Worthy Commentaries on the Financial Crisis
posted by Frank Pasquale
Jeff Madrick’s How We Were Ruined & What We Can Do is a superb synthesis of books and reports on the financial crisis. If we’re going to find a way out of this disaster, we have to fully understand what got us into it. Madrick meticulously traces the steps from laissez-faire ideology to its foreseeably disastrous results:
[T]he Fed did not have adequate information about [key] markets because derivatives were not traded openly and the latest CDOs, including mortgage-backed obligations, were mostly on the books of the shadow banking system. It was a serious lapse of judgment, not to mention responsibility, on the part of the Federal Reserve under Greenspan and the Securities and Exchange Commission under Christopher Cox to fail to seek more comprehensive information far earlier about the surge of lending. . . .
Financial market participants created a financial bubble of tragic proportions in pursuit of personal gain. But the deeper cause was a determination among people with political and economic power to minimize the use of government to oversee the financial markets and to guard against natural excess. If solutions are to be found, the nation requires robust and pragmatic use of government, free of laissez-faire cant and undue influence from the vested interests that have irresponsibly controlled the economy for too long. [emphasis added]
Terry Carter goes into more of the legal details in the article How Lawyers Enabled The Meltdown:
“One of the early causes of today’s problems was the deregulatory ripple that started in the Reagan administration,” says Meyer “Mike” Eisenberg, who held two high-level jobs in the Securities and Exchange Commission over a span of almost 40 years, and now lectures at Columbia Law School in New York City. “That included the appointment of people who didn’t believe in regulation.” . . .
In 1997, Brooksley Born, a former Arnold & Porter partner who chaired the Commodity Futures Trading Commission, asked for public comment on a proposal to force more transparency and nominal supervision over derivative markets. Testifying before Congress, she expressed concern that if left unregulated, derivatives could become a threat to “our regulated markets or, indeed, to our economy without any federal agency knowing about it.”
Treasury Secretary Robert Rubin and Federal Reserve Chairman Alan Greenspan were fiercely opposed. . . . By June 1998, Greenspan and Rubin had taken their complaint to Congress, urging it to intervene. Congress obliged in late 1998 with a six-month moratorium on any action on derivatives to be taken by the CFTC.
Carter also describes how the Supreme Court made it increasingly difficult to hold bad firms and their enablers accountable in decisions like Dura Pharmaceuticals v. Broudo, Tellabs v. Makor, and Stoneridge Investment Partners v. Scientific-Atlanta.
Madrick lays out some important commitments going forward:
One principle should dominate future regulation—the shadow banking system should be brought under the same regulatory oversight as commercial banking. In sum, these firms must maintain minimum capital requirements against the loans they make and mortgage-backed obligations and other CDOs they buy, just as commercial banks do. The structured investment vehicles commercial banks use to avoid such capital and other requirements should be disallowed. A federal agency, most desirably the Federal Reserve, should have the authority and obligation to examine the books of investment banks, hedge funds, and other participants in the shadow banking system to determine the quality of their investments and to set the standards by which capital is deemed adequate. Derivatives should be required to be listed on an exchange, where information about them and their prices is openly visible to market participants and federal authorities. [emphasis added]
Rules are not enough, however. Greenspan had been given the authority to examine the quality of mortgage lending by Congress in the 1990s, but simply did not use it, pleading free-market principles. The SEC under Bush appointee Cox could have examined the books of investment banks, but again mostly did not bother. Congress will have to talk louder and exercise stronger authority.
Any regulation should also take account of the incentives for managers to take company risk for personal benefit. The ability to take immediate profits from fees on risky loans infected the financial industry and eventually the entire economy, and made possible disproportionately large annual bonuses. These incentives were among the main causes of the irresponsibility on Wall Street. The best way to prevent that from occurring is to base the bonuses and compensation of financial executives on the long-term profitability of the investment firms for which they work.
My sense is that firms won’t do that until they are forced to. Given the recent controversies over pay for nonperformance that persists even today, that should be a minimum requirement imposed on any further bailout money. Gretchen Morgenson provides more useful perspectives:
Gary H. Stern, president of the Federal Reserve Bank of Minneapolis and co-author of “Too Big to Fail: The Hazards of Bank Bailouts” . . . [has] expressed deep unease over the consequences of using taxpayer money to rescue big and reckless financial institutions.
“The too-big-to-fail problem, with which I have long been concerned, has been exacerbated by actions taken over the past year to bolster financial stability,” he said, according to his prepared remarks. While conceding that the recent lifelines were appropriate, given the circumstances, he said that “it is critical that we address ‘too big to fail’ because, if left unchecked, it could well be a major source of future instability.”
Mr. Stern’s solution is an approach he calls “systemic focused supervision.” It involves “early identification, enhanced prompt corrective action and stability-related communication.” [R]egulators would identify what Mr. Stern described as “material exposures between large financial institutions and between these institutions and capital markets.” In other words, regulators would know where the fault lines are before the earthquake begins. And they would be better able to assess which institutions require support and which could be cut loose.
As Morgenson declared in a later article, “The crisis is an opportunity to go back to a banking model designed to do more than simply enrich folks at the top.” It’s hard to believe there are any responsible commentators left who don’t recognize that was the chief purpose, and disastrously enduring legacy, of the Rubin/Paulson/Greenspan ancien regime.
January 29, 2009 at 7:03 pm
Posted in: Economic Analysis of Law
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Responses (1)
A.J. Sutter - January 30, 2009 at 1:28 am
How ancien is that regime? Weren’t Summers and Geithner in there somwehere?
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