Wednesday, January 26, 2011

What Caused the Financial Crisis and Why It Matters Now

The Financial Crisis Inquiry Commission (FCIC) completed its report on what caused the financial crisis and it’s surprisingly good.  Of the five causes of the financial crisis I identified in September 2008, the FCIC has fingered all but two. (I later posted about some other ones.) Of these, the most important are excesses in bank leverage, deregulation, shoddy lending decisions, and Wall Street political contributions.

What it seems to have missed, in my view, are extremely weak disclosure of what Wall Street was selling – which made it impossible for investors to understand the risks and a compensation scheme for participants that encouraged them to care only about closing big Mortgage-Backed Securities (MBS) deals, rather than their long-term profit or loss.  In part because Dodd-Frank was passed last year before the FCIC report was released, important work must yet be done to prevent the next financial crisis.

The FCIC report lists seven causes of the financial crisis and as indicated below, I commented on them over the last five years. According to the New York Times, the FCIC report, based on 700 interviews and 19 hearings, will be a 576 page book that highlights the following causes:
  • Fed chairs missing dangers of deregulation and risks of subprime. As I posted in 2008, Alan Greenspan was a tireless booster of securitization -- as far back as 2002. In 2007, I noted that Ben Bernanke wrongly insisted that subprime was contained.
  • Bush administration inconsistency. In September 2008, I pointed out that it was confusing to investors that Bush bailed out Bear Stearns, let Lehman Brothers fail because he was smarting from criticism about moral hazard from his political base -- then bailed out American International Group a few days later.
  • Deregulation of derivatives. In 2008, I commented on how then-presidential candidate's John McCain's economic advisor, Phil Gramm, pushed successfully to deregulate derivatives in 2000 -- a move that tanked AIG by letting it sell Credit Default Swaps (CDS) without disclosing its positions or setting aside capital to cover potential losses.
  • Too much Wall Street money buying off regulators. In 2009, I posted about how billions in Wall Street campaign contributions and lobbying fees called off the regulatory dogs -- and continues to do so.
  • Too much bank leverage. In 2008, I pointed out that due to 40:1 ratios of Wall Street borrowing to equity, it would take a mere 3% decline in asset values to wipe out that capital.
  • Poor underwriting practices and risky bets by bankers. In August 2008, I argued that securitization was a flawed practice based on shoddy models that provided false comfort.
  • Compromised ratings agencies. In August 2007, I argued that due to their compensation conflicts, ratings agencies had a powerful incentive to wrap financial toxic waste in gold.
I think this report appears to have missed two important reasons for the financial crisis (although they may appear when the report is released Thursday):
  • Botched incentives. As I posted many times between 2007 and 2010, people do what they're paid to do. And on Wall Street, the pay goes to those who close the most big deals the fastest. That leads to quantity over quality when it comes to creating investments and all that money drains talent from more productive sectors of the economy.
  • Conflicted financial reporting. I have written extensively between 2006 and 2010 about how letting managers write their own report cards gives them a license to steal -- as evidenced by Bernie Madoff -- who made up fake account statements to hide his $65 billion theft -- and Lehman Brothers -- that used an obscure accounting rule to keep from reporting how much money it was really borrowing.
If the FCIC could lead to iron-clad fixes to the seven problems outlined in its report and the two additional ones I highlighted could be repaired, I think we'd be able to feel more assured that Wall Street could fill its role of raising capital without putting the world at risk of financial collapse.

Here's the goal: A financial system that limits leverage and creates solid, long-term investments whose risks can be hedged at a reasonable price. That Wall Street would be run by talented people who get bonuses paid over a decade based on the long-term performance of the investments they create. And an independent government agency -- paid for by taxes on investment balances and free of Wall Street campaign contributions and lobbying fees -- would produce financial reports on that performance.


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