An autopsy of the US financial system accident suicide or negligent homicide

Description
The purpose of this postmortem is to assess whether the design, implementation, and
maintenance of financial policies during the period from 1996 through 2006 were primary causes of the
financial system’s demise

Journal of Financial Economic Policy
An autopsy of the US financial system: accident, suicide, or negligent homicide
Ross Levine
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To cite this document:
Ross Levine, (2010),"An autopsy of the US financial system: accident, suicide, or negligent homicide",
J ournal of Financial Economic Policy, Vol. 2 Iss 3 pp. 196 - 213
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David G. Tarr, (2010),"The political, regulatory, and market failures that caused the US financial
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J ames Barth, J ohn J ahera, (2010),"US enacts sweeping financial reform legislation", J ournal of Financial
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Gordon Rausser, William Balson, Reid Stevens, (2010),"Centralized clearing for over-the-
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An autopsy of the US ?nancial
system: accident, suicide,
or negligent homicide
Ross Levine
Department of Economics, Brown University, Providence, Rhode Island, USA
Abstract
Purpose – The purpose of this postmortem is to assess whether the design, implementation, and
maintenance of ?nancial policies during the period from 1996 through 2006 were primary causes of the
?nancial system’s demise.
Design/methodology/approach – To draw conclusions about the policy determinants of the crisis,
the paper studies ?ve important policies: Securities and Exchange Commission (SEC) policies toward
credit rating agencies, Federal Reserve policies concerning bank capital and credit default swaps, SEC
and Federal Reserve policies about over-the-counter derivatives, SEC policies toward the consolidated
supervision of major investment banks, and government policies toward two housing-?nance entities,
Fannie Mae and Freddie Mac.
Findings – The evidence is inconsistent with the view that the collapse of the ?nancial system was
caused only by the popping of the housing bubble (“accident”) and the herding behavior of ?nanciers
rushing to create and market increasingly complex and questionable ?nancial products (“suicide”).
Rather, the evidence indicates that senior policymakers repeatedly designed, implemented, and
maintained policies that destabilized the global ?nancial system in the decade before the crisis.
Moreover, although the major regulatory agencies were aware of the growing fragility of the ?nancial
system due to their policies, they chose not to modify those policies, suggesting that “negligent
homicide” contributed to the ?nancial system’s collapse.
Originality/value – Although in?uential policymakers presume that international capital ?ows,
euphoric traders, and insuf?cient regulatory power caused the crisis, this paper shows that these
factors played only a partial role. Thus, current reforms represent only a partial and thus incomplete
step in establishing a stable and well-functioning ?nancial system. Since systemic institutional
failures helped cause the crisis, systemic institutional reforms must be a part of a comprehensively
effective response.
Keywords Financial institutions, Regulation, Economic policy, Economic conditions,
United States of America
Paper type Research paper
1. Introduction
In?uential policymakers emphasize that the ?nancial crisis was largely precipitated
by a series of unforeseeable events that conspired to produce a bubble in the
housing market. In particular, Bernanke (2009a, b), Greenspan (2010), Henry Paulson,
Romer (2009) and Rubin (2010) stress that large capital in?ows to the USA lowered
interest rates, fueled a boom in mortgage lending, a reduction in loan standards, and
?nancial innovations that produced an unsustainable explosion of credit. This view
characterizes the collapse of the ?nancial system as re?ecting “accidents,” such as
the bursting of the housing bubble, and “suicide,” such the herding behavior of
?nanciers rushing to create and market increasingly complex and toxic ?nancial
products[1]. Greenspan (2010), for example, depicts the ?nancial crisis as a once in
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1757-6385.htm
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pp. 196-213
qEmerald Group Publishing Limited
1757-6385
DOI 10.1108/17576381011085421
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a “hundred years ?ood” and a “classic euphoric bubble.” From this perspective,
policymakers responded to a crisis that happened to them.
This view, however, is arguably incomplete and could impede the development of
bene?cial ?nancial reforms. While large international capital ?ows to the USA fueled
speculative investments in real estate and while ?nancial shenanigans helped destabilize
the global ?nancial system, a different view holds that policies caused this crisis.
According to this view, the Federal Reserve, Securities and Exchange Commission (SEC),
Congress, and other of?cial agencies implemented policies that spurred excessive risk
taking and the eventual failure of the ?nancial system. Thus, when policymakers
highlight the global savings glut and “irrational exuberance,” this de?ects attention from
the potential policy determinants of the crisis.
In this autopsy, I assess whether key ?nancial policies during the period from 1996
through 2006 contributed to the ?nancial system’s demise. I analyze the decade before the
cascade of ?nancial institution insolvencies and bailouts and hence before policymakers
shifted into an “emergency response” mode. Thus, I examine a comparatively calmperiod
during which the regulatory authorities could assess the evolving impact of their policies
and make adjustments. Speci?cally, I study ?ve important policies:
(1) SEC policies toward credit rating agencies.
(2) Federal Reserve policies that allowed banks to reduce their capital cushions
through the use of credit default swaps (CDSs).
(3) SEC and Federal Reserve policies concerning over-the-counter (OTC)
derivatives.
(4) SEC policies toward the consolidated supervision of major investment banks.
(5) Government policies toward two housing-?nance entities, Fannie Mae and
Freddie Mac.
Fromthis examination, I drawtentative conclusions about the determinants of the crisis.
The evidence indicates that senior policymakers repeatedly designed, implemented,
and maintained policies that destabilized the global ?nancial system in the decade
before the crisis. The policies incentivized ?nancial institutions to engage in activities
that generated enormous short-run pro?ts but dramatically increased long-run fragility.
