Who's to Blame for the World Economic Crisis? At last some answers from the US Senate 6-21-11

There's plenty of blame to go around among those in Washington, Wall Street and the home loan business. An excellent, long, well-researched front page article in the NY Times October 9, 2008 by Peter S. Goodman points the finger at long-time, venerated Federal Reserve Chairman, Alan Greenspan who was a disciple of Ayn Rand of "The Fountainhead," "Atlas Shrugged" and "who portrayed collective power as an evil force set against the enlightened self interest of individuals."

According to Goodman, Greenspan's faith in derivatives and his opposition to their regulation was abetted by Clinton's Treasury Secretaries Robert Rubin of Goldman Sachs and Larry Summers, free market economist from Harvard and Senator Phil Gramm from Texas who was instrumental in the passage of laws de-regulating banking and Wall Street firms at a time when additional regulations were badly needed.. Goodman doesn't discuss the unethical practices in the subprime home mortgage market, but sleazy characters like Angelo Mozilo, CEO of Countrywide, should be added to the cast of malefactors.

Goodman also gives credit to a number of individuals who warned about the growing popularity of derivatives on Wall Street. The warnings of Warren Buffett, George Soros, Felix Rohatyn were rebuffed by Greenspan, Gramm, Rubin and Somers. Soros avoids using derivatives, according to Goodman "because we don't really understand how they work." Rohaytn, one of the most respected financial gurus, described derivatives as "potential hydrogen bombs." Warren Buffett FIVE YEARS ago called derivatives "financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."

Alan Greenspan disagreed: "Not only have individual financial institutions become less vulnerable to shocks from underlying risk factors, but also the financial system as a whole has become more resiliant. [As Fed Chairman in 2004]. Goodman points out that Greenspan, for more than a decade, fiercely objected whenever derivatives came under scrutiny in Congress or on Wall Street. Greenspan: "What we have found over the years in the market place is that derivatives have been an extraordinarliy useful vehicle to transfer risk from those who shouldn't be taking it to those who are willing to and are capable of doing so. Mr. Greenspan told the Senate Banking committee in 2003, "We think it would be a mistake to more deeply regulate the (derivative) contracts.

Goodman mentions two others who deserve credit for warning of the coming crisis and pressing for regulations which could have averted it: Congressman William J. Markey of Massachusetts in 1992, when he was head of the House subcommittee on telecommunications and finance, asked the GAO to to study derivatives risks. Two years later, the office released it's report identifying "significant gaps and weaknesses in the regulatory oversight of derivatives. "The sudden failure or abrupt withdrawal from trading of any of these large U.S. dealers (in derivatives) could cause liquidity problems in the markets and could also pose risks to others, including federally insured banks and the financial system as a whole," Charles Bowsher, head of the GAO testified before Mr. Markey's committee in 1994. "In some cases intervention has and could result in a financial bailout paid for or guaranteed by taxpayers." Greenspan was reassuring. Channeling Ayn Rand he testified that "Risks in financial markets, including derivatives, are being regulated by private parties....There is nothing superior per se in federal regulation that makes it superior to market regulation."

Brooksley Born, head of the Commodities Futures Trading Commission that regulates options and futures trading, also warned of the dangers of derivatives trading. she testified before Congress that unfettered, opaque trading could "threaten our regulated markets or indeed our economy withoug any federal agency knowing about it." She called for greater disclosure of trades and reserves to cushion against losses.

Ms. Born's views elicited fierce oppostiion from Greenspan and Rubin, then Treasury Secretary. "Greenspan told Brooksley that she essentially didn't know what she was doing and she'd cause a financial crisis," said Michael Greenberger, who was a senior director at the Commodity Trading Commission. "Brooksley was this woman who was not playing tennis with these guys. and not having lunch with these guys. There was a little bit of the feeling that this woman was not of Wall Street."

In 2000 at a hearing on the merger boom, Greenspan testified that Wall Street had tamed risk. "Aren't you concerned with such a growing concentration of wealth that if one of these huge institutions fails, that it will have a horrendous impact on the national and global economy?," queried Representative (now Senator) Bernie Sanders from Vermont. Greenspan responded, "No. I'm not."

Still, savvy investors like Warren Buffett continued to raise alarms about derivatives as he did in 2003 in his annual letter to shareholders of Berkshire Hathaway: "Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers. The troubles of one could quickly infect the others."

[The above is quoted and paraphrased from Mr. Goodman's excellent article in the New York Times October 9, 2008. A link to the highly recommended article appears below.]

