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They Didn’t Regulate Enough and Still Don’t

The White House
Barack Obama with Ben Bernanke on Martha’s Vineyard, just before the announcement 
of Bernanke’s reappointment as chairman of the Federal Reserve, August 25, 2009

Practically everyone now agrees that the steep recession of the last two years was caused, at least in part, by lack of government oversight of the financial industry. The half-dozen or so federal agencies that are responsible for regulating the financial community ignored the dangerously risky activities of bankers and traders; so did the Federal Reserve and the US Treasury.

It is true that these agencies faced a tangle of complexities. The institutions deeply involved in the recent crisis include traditional commercial banks that take savers’ deposits as well as investment banks, mortgage brokers, credit-rating agencies, hedge funds, money market mutual funds, insurance companies, and government-sponsored enterprises such as the Federal National Mortgage Association (Fannie Mae).

Among them, these entities control many trillions of dollars, a large portion of which is in the form of derivatives contracts, investment vehicles that enable banks and other investors to buy and sell securities with little capital and also manage risk. (As just one example, if I believe the price of gold will go up, I do not have to buy the bars of gold: for much less money, I can buy a contract—a derivative—that is accepted by a “counterparty,” who will pay me if the gold price rises within a certain period of time, but will keep my payment for the contract if the price falls.) These derivatives, however, are traded over the counter and out of sight of regulators. In recent years special kinds of derivatives, known as credit default swaps, were sold in enormous volume as insurance against risky, mortgage-backed investments but with no government regulations to help insure that counterparties would meet their obligations to pay. Moreover, the interests of all these institutions are well represented in Washington by influential lobbyists. According to the Center for Responsive Economics, the finance, insurance, and real estate industry spent $223 million on lobbying in the first half of 2009, second only to the health care industry.1

President Obama promised soon after taking office to reregulate the financial markets in a comprehensive regulatory bill. The administration released its proposals on June 14 in “Financial Regulatory Reform: A New Foundation,” a lengthy white paper—not extensively covered by the press—that was overseen by Treasury Secretary Timothy Geithner and Lawrence Summers, the director of the National Economic Council, who served as Treasury secretary during the Clinton administration.2 Rarely has an administration had a better opportunity to explore deeply how modern financial markets work and have evolved, and how readily they can be abused.

On balance, the white paper, though it contains several worthy ideas, was disappointing. Offering little more than a wide-ranging summary of existing regulatory proposals, it did not attempt to analyze why the crisis occurred or was so intense; nor did it identify in any detail the rules or regulations that were lacking that might have prevented the crisis. The President, in a mid-September speech on Wall Street, exhorted the financial community to support reform, but essentially reiterated last June’s proposals.

The white paper’s relative lack of new analysis raises questions about what critical lessons the Obama team learned from its closed-door meetings with bankers, brokers, economists, former regulators, a handful of consumer advocates, and the current overseers of regulatory agencies over the preceding months. When Geithner appeared at congressional hearings in July and early August to defend the plan for the first time, he met with open criticism from several of the key regulators themselves, who also testified. They included the chairs of the Federal Reserve, the Federal Deposit Insurance Corporation, and the Securities and Exchange Commission, all of whom had substantive quarrels with the plan.

This opposition may have been inevitable, since the administration wanted to streamline regulatory powers, and possibly eliminate some regulatory agencies altogether. The most refreshing of the administration’s proposals is its call for a new financial consumer protection agency to maintain standards for mortgages, credit cards, and basic investment products. But this idea was publicly criticized by Ben Bernanke, the Federal Reserve chairman, who argued that most of these matters were already under the jurisdiction of the Fed.

For her part, Sheila Bair, the chairwoman of the Federal Deposit Insurance Corporation, who like Bernanke was a Bush appointee, was critical of the white paper’s proposal to place the Fed in charge of minimizing what is known as “systemic risk.” Such risk can occur when a financial institution is so large or interconnected—the insurance giant AIG and the banking conglomerate Citigroup are obvious examples—that its failure can jeopardize the entire financial system. Bair had long differed with Bernanke over the Fed’s financial bailout policies, and warned that the administration’s solution would confer too much power on the Fed. She prefers the creation of a new independent council to monitor systemic risk in which all the major regulators participate.

In July, a group headed by former SEC chairmen Arthur Levitt and William Donaldson also concluded that an independent council, not the Federal Reserve, should have the authority to manage systemic risk. This group was concerned in part by the Fed’s poor performance, before the credit crisis erupted, in regulating the commercial banks and mortgage-writing institutions already under its supervision. The Fed neither demanded that more capital be set aside against risky investments nor raised standards for writing mortgages.

By early October, Bernanke, who was recently appointed to a second term by Obama pending Senate confirmation, seemed more open to the idea of a council of regulators. “We have never supported, and the administration has never supported, a situation in which the Fed would be some kind of untrammeled super-regulator,” he told the House Financial Services Committee.

