The financial crisis inquiry commission - first take

Superbowl Sunday note: Community owned Green Bay Packers are the only small market team left in the NFL and they do pretty well. The report is here and it contains a good summary of what we already know, plus a lot of analysis that counters the comfortable assumptions of most participants - including the standard narrative from the progressives.
From 1978 to 2007, the amount of debt held by the financial sector soared from $3 trillion to $36 trillion, more than doubling as a share of gross domestic product. The very nature of many Wall Street firms changed—from relatively staid private partnerships to publicly traded corporations taking greater and more diverse kinds of risks. By 2005, the 10 largest U.S. commercial banks held 55% of the industry’s assets, more than double the level held in 1990. On the eve of the crisis in 2006, financial sector profits constituted 27% of all corporate profits in the United States, up from 15% in 1980. Understanding this transformation has been critical to the Commission’s analysis.
So that's a huge structural change in the economy that is going to take years or decades to fix - if it is fixable. And the obvious barrier to fixing is in the power of the industry itself
From 1999 to 2008, the financial sector expended $2.7 billion in reported federal lobbying expenses; individuals and political action committees in the sector made more than $1 billion in campaign contributions.
I think this understates, since it does not include advertising in the media and money going to think tanks and universities. In the summary, they pinpoint two causes for the regulatory failure that permitted the crisis. First, the three decades of deregulation under a theory that makes no sense.
More than 30 years of deregulation and reliance on self-regulation by financial institutions, championed by former Federal Reserve chairman Alan Greenspan and others, supported by successive administrations and Congresses, and actively pushed by the powerful financial industry at every turn, had stripped away key safeguards, which could have helped avoid catastrophe. This approach had opened up gaps in oversight of critical areas with trillions of dollars at risk, such as the shadow banking system and over-the-counter derivatives markets. In addition, the government permitted financial firms to pick their preferred regulators in what became a race to the weakest supervisor.
Second, the Bush administration's unwillingness to enforce the regulations in place.
Yet we do not accept the view that regulators lacked the power to protect the financial system. They had ample power in many arenas and they chose not to use it. To give just three examples: the Securities and Exchange Commission could have required more capital and halted risky practices at the big investment banks. It did not. The Federal Reserve Bank of New York and other regulators could have clamped down on Citigroup’s excesses in the run-up to the crisis. They did not. Policy makers and regulators could have stopped the runaway mortgage securitization train. They did not. In case after case after case, regulators continued to rate the institutions they oversaw as safe and sound even in the face of mounting troubles, often downgrading them just before their collapse. And where regulators lacked authority, they could have sought it. Too often, they lacked the political will—in a political and ideological environment that constrained it—as well as the fortitude to critically challenge the institutions and the entire system they were entrusted to oversee.
The second point is one that progressive economic critics consistently overlook. If the executive branch is under the control of a highly active ideologically assertive and deeply corrupt administration, as it was between 2000 and 2008, regulations don't matter. There was no way that a Bush dominated SEC or other agencies would vigilantly enforce the laws on the books and similarly with the Federal Reserve which is nominally, but not actually independent (only poor and weak nations allow their central bank to be "independent" of the political system- which makes their nations essentially dependencies of the banking systems of richer countries.) The commission then goes on to document the remarkable failure of the real world to operate in accord with the efficient market hypothesis or any of the basic tenants of standard economics. They are amazed by the "governance" of financial institutions.
Many of these institutions grew aggressively through poorly executed acquisition and integration strategies that made effective management more challenging. The CEO of Citigroup told the Commission that a $40 billion position in highly rated mortgage securities would “not in any way have excited my attention,” and the co-head of Citigroup’s investment bank said he spent “a small fraction of 1%” of his time on those securities. In this instance, too big to fail meant too big to manage.
Forty billion here/forty billion there - what's the big deal?
In the years leading up to the crisis, too many financial institutions, as well as too many households, borrowed to the hilt, leaving them vulnerable to financial distress or ruin if the value of their investments declined even modestly. For example, as of 2007, the five major investment banks—Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, and Morgan Stanley—were operating with extraordinarily thin capital. By one measure, their leverage ratios were as high as 40 to 1, meaning for every $40 in assets, there was only $1 in capital to cover losses. Less than a 3% drop in asset values could wipe out a firm. To make matters worse, much of their borrowing was short-term, in the overnight market—meaning the borrowing had to be renewed each and every day. For example, at the end of 2007, Bear Stearns had $11.8 billion in equity and $383.6 billion in liabilities and was borrowing as much as $70 billion in the overnight market. It was the equivalent of a small business with $50,000 in equity borrowing $1.6 million, with $296,750 of that due each and every day. One can’t really ask “What were they thinking?” when it seems that too many of them were thinking alike. And the leverage was often hidden—in derivatives positions, in off-balance-sheet entities, and through “window dressing” of financial reports available to the investing public.