Moreover, the evidence suggests that the regulatory agencies were aware of the
consequences of their policies and yet chose not to modify those policies. On the whole,
these policy decisions re?ect neither a lack of information nor an absence of regulatory
power. They represent the selection – and most importantly the maintenance – of
policies that increased ?nancial fragility. The crisis did not just happen to policymakers.
The evidence does not reject the impact of international capital ?ows, asset bubbles,
herd behavior by ?nanciers, or excessively greedy ?nanciers on ?nancial instability,
which have been carefully analyzed by, for example, Acharya and Richardson (2009),
Jagannathan et al. (2009), Kamin and DeMarco (2010), Obstfeld and Rogoff (2009) and
Rose and Spiegel (2010). Rather, this paper documents that ?nancial regulations and
policies created incentives for excessive risk and the ?nancial regulatory apparatus
maintained these policies even as information became available about the growing
fragility of the ?nancial system. Since policymakers did not intend to destroy the
?nancial system, I refer to this policy view as “negligent homicide,” not as murder.
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Although I do not make policy recommendations here, the analyses are relevant for
those designing reforms (Barth et al., 2010; Levine, 2010). Since technical glitches,
regulatory gaps, and insuf?cient regulatory power played only a partial role in
fostering the crisis, reforms that rectify these failures represent only a partial and thus
incomplete step in establishing a stable ?nancial system that promotes growth and
expands economic opportunities. There was also a systemic failure of the ?nancial
regulatory system – the system associated with evaluating, reforming, and
implementing ?nancial policies: key authorities knew that policies were distorting
the allocation of capital and did not reform those policies.
It is worthhighlightingthree limitations withthis paper. First, I drawona wide arrayof
insightful examinations of the crisis from newspaper articles, books, regulatory agency
documents, and research papers. I do not provide new examples or data. Second, related,
limitation is that I do not conduct a comprehensive examination of all policies related to
the crisis. In particular, there was a massive failure of corporate governance, not just
regulatory governance. The board of directors of many ?nancial institutions did not
effectively induce management to act in the best interests of shareholders and others with
?nancial claims on the ?rms as shown by Bebchuk (2010a, b). Rather, in reexamining
selective pieces of evidence, I showthat anenduringbreakdownof the ?nancial regulatory
system was a primary factor in the ?nancial crisis.
Third, ?nancial regulators and policymakers do not share a uniform view of the
?nancial crisis. Of?cials acknowledge that regulatory mistakes were made. While they
tend to focus on an absence of regulatory power to cope with failing institutions and
regulatory gaps in which shadow?nancial institutions operated with little oversight, there
are also cases in which the major agencies acknowledge de?cient supervisory and
regulatory practices (Geithner, 2009). For example, the Federal Reserve noted that it failed
to monitor Citibank adequately as far back as 2005 and did not correct this shortcoming
even after Citibank’s ?nancial condition deteriorated in 2008 (Chan and Dash, 2010).
As other examples, the Inspector General of the Federal Reserve and Federal Deposit
Insurance Corporation (FDIC) provided detailed evidence that regulators failed to
implement their own rules to rein in the excessively risky behavior of banks (FDIC Of?ce
of Inspector General, 2009-2010; Of?ce of Inspector General of the Board of Governors of
the Federal Reserve System, 2010; Chan, 2010b). Thus, mycharacterizationof “the” viewof
policymakers couldbe criticizedas anunhelpful caricature. However, mygoal is to provide
a simple, but relevant, summary of the public view of the most senior policymakers as a
mechanism for framing and motivating my assessment of what went wrong.
In the remainder of the paper, I discuss how the ?nancial crisis was shaped by
policies toward credit rating agencies (Section 2), CDSs and commercial banks
(Sections 3 and 4), investment banks (Section 5), and Fannie Mae and Freddie Mac
(Section 6). Section 7 concludes.
2. The credit rating agencies
These errors make us look either incompetent at credit analysis or like we sold our soul to the
devil for revenue, or a little bit of both.
A Moody’s managing director responding anonymously to an internal management survey,
September 2007, as quoted in Morgenson (2008).
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2.1 Background
Credit rating agencies were indispensable to the crisis. To appreciate their role,
consider the following sequence of transactions underlying the vast misallocation of
global credit. Mortgage companies routinely provided loans to borrowers with little
ability to repay those debts because:
.
they earned fees for each loan; and
.
they could sell those loans to investment banks and other ?nancial institutions.
Investment banks and other ?nancial institutions gobbled-up those mortgages
because:
.
they earned fees for packaging the mortgages into new securities; and
.
they could sell those new mortgage-backed securities (MBSs) to other ?nancial
institutions, including banks, insurance companies, and pension funds around
the world.
These other ?nancial institutions bought the MBSs because credit rating agencies said
they were safe. By fueling the demand for MBS and related securities, credit rating
agencies encouraged a broad array of ?nancial institutions to make the poor investments
that ultimately toppled the global ?nancial system. Thus, an informed postmortemof the
?nancial system requires a dissection of why ?nancial institutions relied unquestionably
on the assessments of credit rating agencies.
How did they become so pivotal? Until the 1970s, credit rating agencies were
comparatively insigni?cant, moribund institutions that sold their assessments of credit
risk to subscribers. Given the poor predictive performance of these agencies, the
demand for their services was limited for much of the twentieth century (Partnoy,
1999). Indeed, academic researchers found that credit rating agencies produce little
additional information about the ?rms they rate; rather, their ratings lag stock price
movements by about 18 months (Pinches and Singleton, 1978). Now, it is virtually
impossible for a ?rm to issue a security without ?rst purchasing a rating.