 Jeff Madrick's review of recent books by Charles R. Morris (The Trillion Dollar Meltdown), Mark Zandi (Financial Shock: A 360 Degree Look at the Subprime Mortgage Implosion and How to Avoid the Next Financial Crisis) and Gretchen Morgenson (The Reckoning) is the best single source I've seen on how the current world economic crisis occurred and what to do about it.

Charles Morris blames Wall Street, not the government. "Morris makes it clear that it was an unquenchable thirst for easy profits that led commercial and investment banks in the US and around the world--as well as hedge funds, insurance companies, private equity firms, and other financial institutions--to take unjustifyable risks for their own gain and in so doing jeopardize the future of the nation's credit system and now the economy itself...looking back a couple of decades to the development and rapid spread of the investment technique on Wall Street of packaging loans, principally mortgages...into an investment vehicle in which pension funds, money managers, foreign governments, hedge funds and others could invest..."

Morris points to the contribution to the fiasco of Larry Fink of First Boston in 1983 who was the first to divide mortgage packages into "tranches" or tiers based on risk which were assigned interest rates according to estimates of risk. The lowest tiers were called "toxic waste" were typically bought by hedge funds.

Another critical element in the plot was the fact that the bond rating agencies were paid by the commercial and investment banks issuing the securities. The rating agencies used statistical models that did not take into account the possibility of a crash in housing prices.

Greenspan's cut in the target fed funds rate from 6.5% in 2000 to 1 percent in 2003 making borrowing for major institutions almost free. They borrowed at low short-term interest rates and invested the money in longer-term mortgages, a dangerous strategy that contributed to the S&L bankruptcies in the 1980s.

Mark Zandi points out that by 2006 more than $1.1 trillion of the $3 trillion in mortgages were either sub-prime or Alt-A (undocumented)...The frenzied sub-prime lending occurred AFTER the housing market had already climbed to unthinkable heights.

Bankers and mortgage brokers promoted enticing loans, the most important of which was the adjustable rate mortgage or ARM, in order to lower mortgage payments temporarily to levels that might seem within the means of low-income home buyers.

Madrick offers the following principles for the future

1. The shadow banking system (hedge funds, private equity should be brought under the same regulatory oversight as commercial banking, i.e., minimum capital requirements.

2. The structured investment vehicles commercial banks use to avoid capital requirements should be disallowed.

3. The Fed should be empowered to and obligated to examine the books of investment banks, hedge funds and other participants in the shadow banking system.

4. Derivatives should be required to be listed on an exchange.

5. Any regulation should take into account the incentives for managers to take company risk for personal benefit...The best way to accomplish this is for bonuses and compensation to be based on the long-term profitability of the investment firms.

Rescue Plan

1. The credit system must be unfrozen and loans must flow again, including mortgages.

2. Demand for goods and services must be restored to slow the downward spiral now underway.

1-14-09

Here's a link to Madrick's excellent article

http://www.nybooks.com/articles/22280

Think Tank Notes about public policy.

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October 23, 2008 The Whole Intellectual Edifice

Alan Greenspan's testimony today before the House Committee on Oversight and Government Reform is likely to be quoted for years. Is there anyone in Washington with a better instinct for the jugular than Henry Waxman, the committee chairman, whose questioning evoked some of Greenspan's most evocative comments? (I know George already quoted this material, but it's worth quoting again.)

Greenspan: I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms...

Waxman: In other words, you found that your view of the world, your ideology, was not right, it was not working.

Greenspan: Absolutely, precisely. You know, that's precisely the reason I was shocked, because I have been going for 40 years or more with very considerable evidence that it was working exceptionally well.

At another point, Greenspan said that his faith in Wall Street's ability to regulate itself was based on his assumption that rational firms would not expose themselves to self-destructive risks. He also assumed that the markets would "properly price" risky bundles of subprime mortgages, so that investors worldwide would understand that they presented unusual risks. He continued, "The whole intellectual edifice...collapsed in the summer of last year."

This is poignant, but also evasive. The system of unregulated incentives, compensation systems, and business practices Greenspan oversaw-or at least tolerated without comment-was riddled with obvious conflicts of interest. Why were collateralized debt securities bundling reckless subprime mortgages "mis-priced," as Greenspan would have it? In substantial part it was because the for-profit ratings agencies, Moody's and Standard & Poors, blessed them as sound products, largely on the basis of representations made to them by the banks that marketed the securities. Why did the ratings agencies fail to detect the true risks embedded in these securities-a failure of intelligence collection as grotesque as any preceding the invasion of Iraq? Not a complicated question: they were paid for their opinions by the very banks that sold the faulty products. McCain's language is hard to argue with in this case-that's structural corruption. Posted by Steve Coll