An Autopsy of the Financial System:

1. An Autopsy of the Financial System: Accident, Suicide, or Negligent Homicide?

2. Suicide: Crisis happened to policymakers • Greenspan: “The roots of the crisis reach … to the aftermath of the Cold War … … that led to a dramatic decline of real long-term interest rates. … that in turn engendered a dramatic global home price bubble, which was heavily leveraged … … A classic euphoric bubble … Everybody missed it.” • Prince (former CEO of Citigroup): • “When the music stops … things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”

3. Accident: Crisis happened to policymakers • Greenspan, Bernanke, Paulson, Geithner, Romer: • It was a “hundred years” flood • Global savings glut • Massive capital inflows to the U.S. • Financial innovation, fraud, and herd behavior • Robert Rubin: • I’m sorry that [we] could not see the unprecedented market collapse that lay before us.”

4. Negligent homicide: regulators caused the crisis • Negligent homicide: • “Willfully blind” • “Allowing avoidable dangers and risks to continue” • “Cause” includes not adapting to avoidable dangers • Innovation + old (good) regulations  reckless regulations • Senator Carl Levin: “The recent financial crisis was not a natural disaster; it was a manmade economic assault.”

5. Outline • A few words on the suicide and accident views • Negligent homicide? • 5 policies • 1996-2006 !!!!!!!!!!!!!!!!!!!!! NOT 2007 – 2010

6. A few words on the suicide and accident explanations

7. There really was a boom. Perhaps a bubble

8. But, was it simply suicide? • Regulators knew about the bubble. • … and NINJA loans • … and that housing prices fall (40% of years) • … and banks’ exposure to real estate

9. Who was supervising the safety and soundness of the banking system?

10. Suicide and accident explanations … • Valid, but incomplete • Deflect attention from policymakers

11. Negligent homicide credit rating agencies (CRAs)

12. Credit rating agencies • How did they become so pivotal?

13. Credit rating agencies • SEC invents the Nationally Recognized Statistical Rating Organizations (NRSRO) designation in the 1970s to establish capital requirements on broker-dealers. • Cascade: • Fed and other domestic and foreign bank regulations • Insurance and pension regulators in U.S. and abroad • Other federal, state, and municipalities in U.S. and abroad. • All major purchasers of securities MUST use ratings • NRSROs start charging issuers instead of buyers.

14. Conflicts of interest: 1 • Credit rating agencies sell “licenses,” not ratings. • Regulation and law protects CRAs from market discipline • Regulation mitigates reputational capital concerns • Legal liability not an issue because of law • Profits f{ quantity, not quality }

15. Conflicts of interest 2: Why things deteriorated • Structured product boom late-1990s  quantity! • Rating agencies paid to structure: Consulting • And, then to rate those structures: Rating • The profits were enormous • Regulatory protections • + invention of structured products • + combining consulting and rating • = enormous profits … operating margins over 50%

16. Credit rating agencies knew … • “These errors make us look either incompetent at credit analysis or like we sold our soul to the devil for revenue ...” • Moody’s MD in 2007 • “Let’s hope we are all wealthy and retired by the time this house of cards falters.” • S&P employee in 2004

17. This was negligent homicide • CRAs created and protected by regulators • Congress prohibits regulators from monitoring rating methods. • Regulators maintain unique designation and reliance • Problems were well-known years before the crisis: • Accounting scandal… VERY similar. • There were conferences and articles. • Policymakers recklessly endangered the global economy

18. Negligent homicide Credit default swaps and bank capital

19. Example: Credit default swaps • JP Morgan developed CDSs in 1994 to: • Reduce bank credit risk • Free-up regulatory capital for more lucrative investments • Explosive growth: • By 2007, notional value of $62 trillion, yes that is correct • US banks transact in CDSs, reducing capital • AIG writes many CDSs to banks.

20. Regulators knew of growing problems • Geithner was very concerned • Formed task force headed by Corrigan (NY-Fed / Goldman) • Tried to negotiate with banks • Accumulating evidence, 1996-2007, made BofG concerned • Counterparty risk associated with CDS • Risk to banks associated with mortgage-related instruments. • FBI warns of an “epidemic of fraud” in sub-prime mortgages, on which many CDSs were based. • Internal reports at the BofG indicate that this was very well-known.