While this debate has unfolded among the regulators, Democratic members of Congress have also criticized the Obama plan, among them Barney Frank, who chairs the House Financial Services Committee, and Christopher Dodd, who is head of the Senate Banking Committee, and is now proposing to merge four banking regulators, including the Fed, into one super-regulator. Both Frank and Dodd are planning to produce their own regulatory bills, but at this point, it seems unlikely that a comprehensive bill can be passed this year or early next, and the chances of setting up the new consumer protection agency seem smaller. Not only banks but such powerful corporations as American Express have been lobbying hard against it. The Obama administration and Frank are already watering down the proposed duties of the agency.

Responding to the widespread criticism, Lawrence Summers also indicated in mid-September that the administration may be open to modifying some of its proposals, for example by establishing a monitor of systemic risk that includes other regulators as well as the Fed. What is clear, however, is that the Obama administration has lost leadership of the issue of reforming Wall Street.

In fact, much of Wall Street has already returned to the aggressive practices that were widespread before the crisis, including high levels of compensation and the creation and trading of risky derivative contracts. And profits of financial firms, such as Goldman Sachs and JPMorgan Chase, often based on the same sorts of trading as in the past, are for the moment rebounding.

Perhaps the major deficiency of the Obama administration’s plan for financial reform is that it presents no persuasive hypothesis why the credit system collapsed in the fall of 2008. Instead, the Treasury white paper provides a sweeping list of contributing problems—all of them well known—and gives none of them priority over others. They include granting subprime mortgages to people with inadequate incomes; the historically rapid run-up in housing prices over the preceding five years; excessive risk-taking and levels of debt among financial firms, especially investment banks such as Bear Stearns and Lehman Brothers; overreliance on private credit-rating agencies (whose fees are paid by the companies they rate); the widely criticized salaries and bonuses that rewarded risk-taking without commensurate penalties for failure; and the unregulated trading in derivatives, mentioned above, which also encouraged risky investing. Just listing such problems evades what is needed: an inquiry into the principal causes of a system-wide collapse.

In many cases there were relevant regulations that might have been used and were disregarded. The Federal Reserve, for example, had the authority to investigate the risks posed by different kinds of mortgages. One of its governors, Edward M. Gramlich, publicly urged such an inquiry in the early 2000s. But Alan Greenspan, then chairman, rejected his advice.3 Commercial banks also had off-balance-sheet subsidiaries, known as structured investment vehicles, that enabled them to invest aggressively with low levels of capital. The Fed could have investigated or more closely restricted these entities, but did not.

The Securities and Exchange Commission had the power to restrict the amounts of debt taken on by investment banks; yet in 2004 it specifically allowed major investment banks to increase their leverage. By the time of the crisis, they were borrowing thirty times or more than their reserve capital. Nor did the SEC examine and question the quality of the investments the securities firms were making with all the money they borrowed, which it had the authority to do.

There were ample opportunities to tighten regulations as well. The former chairwoman of the Commodity Futures Trading Commission, Brooksley Born, for example, had requested powers to regulate derivatives in the late 1990s, but was denied them by the Clinton administration’s economic team, which included Robert Rubin, then Treasury secretary, and Lawrence Summers, then his deputy. Summers in particular was a powerful advocate of deregulation or light supervision in the late 1990s. They argued that these derivatives generally reduced risk in markets and that regulations would impede investors’ ability to create such instruments, a classic free-market defense.

Every financial crisis seems to have been driven in part by a different false assumption about the behavior of financial markets. The myth this time was that mortgages and securities based on them were backed by real estate, and therefore unusually solid. What was ignored, or systematically understated by complex computerized programs that used historical trends to predict the future, was that the prices paid for the housing eventually far exceeded any reasonable value and the indebtedness of the homeowners could not be sustained.

Banks and mortgage brokers that issued mortgages to home buyers were able to sell them immediately to investment banks and thus were less concerned about the creditworthiness of the borrowers than they traditionally had been. They profited from the mortgages regardless of whether they later went into default. This was possible because the investment banks then packaged these mortgages into complex securities with differing interest rates to make them highly attractive investments to a variety of pension funds, mutual funds, international investors, and even subsidiaries of their own banks. Money market funds, which promised almost riskless investments and catered especially to small investors, lent money to these investment banks and others at low rates, locking themselves into loans that were riskier than they realized. Low interest rates promulgated by the Federal Reserve in the early 2000s to stave off a recession also encouraged more lending.

  1. 1

    See www.opensecrets.org/lobby/top.php?showYear=2009&indexType=c.

  2. 2

    Timothy Geithner and Lawrence Summers, “A New Financial Foundation,” The Washington Post, June 15, 2009.

  3. 3

    Edmund L. Andrews, “Fed Shrugged as Subprime Crisis Spread,” The New York Times, December 18, 2007.

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