2.2 The creation of NRSROs
In 1975, the SEC created the Nationally Recognized Statistical Rating Organization
(NRSRO) designation, which it granted to the largest credit rating agencies. The SEC
then relied on the NRSRO’s credit risk assessment in establishing capital requirements
on SEC-regulated ?nancial institutions.
The creation of – and reliance on – NRSROs by the SEC triggered a cascade of
regulatory decisions that increased the demand for their credit ratings. Bank regulators,
insurance regulators, federal, state, and local agencies, foundations, endowments, and
numerous entities around the world all started using NRSROratings to establish capital
adequacy and portfolio guidelines. Furthermore, given the reliance by prominent
regulatory agencies on NRSRO ratings, private endowments, foundations, and mutual
funds also used their ratings in setting asset allocation guidelines for their investment
managers. NRSRO ratings shaped the investment opportunities, capital requirements,
and hence the pro?ts of insurance companies, mutual funds, pension funds, and a
dizzying array of other ?nancial institutions.
Unsurprisingly, NRSROs shifted from selling their credit ratings to subscribers
to selling their ratings to the issuers of securities. Since regulators, of?cial agencies,
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and private institutions around the world relied on NRSRO ratings, virtually every
issuer of securities was compelled to purchase an NRSRO rating if it wanted a large
market for its securities. Indeed, Partnoy (1999) argues that NRSROs essentially sell
licenses to issue securities; they do not primarily provide assessments of credit risk[2].
2.3 Con?icts of interest in credit rating agencies
There are clear con?icts of interest associated with credit rating agencies selling their
ratings to the issuers of securities. Issuers have an interest in paying rating agencies
more for higher ratings since those ratings in?uence the demand for and hence the
pricing of securities. And, rating agencies can promote repeat business by providing
high ratings. Interestingly, the vice president of Moody’s explained in 1957 that:
[ W]e obviously cannot ask payment for rating a bond. To do so would attach a price to the
process, and we could not escape the charge, which would undoubtedly come, that our ratings
are for sale (Morgenson, 2008).
Nevertheless, credit rating agencies convinced regulators that reputational capital
reduces the pernicious incentive to sell better ratings. If a rating agency does not
provide sound, objective assessments of a security, the agency will experience damage
to its reputation with consequential rami?cations on its long-run pro?ts. Purchasers
of securities will reduce their reliance on this agency, which will reduce demand for all
securities rated by the agency. As a result, issuers will reduce their demand for the
services provide by that agency, reducing the agency’s future pro?ts. From this
perspective, reputational capital is vital for the long-run pro?tability of credit rating
agencies and will therefore contain any short-run con?icts of interest associated with
“selling” a superior rating on any particular security.
Reputational capital will reduce con?icts of interest, however, only under particular
conditions. First, the demand for securities must respond to poor rating agency
performance, so that decision makers at rating agencies are punished for issuing
bloated ratings on even a few securities. Second, decision makers at rating agencies
must have a suf?ciently long-run pro?t horizon, so that the long-run costs to the
decision maker from harming the agencies reputation outweigh the short-run bene?ts
from selling a bloated rating.
These conditions do not hold, however. First, regulations weaken the degree to
which a decline in the reputation of a credit rating agency reduces demand for its
services. Speci?cally, regulations induce the vast majority of the buyers of securities to
use NRSRO rating in selecting assets. These regulations hold regardless of NRSRO
performance, which moderates the degree to which poor ratings performance reduces
the demand for NRSRO services. Such regulations mitigate the positive relation
between rating agency performance and pro?tability. Second, ?nancial innovation in
the form of securitization dramatically changed the incentives of decision makers at
credit rating agencies, inducing them to sell bloated ratings at the expense of a loss in
the long-run reputation of the agency.
2.4 Securitization and the intensi?cation of con?icts of interest
The explosive growth of securitized and structured ?nancial products from the late
1990s onward materially intensi?ed the con?icts of interest problem. Securitization
and structuring involved the packaging and rating of trillions of dollars worth of new
?nancial instruments. Huge fees associated with processing these securities ?owed to
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banks and NRSROs. Impediments to this securitization and structuring process, such
as the issuance of low credit rating on the securities, would gum-up the system,
reducing rating agency pro?ts.
In fact, the NRSROs started selling ancillary consulting services to facilitate the
processing of securitized instruments, increasing NRSRO incentives to exaggerate
ratings on structured products. Besides purchasing ratings fromthe NRSROs, the banks
associated with creating structured ?nancial products would ?rst pay the rating
agencies for guidance on how to package the securities to get high ratings and then pay
the rating agencies to rate the resultant products.
Other evidence also indicates that rating agencies adjusted their behavior to capture
the pro?ts made available by securitization and the design of new structured ?nancial
products. Lowenstein’s (2008) excellent description of the rating of a MBS by Moody’s
demonstrates the speed with which complex products had to be rated, the poor
assumptions on which these ratings were based, and the pro?ts generated by rating
structured products. Other information indicates that if the rating agencies issued a
lower rating than countrywide (a major purchaser of NRSRO ratings) wanted, a few
phone calls would get this changed (Morgenson, 2008). Indeed, internal e-mails indicate
that the rating agencies lowered their rating standards to expand the business and
boost revenues. A Standard and Poor’s employee noted in 2004:
We are meeting with your group this week to discuss adjusting criteria for rating C.D.O.s of
real estate assets this week because of the ongoing threat of losing deals. Lose the C.D.O. and
lose the base business – a self reinforcing loop (Chan, 2010a).
A collection of documents released by the US Senate suggests that NRSROs
consciously adjusted their ratings to maintain clients and attract new ones.
