The Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States
PublicAffairs, 545 pp., $14.99 (paper)
a film directed by Charles Ferguson
Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance
edited by Viral V. Acharya, Thomas F. Cooley, Matthew P. Richardson, and Ingo Walter
Wiley, 573 pp., $49.95
Reforming US Financial Markets: Reflections Before and Beyond Dodd-Frank
by Randall S. Kroszner and Robert J. Shiller, edited and with an introduction by Benjamin M. Friedman
MIT Press, 152 pp., $19.95
With its revealing accounts of the Wall Street practices that led to the recession of 2008 and 2009, the recent report of the Financial Crisis Inquiry Commission (FCIC) is the most comprehensive indictment of the American financial failure that has yet been made. During two years of investigations, the commission accumulated evidence of many hundreds of irresponsible, self-serving, and unethical practices by Wall Street bankers and systematic tolerance of them by regulators.
Written by the six members appointed by congressional Democrats, the FCIC report concludes, “The crisis was the result of human action and inaction, not of Mother Nature or computer models gone haywire.” Many readers would think the conclusion obvious. But Wall Street professionals repeatedly claimed that similar crises occurred frequently in the history of modern capitalism, that they are merely the price paid for a dynamic and innovative economic system, and that individuals were not to blame. They thus minimized their own responsibility for the events and cast doubt on the need for significantly more intense regulation of their activities. The FCIC majority dismisses such arguments.
Can we then infer that future crises may be avoided by intelligent and unbiased financial regulators and a chastened Wall Street? A 2,300-page set of regulations—known as the Dodd-Frank Act after its congressional sponsors, Senator Chris Dodd and Representative Barney Frank—was passed last year to accomplish just that. In a television interview with Charlie Rose this March, Frank said he “got better than 90 percent” of what he wanted. The act has some bite. It proposes ways to deal with many of the practices that contributed to the crisis, including inadequate capital requirements, excessive Wall Street compensation, and damaging conflicts of interest in credit ratings agencies that readily assigned their highest ratings to risky debt. It tries to regulate trading of speculative securities like derivatives, which enabled bankers to wage huge bets with little capital on the movement of securities prices.
Under Dodd-Frank, a new oversight board, composed of members of regulatory agencies led by the Federal Reserve, will now be charged with assessing the level of so-called systemic risk of major financial institutions and imposing stricter capital rules or even shutting institutions down if they are deemed to put the financial system at risk—that is, if their failure might bring down many other institutions with them and endanger the American economy. Now there will be regulation not only of traditional commercial banks, which always fell under the purview of the Federal Reserve, but also investment banks, money market funds, and perhaps even hedge funds, which had been hardly regulated at all.
The Consumer Financial Protection Bureau has also been established inside the Federal Reserve to write new requirements for mortgages, consumer loans, and the other consumer credit products that were so badly abused. Of particular concern, people with poor credit and low incomes were sold so-called subprime mortgages that were deceptively cheap at the outset, sometimes requiring no down payments, but whose annual interest charges skyrocketed in later years. The availability of mortgage finance drove housing prices ever higher, and when they collapsed, beginning in roughly 2006, the growing amount of bad debt that resulted caused a collapse of Wall Street and then the global economy.
But the Dodd-Frank Act has largely pushed responsibility for writing and implementing the new rules onto existing regulators, including the Federal Reserve, the Securities and Exchange Commission, the Commodities Futures Trading Commission, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency. This will likely prove a damaging flaw. These regulators are by and large the same agencies that tolerated the excessively risky behavior in the first place. Even if they write effective rules they will face pressure from Wall Street lobbyists and mostly Republican legislators to soften restrictions and eliminate some of the critical ones. If the restrictions remain intact, which is likely in view of the Democratic majority in the Senate, the question remains whether the regulators will enforce them vigorously once the economy recovers and the crisis fades in memory. Several agencies have already missed the deadlines to write new rules. Some are worried that the Consumer Financial Protection Bureau will be neutralized by Congress. Wall Street spent $2.7 billion on lobbying between 1999 and 2008 and is lobbying vigorously again.
The Dodd-Frank Act could have been much more effective. It could, from the outset, have set high capital requirements—the amount of money that banks and other financial institutions have to put aside for possible losses. It could have broken up today’s enormous banks, which have grown rapidly in size since the crisis. Measured by their profits, the six largest financial institutions in the US now account for 55 percent of all banking assets. It could have divided the banks by function in order to reduce the overlapping of investment activities, which increases the chances of damage to the entire financial system. For example, those banks that accept federally insured deposits from savers could have been restricted to making loans to consumers and businesses. Other institutions that raise money independently of government guarantees could have been allowed to sell more risky stocks or corporate bonds to investors or speculate in securities with their shareholder capital.
The only action proposed by Dodd-Frank along these lines is known as the Volcker Rule, named after former Federal Reserve chairman Paul Volcker. It would prohibit proprietary trading by banks that typically accept the public’s deposits—that is, it would limit speculative investments with the institution’s own capital. But even the Volcker Rule has not been clearly formulated and applied. The question still not answered is why regulators would perform better in the future than in the past two decades.
The FCIC report will probably not provoke tougher regulation in Washington. Its strength is its accumulation of fact and example. By contrast, Charles Ferguson’s popular, Oscar-winning documentary Inside Job tells the story of the crisis with directness and clarity, partly because he is willing to make pointed accusations against specific federal regulators and Wall Street bankers. In interviewing some of those he thinks of as culprits, including several prominent economists, he finds that they have hardly anything to say in their defense. Those he did not interview are often shown in revealing congressional testimony. We see Alan Greenspan, the former Federal Reserve chairman, assuring Congress that derivatives, including those guaranteeing subprime mortgage securities, required no federal regulation at all. In fact, unregulated derivatives were a principal source of the risk-taking that brought down the financial system.