21. Regulators knew of growing problems, • but chose not to act.

22. FED could have argued the following • FED does not have ability to assess counterparty risk. • … neither, does it have confidence in credit rating agencies. • FED is responsible for safety/soundness of banking system • Therefore, the FED will not allow banks to reduce capital. • The issue is not the 1996 decision. • The issue is the Fed maintained its policies.

23. Negligent homicide More on CDSs

24. The Warning by Brooksley Born • OTC derivatives – including CDSs -- subject to • Fraud, Manipulation, Failure, Opacity • E.g., Orange county, Gibson Greeting Cards, Proctor & Gamble, • E.g., exploitation of unsophisticated school districts & municipalities, • E.g., LTCM, impossible to assess systemic ramifications. • OTC derivatives involve hundreds of trillions of dollars • Commodity Future Trading Commission • Calls for greater transparency • Concerns (obvious concerns) about systemic risk

25. The Response by the “Oracle” • Stop move toward transparency • Commodity Futures Modernization Act of 2000 • Exempted OTC derivatives from oversight • Policy enforced ignorance of an enormous, systemically important market

26. Negligent homicide The SEC and investment banks

27. Total failure • All five major investment banks “fail” in 2008. • “We have a good deal of comfort about the capital cushions at these firms at the moment” • Christopher Cox, SEC chairman, 3/11/2008. • 3 days before FED provided emergency $25 billion loan to Bear Stearns.

28. 3 Coordinated SEC policies in 2004 • Exempt 5 major broker-dealers from net capital rule. • SEC to provide consolidated supervision of big 5 • Consolidated Supervised Entities (CSEs) • Holding company and all affiliates. • Complex, systemically important responsibility • Decide not to build capability • 7 people to oversee holding companies with $4 trillion • Eliminate risk management office • Fail to complete any inspections in18 months before Bear Stearns • Weaken enforcement

29. And, they ask Congress to lay-off “The bill should be amended to recognize the unique ability of the Commission to comprehensively supervise the consolidated groups … the Commission has established a successful consolidated supervision program” • SEC’s Deputy Director testimony before the U.S. House of Representatives Financial Services Committee, 4/25/2007. • 18 months later, all of the “consolidated groups” vanished.

30. My verdict • Willful blindness & • Reckless endangerment

31. Negligent homicide Fannie Mae and Freddie Mac

32. Fannie Mae, Freddie Mac, HUD, FHA, etc. • GSEs facilitate housing through secondary market by • Purchasing, Guaranteeing, Securitizing • Purchasing and holding • GSEs make money by • Borrowing cheaply, helped by government guarantee              • Lending more expensively via buy and hold mortgages              • “Selling” guarantees • GSE Profits • Limited by the size of market • Threatened by potential regulatory interventions • So, they …         

33. Expand market & deflect threats!! • Expand market in the mid-1990s • Quantitative application of Community Reinvestment Act • GSEs pushed/rush into sub-prime type mortgages • Thus, there was a change. • Political threats assuaged through: • Campaign contributions and • other emoluments.

34. Subprime-trait mortgages  Boom • By 2001: No down payment mortgages • 45% of GSE purchases have subprime traits: 2005-7 • Low FICO Scores and High LTV ratios • Negative amortization and low documentation • Triggers low quality lending throughout system • September 7, 2008 • $7 trillion institutions fail • Estimated losses … $400 billion and counting

35. Postmortem of the GSEs • Policymakers created incentives for massive risk-taking • Did not respond as GSEs became systemically fragile • There were press warnings for the decade before the failed • Greenspan warned Congress in 2004 • Congress defeated legislation to reform GSEs

36. Lessons

37. Autopsy results • There is a systemic problem with financial regulation • The crisis was not only an accident or bubble • Nor primarily a lack of information or power by regulators • The problem was not primarily associated with most of the targets of the financial reform bill • Policymakers implemented and maintained bad policies • for the 10-15 years before the crisis • even as they learned of the effects of their policies. • Systemic change requires greater check and balances • On regulators • On bank executives