The short-run pro?ts from these activities were mind bogglingly large and made the
future losses from the inevitable loss of reputational capital irrelevant. For example,
the operating margin at Moody’s between 2000 and 2007 averaged 53 percent. This
compares to operating margins of 36 and 30 percent at Microsoft and Google, or
17 percent at Exxon. It is true that the performance of the rating agencies played a
central role in the crisis. Thus, rating agencies faced little market discipline, had no
signi?cant regulatory oversight, were protected from competition by regulators and
legislators, and enjoyed a burgeoning market for their services. Indeed, the 2006 Credit
Rating Agency Reform Act speci?cally prohibited the SEC from regulating an
NRSRO’s rating methodologies. It was good to be an NRSRO.
The regulatory community did not adapt to these well-known developments.
Distressingly, the intensi?cation of con?icts of interest through the selling of consulting
services by rating agencies closely resembles the ampli?cation of con?icts of interest
when accounting ?rms increased their sales of consulting services to the ?rms they were
auditing. This facilitated the corporate scandals that emerged less than a decade ago,
motivating the Sarbanes-Oxley Act of 2002. Yet, still, regulators did not respond as
rating agencies pursued these increasingly pro?table lines of business.
2.5 Conclusions
While the crisis does not have a single cause, the behavior of the credit rating agencies
is a de?ning characteristic. It is impossible to imagine the current crisis without the
activities of the NRSROs. And, it is dif?cult to imagine the behavior of the NRSROs
without the regulations that permitted, protected, and encouraged their activities.
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In terms of the postmortem, the role of NRSROs is not an example of “accidental”
death or “suicide.” The con?icts of interest within NRSROs have been known for
decades and the further perversion of incentives due to securitization was predicted
over a decade before the crisis. Similarly, it is dif?cult to view the NRSROs as suicidal.
The decision makers at NRSROs made enormous amounts of money. It was a logical,
rational, and legal decision. As noted in an internal e-mail by an S&P employee, “Let’s
hope we are all wealthy and retired by the time this house of cards falters” (Chan,
2010a). Rather, the evidence is most consistent with the view that regulatory policies
and Congressional laws protected and encouraged the behavior of NRSROs.
3. CDSs and bank capital
3.1 Background
Next, consider the role of complex derivative contracts, including CDSs. According to
this view, ?nanciers used newly designed ?nancial instruments to boost pro?ts,
with the systemic risks of these ?nancial innovations largely unknown. When
the housing market faltered, triggering a devastating reduction in the price of derivative
securities, this shocked both markets and regulators. But, is this an accurate, complete
characterization?
A CDS is an insurance-like contract written on the performance of a security or
bundle of securities. For example, purchaser A buys a CDS from issuer B on security C.
If security C has a prede?ned “credit-related event,” such as missing an interest
payment, receiving a credit downgrade, or ?ling for bankruptcy, then issuer B pays
purchaser A. While having insurance-like qualities, CDSs are not formally insurance
contracts. Neither the purchaser nor the issuer of the CDS needs to hold the underlying
security, leading to the frequently used analogy that CDSs are like buying ?re
insurance on your neighbor’s house. Moreover, since CDSs are not insurance contracts,
they are not regulated as tightly as insurance products. CDSs are ?nancial derivatives
that are transacted in unregulated, OTC markets.
In principle, banks can use CDSs to reduce both their exposure to credit risk and the
amount of capital held against potential losses. For example, if a bank purchases a CDS
on a loan, this can reduce its credit risk: if the loan defaults, the counterparty to the CDS
will compensate the bank for the loss. If the bank’s regulator concludes that the
counterparty to the CDS will actually pay the bank if the loan defaults, then the regulator
typically allows the bank to reallocate capital to higher expected return, higher
risk assets.
3.2 The Fed, CDSs, and bank capital
The Fed made a momentous decision in 1996: it permitted banks to use CDSs to reduce
capital reserves (Tett, 2009, p. 49). Regulators treated securities guaranteed by a seller
of CDSs as having the risk level of the seller – or more accurately, the counterparty –
of the CDS. For example, a bank purchasing full CDS protection from American
International Group (AIG) on collateralized debt obligations (CDOs) linked to
sub-prime loans would have those CDOs treated as AAA securities for capital
regulatory purposes because AIG had an AAA rating from a NRSRO, i.e. from a
SEC-approved credit rating agency.
Consequently, banks used CDSs to reduce capital and invest in more lucrative,
albeit more risky, assets. For example, a bank with a typical portfolio of $10 billion of
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commercial loans could reduce its capital reserves against these assets from about $800
million to under $200 million by purchasing CDSs for a small fee (Tett, 2009, p. 64). The
CDS market boomed following the Fed’s decision. By 2007, the largest US commercial
banks had purchased $7.9 trillion in CDS protection and the overall CDS market
reached a notional value of $62 trillion (Barth et al., 2009).
There were, however, serious problems associated with allowing banks to reduce their
capital via CDSs. Given the active trading of CDSs, it was sometimes dif?cult to indentify
the actual counterparty legally responsible for compensating a bank if an “insured”
security failed. Furthermore, some bank counterparties developed massive exposures to
CDS risk. For example, AIG had a notional exposure of about $500 billion to CDSs
(and related derivatives) in 2007, while having a capital base of about $100 billion to cover
all its traditional insurance activities as well as its ?nancial derivatives business. The
growing exposure of AIG and other issuers of CDSs should have – and did – raise
concerns about their ability to satisfy their obligations in times of economic stress.