So the first problem is that, although it's kind of obvious that people who manage and work for corporations will, at best, have divided loyalties, conventional economics pretends that the goals of the firm are identical to the goals of the management. Why would you buy the bonds of a company like Bear-Stearns or do business with them when it was known that they needed to borrow tens of billions of dollars every night just to stay afloat? Why would you invest in their shares? The answer is in common Wall Street acronyms OPM and IBG/YBG. OPM stands for "other people's money" which is what the managers of these companies used for their bets. IBG/YBG stands for "I'll be gone/You'll be gone" - the trade will be done, the bonus or other individual reward will have been carried home, and the decision maker will be retired or working elsewhere when the bill comes due. This problem was diagnosed in 1776 by Adam Smith in "The Wealth of Nations" which is the third of the trio of books constantly cited but never read by American Conservatives (the Bible and the Federalist Papers are the other two).
The trade of a joint stock company is always managed by a court of directors. This court, indeed, is frequently subject, in many respects, to the control of a general court of proprietors. But the greater part of those proprietors seldom pretend to understand anything of the business of the company, and when the spirit of faction happens not to prevail among them, give themselves no trouble about it, but receive contentedly such half-yearly or yearly dividend as the directors think proper to make to them. This total exemption from trouble and from risk, beyond a limited sum, encourages many people to become adventurers in joint stock companies, who would, upon no account, hazard their fortunes in any private copartnery. Such companies, therefore, commonly draw to themselves much greater stocks than any private copartnery can boast of. [...] The directors of such companies, however, being the managers rather of other people's money than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master's honour, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company. [cite]
Reading this highlights the importance of one of the observations made in the first paragraph quoted here: "The very nature of many Wall Street firms changed—from relatively staid private partnerships to publicly traded corporations taking greater and more diverse kinds of risks." Standard economists use a really deceptive sleight of hand in pretending that the interests of the firm (corporation) and the interests of the directors and officers of the firm are aligned. This permits them to use a model of the market the sum of many individual choices. But the financial crisis illustrated that corporate managers and investors have financial interests that are not in the least aligned with the "interests of the firm". Even many of the stockholders don't worry about long term health of the firm - the more liquid the market, the easier it is for them simply speculate on the valuations other people put on the company. A second weakness in conventional economics is that it consistently pretends away the role of government in creating and maintaining markets and in setting the rules for markets. In this case, the market for mortgage based securities resulted from a deliberate government policy.
The kings of leverage were Fannie Mae and Freddie Mac, the two behemoth government-sponsored enterprises (GSEs). For example, by the end of 2007, Fannie’s and Freddie’s combined leverage ratio, including loans they owned and guaranteed, stood at 75 to 1
Fannie and Freddie were remarkably badly structured institutions: they were stockholder owned, profit making (and high dividend producing) organizations operating under poorly defined government guarantees with a mission to create a market that basically subsidized the real-estate bubble. The Republicans have tried desperately to assign the blame for the crisis to Fannie and Freddie under the standard Republican idea about every problem: some black guy did it. But the real beneficiaries of the government subsidy of these institutions were the bond and stockholders who had their risks underwritten by the public but kept their profits private and the firms and individuals in the whole real-estate sector that was pumped up by the securitization market. The people buying bonds that allowed Fannie and Freddie to operate with $75 of debt for every dollar of equity got interest above treasury bond interest because of a supposed risk that was not really a risk at all. If you want to see some really embarrassing whining from the stockholders who participated in this scam, Ralph Nader's Wall Street Journal article is a goldmine - and an indication of where his destructive politics come from. For now, I want to end by citing the report's documentation of how the middle class was bought off by mortgage scam.
But financial firms were not alone in the borrowing spree: from 2001 to 2007, national mortgage debt almost doubled, and the amount of mortgage debt per household rose more than 63% from $91,500 to $149,500, even while wages were essentially stagnant. When the housing downturn hit, heavily indebted financial firms and families alike were walloped.
Many of those people in booming exurbs, places like Phoenix and Sugarland and Plano who became "rich" on real-estate appreciation became the foundation of the Republican party and helped it win elections time and again.


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