreclosure counsel must continue to update their archive of case law with favorable decisions, such as the ones cited in this article. With a united front in defending these challenges, MERS will knock out claims left and right, eventually finding itself in a permanent place of victory."

While some of the rhetoric is over the top, there is a serious problem. Not only are the legality of many foreclosures in question, but so are the validity of the securities backed by mortgages, which face both security and tax law questions. In addition, local governments are realizing that they may have lost significant fee income because of MERS. For example, one lawsuit claims that California local governments are owed at least $60 billion (not a typo) in recording fees. Apparently, the state has not joined in the lawsuit, and it is not clear it will, but $60 billion might seem to be a tempting amount of money for a state with serious budget problems. Other state and local governments are looking into this.

It will take some time for the legal issues to be settled in the states. While The Washington Post article speaks of legislation that would effectively mean the end of MERS by prohibiting the GSEs from purchasing or securitizing mortgages which are in MERS, one can be sure that there are lobbyists who are fighting to preserve MERS and, if necessary, get legislation passed that blesses what has been done in the past. The constitutionality of any such legislation, if enacted, could well end up being decided by the Supreme Court.

The creation of MERS in the 90s in such a way that these legal challenges are gaining traction is a failure of both the government and the private sector. Government regulators did not analyze MERS as much as they should have when it was created. They had plenty of authority under banking, security, and tax laws to demand changes if they thought it necessary. For its part, the private sector (major banks and Fannie and Freddie) did not listen to warnings about the legal risks. These failures now pose risks to all of us.

Acting Comptroller John Walsh indicated that the OCC and other bank regulators are looking into MERS. While his statement to this effect seems more focused on operational issues, the OCC and other government agencies must be worried about the legal issues. I suspect that they do not know what to do. The risks the government must see if court decisions go against MERS are that financial institutions and financial markets could again be in serious trouble and that Fannie Mae and Freddie Mac could face even more losses, which it seems would need to be covered by the federal government (meaning all of us). On the other hand, the Executive Branch will find it difficult to influence what state and federal courts will do, and the legal questions about MERS are not frivolous.

Some may think MERS will eventually be found to be a proper and legal mechanism for handling mortgages. It has to be, they may believe, because otherwise, the financial system would again be put at risk, and, after all, those foreclosed on are in default on their loans.  Perhaps.  But it may not go that way. One hopes that some creative thinking in the government is being done about what might be done to resolve the MERS issues in a fair, workable, and legal manner.

Financial Crisis Inquiry Commission: Republican “Financial Crisis Primer”

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.