3.3 The Fed maintains its policy despite growing risks
The Fed was aware of the growing danger to the safety and soundness of the banking
system from CDSs[3]. For instance, Tett (2009, p. 157-63) recounts how Timothy
Geithner, then President of the New York Federal Reserve Bank, became concerned in
2004 about the lack of information on CDSs and the growing counterparty risk facing
banks. Barth et al. (2009, p. 184-93) demonstrate through the use of internal Fed
documents that it knew by 2004 of the growing problems associated with subprime
mortgage-related assets, on which many CDSs were written. Indeed, the FBI publicly
warned in 2004 of an epidemic of fraud in subprime lending. In terms of the sellers of
CDSs, detailed accounts by Lewis (2009) and McDonald and Robinson (2009) illustrate
the Fed’s awareness by 2006 of AIG’s growing fragility and the corresponding
exposure of commercial banks to CDS counterparty risk[4].
Yet, even more momentously than the original decision allowing banks to reduce
their capital reserves through the use of CDSs, the Fed did not adjust its policies as it
learned of the growing fragility of the banking system due to the mushrooming use of
increasingly suspect CDSs.
The key question is why the Fed maintained its capital regulations. Bank purchases
of CDSs boomed immediately after the 1996 regulatory decision allowing a reduction in
bank capital from the purchase of CDSs. Why did not the Fed respond by demanding
greater transparency before granting capital relief and conducting its own assessment
of the counterparty risks facing the systemically important banks under its
supervision? Why did not the Fed adjust in 2004 as it learned of the opaque nature of
the CDS market and as the FBI warned of the fraudulent practices associated with the
issuance of the sub-prime mortgages underlying many CDS securities, or in 2006 as
information became available about the fragility of AIG, or in 2007 when hedge funds
warned the Fed, the Treasury, and G8 delegates about the growing fragility of
commercial banks (Tett, 2009, p. 160-3)? Why did not the Fed prohibit banks from
reducing regulatory capital via CDSs until the Fed had con?dence in the ?nancial
viability of those selling CDSs to banks?
The Fed’s decision to maintain its regulatory stance toward CDSs was neither a
failure of information, nor a shortage of regulatory power. Based on a review of internal
Fed documents, Barth et al. (2009, p. 184) note:
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[. . .] even if the top of?cials from these regulatory agencies did not appreciate or wish to act
earlier on the information they had, their subordinates apparently fully understood and
appreciated the growing magnitude of the problem.
And, even in 2004, the Fed issued Interpretive Letter No. 998 that reiterated its capital
regulatory policy with respect to CDSs.
It was a choice; it was a failure of regulatory governance.
The Fed could have modi?ed its capital regulations based on two simple, prudent
premises. First, the Fed is responsible for the safely and soundness of the ?nancial
system, which relies on the largest banks holding capital commensurate with their
risks. Second, the Fed did not have reliable methods for assessing the credit risk of
those selling CDSs to banks, nor could it rely on the credit rating agencies to assess
that counterparty risk. Based on these principles, the Fed could have prohibited banks
from reducing regulatory capital via CDSs until the Fed had con?dence in the ?nancial
viability of those selling CDSs to banks. It is true that the Fed did not have regulatory
authority over CDSs, the credit rating agencies, AIG, or many other sellers of CDSs, so
it could not have directly improved the counterparty risk associated with CDS. But, the
Fed was – and is – responsible for overseeing the safely and soundness of the major
banks. If it had refused to allow banks to reduce their capital reserves via CDSs, the
Fed could have both enhanced the stability of the major banks and indirectly created
incentives for improvements in the CDS market.
3.4 Postmortem
I am not suggesting that the Fed’s decision to allow banks to reduce their regulatory
capital through the purchase of CDSs was the major cause of the global ?nancial crisis.
It is quite dif?cult to quantify the degree to which this policy increased risk taking at
any individual bank or the fragility of the ?nancial system as a whole.
I am suggesting that the evolution of the CDS market, the fragility of the banks, and
the Fed’s capital rules illustrate key features of the ?nancial crisis that are frequently
ignored in current discussions of regulatory reform. First, the problems with CDSs and
bank capital were not a surprise in 2008; there was ample warning that things were
going awry. Second, senior government policymakers created policies that encouraged
reckless behavior by ?nanciers and adhered to those policies over many years even as
they learned about the rami?cations of their policies.
4. Transparency vs the Fed, SEC, and Treasury
Powerful regulators and policymakers thwarted efforts to make the CDS market more
transparent. The Fed (under Alan Greenspan), the Treasury (under Robert Rubin and
then Larry Summers), and the SEC (under Arthur Levitt) squashed attempts by
Brooksley Born of the Commodity Future Trading Commission (CFTC) to shed light on
the multi-hundred-trillion dollar OTC derivatives market, which included CDSs, at the
end of the 1990s.
Incidents of fraud, manipulation, and failure in the OTC derivatives market began
as early as 1994, with the sensational bankruptcy of Orange County and court cases
involving Gibson Greeting Cards and Proctor & Gamble against Bankers Trust.
Numerous problems, associated with bankers exploiting unsophisticated school
districts and municipalities, plagued the market. Further, OTC derivates played a
dominant role in the dramatic failure of long-term capital management (LTCM) in the
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Summer of 1998. Indeed, no regulatory agency had any warning of LTCM’s demise, or
the potential systemic implications of its failure, because it traded primarily in this
opaque market.
In light of these problems and the lack of information on the OTC derivatives
market, the CFTC issued a “concept release” report in 1998 calling for greater
transparency of OTC derivatives. The CFTC sought greater information disclosure,
improvements in record keeping, and controls on fraud. The CFTC did not call for
draconian controls on the derivatives market; it called for more transparency.
The response by the Fed, the Treasury, and the SEC was swift: They stopped the
CFTC. First, they obtained a six month moratorium on the CFTC’s ability to implement
the strategies outlined in its concept release. Second, the President’s Working Group on
Financial Markets, which consists of the Secretary of the Treasury, the Chairman of the
Board of Governors of the Federal Reserve System, the Chairman of the SEC, and the
Chairman of the CFTC, initiated a study of the OTC derivatives market. Finally, they
helped convince Congress to pass the Commodity Futures Modernization Act of 2000,
which exempted the OTC derivates market – and hence the CDS market – from
government oversight.
