posted by Frank Pasquale
The IMF’s quarterly magazine Finance and Development has a number of good articles on the financial crisis, with Noel Sacasa’s Preventing Future Crises leading the pack. He identifies “four sets of innovations and structural changes” that rendered the system unstable:
[P]rocyclical capital and accounting practices and regulations; excessive reliance on backward-looking, market-based risk management models and systems; and a more complex and opaque configuration of players; [and] the originate-to-distribute business model and reliance on wholesale funding markets.
Each of these is worth unpacking in a little more detail before discussing his solutions.
1. Procyclical capital requirements: “During upswings, the value of marked-to-market assets and collateral increases, while loan-loss allowances decrease because default rates are expected to decline in the short run. This raises the value of reported equity and lowers the typically shortsighted probability of default estimates for both borrowers and lenders.”
2. Taking Market Values at Face Value: “Too much reliance on market prices and on oversimplified, backward-looking models to manage risks, while neglecting due diligence and analysis of fundamentals, appears to have resulted in grossly underestimating risks, inducing complacency, and decreasing monitoring.”
3. The shadow banking system’s shadowy ties: “Compared with 30 years ago, the current financial system shows more blurred distinctions between different types of players, greater consolidation, many new types of players, and tighter but more opaque interconnections between them.”
4. The downside of securitization: “Securitization and the development of private-label complex structured credit . . . may . . . have contributed to greater aggregate risk-taking and, instead of resulting in an efficient dispersion of risks, have led to a destabilizing shift of risks toward institutions that could not adequately manage them, to the reversion of some of these risks to banks that had supposedly offloaded them, and to much more uncertainty about the actual distribution of risks among market participants. . . . [Investors] relied excessively on the reputation of the institutions involved and on the credit ratings of the instruments.
Sacasa mentions several “regulatory reform priorities” in the articles, most of which sounded quite plausible to me. Who can doubt the wisdom of “making both capital requirements and macroeconomic policy more countercyclical,” improving the “quality of the credit rating process,” and reducing conflicts of interest? My question is whether any of these goals can be achieved without fundamentally reassessing the culture of compensation in these financial institutions–where the upside for reckless risk-taking is enormous, and the downside trivial.
If Dick Fuld can pilot Lehman to destruction and walk away with half a billion dollars–the total life-product of roughly 10,000 workers at his disposal–why should any future finance industry CEO avoid doing what he did once “normalcy” returns? If John Thain can demand a $10 million bonus from the Merrill Lynch in this of all years, what is the limit on what these people think they are woth–and will try every imaginable form of maneuvering to get? And doesn’t this maneuvering by its very nature depend on ever more volume or velocity of money chanelled into ever-riskier and more leveraged investments?
The Wall Street-Washington nexus of exchange (of campaign contributions for regulatory favors) has made the former party far stronger than the latter. One very important way of righting that balance is to tamp down the ability of people at the top of the investment world to accumulate so much money that they effectively control the terms of their regulation. Unsurprisingly, they managed to basically undo the very provision of the bailout meant to do just that:
Congress wanted to guarantee that the $700 billion financial bailout would limit the eye-popping pay of Wall Street executives, so lawmakers included a mechanism for reviewing executive compensation and penalizing firms that break the rules.
But at the last minute, the Bush administration insisted on a one-sentence change to the provision, congressional aides said. The change stipulated that the penalty would apply only to firms that received bailout funds by selling troubled assets to the government in an auction, which was the way the Treasury Department had said it planned to use the money.
Now, however, the small change looks more like a giant loophole, according to lawmakers and legal experts. In a reversal, the Bush administration has not used auctions for any of the $335 billion committed so far from the rescue package, nor does it plan to use them in the future. Lawmakers and legal experts say the change has effectively repealed the only enforcement mechanism in the law dealing with lavish pay for top executives. “The flimsy executive-compensation restrictions in the original bill are now all but gone,” said Sen. Charles E. Grassley (Iowa), ranking Republican on of the Senate Finance Committee.
Of course, the bankrupt ideology of Bush deregulationism is a key player here. But the material forces behind this plutocratic putsch affect both parties:
[I]f all bubbles and panics are alike, this one, the worst since the Great Depression, also carried the DNA of our own time. Enron had been a Citigroup client. In a now-forgotten footnote to that scandal, [Democratic "wise man" Bob] Rubin was discovered to have made a phone call to a former colleague in the Treasury Department to float the idea of asking credit-rating agencies to delay downgrading Enron’s debt. This inappropriate lobbying never went anywhere, but Rubin neither apologized nor learned any lessons. “I can see why that call might be questioned,” he wrote in his 2003 memoir, “but I would make it again.” He would say the same this year about his performance at Citigroup during its collapse.
The Republican side of the same tarnished coin is Phil Gramm, the former senator from Texas. Like Rubin, he helped push through banking deregulation when in government in the 1990s, then cashed in on the relaxed rules by joining the banking industry once he left Washington. Gramm is at UBS, which also binged on credit-default swaps and is now receiving a $60 billion bailout from the Swiss government.
It’s a sad snapshot of our century’s establishment that Rubin has been an economic adviser to Barack Obama and Gramm to John McCain. And that both captains of finance remain unapologetic, unaccountable and still at their banks, which have each lost more than 70 percent of their shareholders’ value this year and have collectively announced more than 90,000 layoffs so far.
Our nation’s financial establishment has been extraordinarily skillful at insulating itself from the consequences of its recklessness. Only direct limits on the power they exercise–i.e., the money they have–can prevent (or at least alleviate) future crises.