Ferguson never adequately explains derivatives but he makes it clear that Wall Street firms borrowed far too much in order to invest in mortgage debt securities that were far too risky, and no one stopped them. The result was soaring housing prices, which led to more risky mortgages. Then the banks and others sold the risky debt to investors around the world as if it had almost no risk at all. Did Wall Street bankers know they had built a house of cards? Ferguson thinks many did, selling bad products without proper warning to their clients; they didn’t care, he believes, because they were making too much money. But it takes the FCIC report to prove his point by means of carefully accumulated evidence.
When Ferguson accepted his Oscar in late February, he remarked that no one had yet gone to jail for the worst American financial crisis since the Great Depression. This was a telling observation about the weakness of corporate fraud law as well as the lack of vigor of the US Justice Department. Criminal action against Angelo Mozilo, whose firm Countrywide Financial wrote more subprime mortgages than any other, was dropped this winter. The FCIC report provides many examples of the failure of management to warn shareholders of the risks it was taking—apparent violations of disclosure laws that were never even investigated.
Still, jail sentences may have little effect. By the late 1990s, countless accounting frauds culminated in outrageous behavior by Enron, WorldCom, and others, abetted by such giants as Citigroup and the Arthur Andersen accounting firm. Some Enron executives went to prison and Andersen closed down, but this did not discourage deceptive practices in mortgage securities in the mid-2000s. Wall Street is now creating outsize values for social media companies like Facebook and Twitter, well before these companies have generated serious profits. While federal regulators are debating among themselves and with financial lobbyists about new rules, another bubble is likely forming before our very eyes.
Little had been expected of the FCIC because its subpoena power was weak. It was appointed by Congress in the spring of 2009 with the Democrat Philip Angelides as chairman and with a Republican-appointed vice-chairman. Both had to agree if a subpoena were to be served. The nineteen days of public hearings produced angry questions from commissioners and evasive responses from Wall Street CEOs but did not truly expose any major figure. Yet with some six hundred closed-door interviews and reviews of thousands of private documents, the majority report is the definitive history of this period. For the most part, Wall Street made money not by virtue of brilliance but by taking on higher levels of risk—usually by cleverly circumventing existing restrictions on how much it could borrow. Few on Wall Street had to give any money back when losses inevitably escalated.
The report’s conclusions were attacked by the commission’s Republican- appointed minority in a dissent whose length, it said, was limited by the majority. Even so, it did not challenge any of the majority’s facts, and even agreed with many of its conclusions. (A separate, more extreme dissent was issued by Peter Wallison, a codirector of financial policy studies at the American Enterprise Institute who, without responding cogently to any of its charges, acidly claimed that the majority had proved none of its points.) The minority pointed out that other factors, including low interest rates engineered by the Federal Reserve and large-scale Chinese purchases of bonds, stimulated excessive speculation in mortgage securities and the housing bubble. Thus, Wall Street manipulators were not entirely to blame.
Fannie Mae and Freddie Mac, federal agencies with implicit government backing, certainly had a large part in the financing of bad mortgages. The FCIC report finds that the business model of these for-profit giants, with implicit federal guarantees of their debt, was deeply flawed, and it observes that the federal bailout of them has incurred enormous costs. But private bankers financed a large majority of subprime mortgage debt. Moreover, the hundreds of examples of damaging and questionable Wall Street practices as well as regulatory negligence outlined by the majority of the commission are simply too large to be taken as secondary causes of the crisis. As for low interest rates and plentiful Chinese capital, just because money was easy to find doesn’t mean excessive risk-taking was inevitable.*
* Peter Wallison believes that government-subsidized housing, including the efforts of Fannie Mae and Freddie Mac, was the major cause of the collapse. His fuller dissent can be found at www.aei.org/docLib/Wallison dissent.pdf. For a more thorough but somewhat more balanced account of these agencies' part in the crisis, see Viral V. Acharya, Matthew Richardson, Stijn Van Nieuwerburgh, and Lawrence J. White, Guaranteed to Fail : Fannie Mae, Freddie Mac, and the Debacle of Mortgage Finance (Princeton University Press, 2011) . For a strong criticism of the data used by Wallison and the authors of this book, see David Min, Faulty Conclusions Based on Shoddy Foundations, Center for American Progress, available at www.americanprogress.org/issues/2011/02/pdf/pinto_execsumm.pdf. An interesting account of how the government entities accrued power politically appears in Gretchen Morgenson and Joshua Rosner, Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon (Times Books, 2011). ↩
Peter Wallison believes that government-subsidized housing, including the efforts of Fannie Mae and Freddie Mac, was the major cause of the collapse. His fuller dissent can be found at www.aei.org/docLib/Wallison dissent.pdf. For a more thorough but somewhat more balanced account of these agencies' part in the crisis, see Viral V. Acharya, Matthew Richardson, Stijn Van Nieuwerburgh, and Lawrence J. White, Guaranteed to Fail : Fannie Mae, Freddie Mac, and the Debacle of Mortgage Finance (Princeton University Press, 2011) . For a strong criticism of the data used by Wallison and the authors of this book, see David Min, Faulty Conclusions Based on Shoddy Foundations, Center for American Progress, available at www.americanprogress.org/issues/2011/02/pdf/pinto_execsumm.pdf. An interesting account of how the government entities accrued power politically appears in Gretchen Morgenson and Joshua Rosner, Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon (Times Books, 2011). ↩