Senior regulators and policymakers lobbied hard to keep CDSs and other
derivatives in opaque markets. This policy was not an accident; it was a choice.
The point of this addendum is to emphasize that senior regulators and policymakers
lobbied hard to keep CDSs and other derivatives in opaque markets. Thus, a
comprehensive assessment of the causes of the crisis must evaluate why policymakers
made choices like this. Indeed, Timiraos and Hagerty (2010) argue:
Nearly, a year and half after the outbreak of the global economic crisis, many of the problems
that contributed to it haven’t been tamed. The US has no system in place to tackle a failure of
its largest ?nancial institutions. Derivatives contracts of the kind that crippled AIG Inc. still
trade in the shadows. And investors remain heavily reliant on the same credit-ratings ?rms
that gave AAA ratings to lousy mortgage securities.
5. Investment bank capital, risk taking, and the SEC
We have good deal of comfort about the capital cushions at these ?rms at the moment.
Christopher Cox, SEC chairman, March 11, 2008, as quoted from Labaton (2008a).
5.1 Total failure
All ?ve major investment banks supervised by the SEC experienced major
“transformations” in 2008. Only three days after the SEC Chairman expressed
con?dence in the ?nancial soundness of the investment banks on March 11, 2008, the
New York Federal Reserve provided an emergency $25 billion loan to Bear Stearns in a
vain attempt to avert Bear’s failure. A few days later, with additional ?nancial
assistance from the Fed, a failed Bear Stearns merged with the commercial bank
JP Morgan Chase & Co. Six months later, Lehman Brothers went bankrupt, and a few
months later, at the brink of insolvency, Merrill Lynch merged with Bank of America.
In the Autumn of 2008, Goldman Sachs and Morgan Stanley were “pressured” into
becoming bank holding companies by the Federal Reserve and arguably rescued from
failure through an assortment of public programs.
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5.2 Three coordinated SEC policies
The SEC’s ?ngerprints are indelibly imprinted on this debacle. First, the SEC in 2004
exempted the ?ve largest investment banks from the net capital rule, which was a 1975
rule for computing minimum capital standards at broker-dealers[5]. The investment
banks were permitted to use their own mathematical models of asset and portfolio risk
to compute appropriate capital levels. The investment banks responded by issuing
more debt to purchase more risky securities without putting commensurately more of
their own capital at risk. Leverage ratios soared from their 2004 levels, as the bank’s
models indicated that they had suf?cient capital cushions.
Second, in a related, coordinated 2004 policy change, the SEC enacted a rule that
induced the ?ve investment banks to become “consolidated supervised entities” (CSEs):
The SEC would oversee the entire ?nancial ?rm. Speci?cally, the SEC now had
responsibility for supervising the holding company, broker-dealer af?liates, and all
other af?liates on a consolidated basis. These other af?liates include other regulated
entities, such as foreign-registered broker-dealers and banks, as well as unregulated
entities such as derivatives dealers (Colby, 2007). The SEC was charged with evaluating
the models employed by the broker-dealers in computing appropriate capital levels and
assessing the overall stability of the consolidated investment bank. Given the size and
complexity of these ?nancial conglomerates, overseeing the CSEs was a systemically
important and dif?cult responsibility.
Third, the SEC neutered its ability to conduct consolidated supervision of major
investment banks. With the elimination of the net capital rule and the added
complexity of consolidated supervision, the SEC’s head of market regulation, Annette
Nazareth, promised to hire high-skilled supervisors to assess the riskiness of
investment banking activities. But, the SEC did not. In fact, the SEC had only seven
people to examine the parent companies of the investment banks, which controlled
over $4 trillion in assets. Under Christopher Cox, who became chairman in 2005, the
SEC eliminated the risk management of?ce and failed to complete a single inspection of
a major investment bank in the year and a half before the collapse of those banks
(Labaton, 2008a). Cox also weakened the Enforcement Division’s freedom to impose
?nes on ?nancial ?rms under its jurisdiction.
5.3 The effects of these decisions
With these three policies, the SEC became willfully blind to excessive risk taking,
contributing to the onset, magnitude, and breadth of the ?nancial crisis. The SEC has
correctly argued that the net capital rule never applied to the holding company in
defending the 2004 net capital rule. But, this defense is narrowly focused on the net
capital rule alone. It is the combination of SEC policies that helped trigger the crisis, not
only the change in the net capital rule[6].
In easing the net capital rule, adopting a system of consolidated supervision, but
failing to develop the capabilities to supervise large ?nancial conglomerates, the SEC
became willfully blind to excessive risk taking. The evidence points inexorably toward
the SEC as an accomplice in creating a fragile ?nancial system.
Indeed, the current Chairwomen of the SEC, Mary Schapiro, and a court appointed
investigator agree with this assessment. Ms Schapiro noted:
I think everybody a few years ago got caught up in the idea that the markets are
self-correcting and self-disciplined, and that the people in Wall Street will do a better job
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protecting the ?nancial system than the regulators would. I do think the SEC got diverted by
that philosophy (Wyatt, 2010).
Valukas’s (2010) 2,200-page report on the causes of the Lehman Brothers failure to the
bankruptcy court is even more pointed. It notes that:
.
Lehman regularly exceeded its own risk limits; and
.
the SEC knew about these excesses and did nothing.
To conclude, consider the testimony of The SEC’s Deputy Director, Robert Colby (2007),
before the US House of Representatives Financial Services Committee on April 25:
[. . .] the bill as introduced would subject the CSEs that already are highly regulated under the
Commission’s consolidated supervision program to an additional layer of duplicative and
burdensome holding company oversight. The bill should be amended to recognize the unique
ability of the Commission to comprehensively supervise the consolidated groups [. . .] Because
the Commission has established a successful consolidated supervision program based on its
unique expertise [. . .]
About 18 months after the SEC argued that it was successfully supervising the ?ve
major investment banks, they had either gone bankrupt, failed and merged with other
?rms, or were forced to convert to bank holding companies, with billions of taxpayer
dollars spent on facilitating these arrangements. The purposeful elimination of
supervisory guardrails supports a charge of gross negligence, without malice, in
facilitating the ?nancial crisis.
6. Fannie Mae and Freddie Mac
6.1 Background
The government, through the Federal Housing Finance Agency, placed into
conservatorship both the Federal National Mortgage Association (Fannie Mae) and
the Federal Home Loan Mortgage Corporation (Freddie Mac) on September 7, 2008.
Together, these two regulated housing-?nance giants owned or guaranteed almost
$7 trillion worth of mortgages. Fannie Mae and Freddie Mac are Congressionally
chartered, stockholder-owned corporations.
These government-sponsored entities (GSEs) were designed to facilitate housing
?nance. They purchase mortgages from banks and mortgages companies that lend
directly to homeowners, package the mortgages into MBSs, guarantee timely payment
of interest and principal, and sell the MBSs to investors. Besides this core securitization
activity, the GSEs also buy and hold mortgages and MBSs. By increasing the demand
for, and hence the price of, mortgages in the secondary market, the GSEs can reduce
the interest rates the homebuyers pay on mortgages in the primary market, fostering
home ownership.
While facilitating housing is a raison d’etre, the GSEs also used their privileged
positions to earn substantial pro?ts. The GSEs borrowedcheaply: the debt issued bythese
two ?nancial institutions enjoyed an implicit government guarantee, which was made
explicit when the government placed them into conservatorship. Thus, the GSEs could
borrow at low interest rates and buy mortgages with higher interest rates. Over time, the
GSEs increased the degree to which they bought and held mortgages relative to their
securitization role, in which they bought, packaged, guaranteed, and sold MBSs. As long
as there were not too manydefaults, the GSEs made enormous pro?ts. Indeed, pro?ts were
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limited primarily by the size of the mortgage market and threatened by regulatory
interventions that might force GSEs tofunnel more of their earnings intoloweringprimary
mortgage rates, with a concomitant lowering of GSE pro?ts. Fortunately, for the GSEs,
Congress and other policymakers helped expand the mortgage market and kept
regulatory interventions to a minimum.
6.2 Policy changes and effects
Two policies combined to expand the mortgage market for GSEs: the expansion of the
affordable housing mission of GSEs and the Community Reinvestment Act (CRA) as
discussed in Barth et al. (2009), Joint Center for Housing Studies (2008), and Wallison and
Calomiris (2009). Enacted in 1977, the CRA was designed to boost lending to
disadvantaged areas by prohibiting discrimination. In the mid-1990s, under the CRA,
regulators started using quantitative guidelines to induce greater lending to low- and
moderate-income (LMI) areas and borrowers. The Department of Housing and Urban
Development in the mid-1990s put corresponding pressure on the GSEs to adjust their
?nancing standards to facilitate the ?ow of credit to LMI borrowers, encouraging
the GSEs to ?nance lower quality mortgages. Furthermore, Congress also added
an affordable housing mission to the GSEs. In 1991, Fannie Mae announced a
$1 trillion affordable housing initiative, and in 1994, Fannie Mae and Freddie Mac
initiated an additional $2 trillion program for LMI borrowers.
These policies permitted and encouraged the GSEs to accept lower quality
mortgages and hence spurred primary market lenders to lend more to more suspect
borrowers. For example, by 2001, the GSEs were purchasing mortgages that had no
down payment; between 2005 and 2007, they bought approximately $1 trillion of
mortgages with subprime characteristics; which accounted for about 45 percent of their
mortgage purchases (Wallison and Calomiris, 2009 and Fannie Mae, 2008). By
signaling to mortgage lenders that they would purchase mortgages with subprime
characteristics – such as mortgages with low FICO credit scores, high loan-to-value
ratios, negative amortization, low documentation – Fannie and Freddie triggered a
massive movement into the issuance of lower quality mortgages. Mortgage companies
were more willing to accept the fees for making loans to questionable borrowers if they
knew that the GSEs would purchase the loan.
The push into lower quality mortgages created a complex “mutual dependency”
between Congress and the GSEs, fueling their increasingly risky investments
(Wallison and Calomiris, 2009). Congress relied on the GSEs to both promote housing
policies and to provide campaign donations. The GSEs relied on Congress to protect
their pro?table privileges and refrain from regulatory interventions. Each satis?ed its
side of the bargain. The GSEs provided generous campaign contributions and greatly
expanded their funding of LMI borrowers. Pro?ts and bonuses soared. In turn,
policymakers limited regulatory oversight of the GSEs. Indeed, even after the House
Banking Subcommittee and the GSE’s regulator (Of?ce of Federal Housing Enterprise
Oversight) accused them of serious accounting fraud in 2000, 2003, and 2004 and even
as evidence emerged of their ?nancial fragility, Congress did not pass a proposed bill
that would have strengthened supervision of the GSEs and prohibited the GSEs from
buying and holding MBSs. Such a policy shift would have limited GSE exposure to
low-quality mortgages, which ultimately led to their bankruptcy.
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6.3 Postmortem
Deterioration in the ?nancial condition of the GSEs was not a surprise. The New York
Times warned in 1999 that Fannie Mae was taking on so much risk that an economic
downturn could trigger a “rescue similar to that of the savings and loan industry in the
1980s,” and again emphasized this point in 2003 (Holmes, 1999). From 2003 through
2007, the GSE’s regulator warned of excessive risk taking; the Treasury acknowledged
ineffective oversight of the GSEs; Congress discussed the fragility of GSEs and their
illusory pro?ts; Alan Greenspan testi?ed before the Senate Banking Committee in 2004
that the increasingly large and risky GSE portfolios could have enormously adverse
rami?cations; and Taleb (2007) warned that the GSEs “seem to be sitting on a barrel of
dynamite, vulnerable to the slightest hiccup” (Berenson, 2003; Goldfarb, 2008; Labaton,
2003; Greenspan, 2004).
But, Congress did not respond and allowed increasingly fragile GSEs to endanger the
entire ?nancial system. It is dif?cult to discern why. Some did not want to jeopardize the
increased provision of affordable housing. Many received generous ?nancial support
from the GSEs in return for their protection. For the purposes of this paper, the critical
issue is that policymakers did not respond as the GSEs became systemically fragile.
Again, I am not arguing that the timing, extent, and full nature of the housing bubble
were perfectly known. I am arguing that policymakers created incentives for massive
risk taking by the GSEs and then did not respond to information that this risk taking
threatened the ?nancial system.
7. Conclusion
Finance is powerful. As the last few years demonstrate, the malfunctioning of the
?nancial system can trigger economic crises, harming the welfare of many. As the last
few centuries demonstrate, the functioning of the ?nancial system affects long-run
economic growth. If ?nancial systems funnel society’s savings to those with the best
projects, this helps promote and sustain economic progress (Levine, 2005). Getting
?nancial policies right is a ?rst-order priority in creating an environment conducive to
economic prosperity.
This paper has examined the determinants of the recent crisis. Without denying the
importance of capital account imbalances and herd behavior, my analyses suggest that
this is not the entire story. Similarly, while a con?uence of surprises helped trigger the
crisis, the evidence is inconsistent with the view that poor information about ?nancial
institutions was the sole cause of the crisis. Thus, the evidence is inconsistent with
testimonies before the Financial Crisis Inquiry Commission by Robert Rubin (former
Treasury secretary and former director of Citigroup), Charles O. Prince III (former CEO
of Citigroup), and Alan Greenspan (former Chairman of the Fed), who claim that the
crisis was an unprecedented and unpredictable accident. The crisis did not just happen.
Policymakers and regulators, along with private sector coconspirators, helped cause it.
The evidence indicates that ?nancial sector policies during the period from 1996
through 2006 precipitated the crisis. Either by becoming willfully blind to excessive
risk taking or by maintaining policies that encouraged destabilizing behaviors,
policymakers, and regulatory agencies contributed to the ?nancial system’s collapse.
As noted by Senator Carl Levin, “The recent ?nancial crisis was not a natural disaster;
it was a manmade economic assault. It will happen again unless we change the rules.”
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Notes
1. Citigroup’s former CEO, Charles O. Prince, noted to the Financial Times (Nakamoto and
Wighton, 2007), “When the music stops [. . .] things will be complicated. But as long as the
music is playing, you have got to get up and dance. We are still dancing.”
2. See Hill (2010a, b) for insight examinations of credit-ratings ?rms.
3. There is a longer history. In 1992, the President of the NY Federal Reserve Bank, Jerry
Corrigan, expressed grave concerns that derivatives, primarily interest rates swaps,
threatened the stability of banks and threatened the banks with tighter regulations
(Tett, 2009, pp. 17-18). But, Alan Greenspan, the Chairman of the entire Federal Reserve
System, supported the International Swaps and Derivatives Association and successfully
convinced Congress in 1994 to keep derivatives largely unregulated (Tett, 2009, pp. 39-40).
4. Furthermore, although the demise and government conservatorship of AIG in the September
of 2008 is sometimes discussed as a complete surprise, it was not a surprise to the Fed or to
(The) Time magazine, which ran an article on March 17, 2008 titled, “Credit default swaps:
the next crisis.” The article reported that AIG had recently taken an $11 billion write-down
on its CDS holdings and that loses on CDS holdings severely damaged Swiss Reinsurance
Co. and monoline bond insurance companies, including MBIA and Ambac Financial Group
Inc. The article noted explicitly that these developments could be devastating for the
?nancial institutions that purchased credit protection from these insurers. Yet, on March 16,
2008 on CNN, Treasury Secretary Paulson noted that, “I have great, great con?dence in our
capital markets and in our ?nancial institutions. Our ?nancial institutions, banks, and
investment banks, are strong.” (Quoted from Barth et al., 2009, p. 1). Why did not the Fed
prepare for the potential failure of AIG or other major sellers of CDSs in the spring of 2008?
So far, US taxpayers have handed over about $180 billion to AIG.
5. As the SEC Commissioners debated the policy, they noted that it could lead to a “potential
catastrophe” and questioned whether “we really will have investor protection.” Yet, they
ultimately voted for it, with one commissioner noting that he would “keep my ?ngers
crossed for the future.” For an illuminating video of the actual meeting, see Labaton (2008b).
6. The SEC also correctly notes that leverage ratios at the CSE holding companies were higher
during some years in the 1990s than in 2006. But, the nature of ?nancial markets and risk
taking shifted markedly from the 1990s to the mid-2000s due to the explosion of structured
products and the increased use of OTC derivatives. Thus, comparing leverage ratios in the
1990s to those in 2006 is much less informative than comparing leverage ratios from 2004 to
2006, when leverage ratios boomed after the SEC changed its policies.
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Corresponding author
Ross Levine can be contacted at: [email protected]
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