Financial Crisis - Who is Responsible

Congress has established the Financial Crisis Inquiry Commission (FCIC) to determine what caused the financial crisis that required a massive taxpayer bailout of the financial sector. Although various legislators and news pundits have pointed the finger at a number of decisions and institutions, it seems clear to me as I have stated in previous posts that unregulated derivatives were the root cause of the problem.

Some have blamed the Federal Reserve under Alan Greenspan for keeping interest rates too low for too long. In 2003, the Fed kept interest rates low to combat high unemployment rates that were persisting in the recovery from the bursting of the dot.com bubble. Although I agree that Greenspan bears significant responsibility for the financial crisis, his responsibility in my opinion does not derive from his role as Fed Chairman or for keeping interest rates low. Low interest rates are an appropriate economic method for increasing employment and full employment is a legally mandated objective of the Federal Reserve. Just because interest rates were low does not justify bankers taking unreasonable risks. If a bank manager forgets to lock the bank door and a thief walks in and steals money, the thief can not argue innocence blaming the theft on the bank manager.

Some people have argued that the Community Reinvestment Act (CRA) which required all federally chartered banks to increase mortgages to low and moderate income neighborhoods was responsible for the problem mortgages that caused the financial crisis. The CRA only applied to deposit taking banks covered by FDIC insurance and FDIC covered institutions wrote less than 20% of all sub-prime mortgages. In any case, the CRA was passed by Congress in 1977 - more than 30 years prior to the financial crisis - so if the CRA was responsible we should have seen problems earlier.

Some people have blamed Fannie Mae and Freddie Mac for the financial crisis. Fannie and Freddie buy mortgages from primary lenders to make more money available for mortgages thereby increasing home ownership and lowering mortgage interest rates. However, at the height of the financial crisis in 2006, Fannie and Freddie collectively held only 24% of all sub-prime mortgages. Also, keep in mind that Fannie and Freddie never wrote a single mortgage in their history. They only buy mortgages written by other lenders. Also, Fannie and Freddie were subject to much tighter restrictions on the types of loans that they could purchase than the lenders such a Country Wide.

Some people have argued that revoking the major provisions of the Glass Steagall Act in 1999 which separated commercial bank and investment bank activities was responsible. Although I believe that major portions of the Glass Steagall Act should be reimposed, I don't believe that the abolition of the Act was responsible since the Act only applied to deposit taking institutions who wrote and held a small percentage of the sub-prime mortgages and did not apply to the big investment banks such as Goldman.

About 80% of the sub-prime mortgages that caused the financial crisis were lent by unregulated organizations like Country Wide and sold by unregulated investment banks such as Bear Stearns. Consequently, although the Federal Reserve interest rate policies in the 2000's, Fannie and Freddie, and the CRA contributed a little to the problem, they were not responsible for the 2008 financial crisis.

The next step in determining the cause of the crisis requires that we look at what happened to these sub-prime mortgages. The investment banks packaged these sub-prime loans into Collateralized Debt Obligations (CDO's) which eventually came to represent a significant percentage of the portfolios of pension funds, money market accounts held by mom and pop savings accounts, college endowments and charities as well as large investors. Many of the largest buyers of these CDO's could only buy highly rated financial instruments. The way that the investment banks were able to get these CDO's rated highly buy the rating agencies (Moodys, S&P) was to purchase Credit Default Swaps (CDS) primarily from AIG. The CDS's were essentially insurance whereby if the sub-prime borrowers did not pay back their mortgages then AIG would pay for the loss. Consequently, at least on the face, the CDS essentially made investing in sub-prime mortgages risk free. Now the problem with the AIG insurance was that AIG never had sufficient reserves on hand to pay any significant amount in claims. What AIG did was essentially equivalent to me personally selling hurricane insurance to condo owners in Florida and spending the premiums I collected on yachts and vacations in years when there were no hurricanes and then when a hurricane hit, since I wouldn't have any money to pay the claims, I would just go bankrupt and sail off on my yacht.

In summary, if AIG did not sell the credit default swaps (or was required to keep adequate reserves to pay claims), the investment banks would not have been able to sell the sub prime CDO's to investors so there wouldn't have been any demand for sub-prime based mortgage investments so lenders would not have been able to sell the junk to anyone and would not have written the sub-prime mortgages and we would have avoided the financial crisis caused by the sub-prime mortgages. The rating agencies and the investment banks could reasonably be said not to have exercised due diligence for not checking out AIG's ability to pay off in the case of a claim.

OK, so if the root cause was the availability of credit default swaps sold primarily by AIG, who is responsible? When reading the following, keep in mind that a credit default swap is a type of financial instrument called a derivative. If I had to pick one person responsible for the financial crisis I would pick former president Bill Clinton.

Brooksley Born is a Stanford educated attorney with over 30 years experience as an attorney specializing in financial instruments and derivatives. She is a personal friend of Hillary Clinton who at Mrs. Clintons suggestion was considered for the position of Attorney General by President Clinton. President Clinton interviewed her and declined to nominate her because he found her personality colorless but did nominate and appoint her as chairperson of the Commodity Futures Trading Commission (CFTC) in 1994. In her role at the CFTC, Ms. Born became seriously concerned that unregulated derivatives, especially credit default swaps, posed the potential to cause a significant financial crisis. The CFTC consequently initiated a process to develop comprehensive regulations for the derivatives markets. Clinton's Council of Economic Advisors led by Alan Greenspan and Larry Summers with the support of then Treasury Secretary Robert Rubin and SEC Chair Levitt had a fit, threatened to have Born removed as CFTC chair and eventually persuaded Congress to pass a law that prevented the CFTC from regulating derivatives. Although Greenspan and Summers were the two who spearheaded the effort to prevent the regulation of derivatives, Greenspan and Summers reported to the President who supported their efforts. If Clinton had taken the time to understand the threat and supported Ms. Born, there is a good chance that derivatives would have been regulated, AIG would not have been able to sell swaps which would have caused the rating agencies to rate packages of sub-prime mortgages as junk which would have prevented the purchase of these investments by some of the largest purchasers which would have prevented the investment banks from selling them which would have prevented the lenders from writing sub-prime mortgages.

What concerns me at this time is that the regulations being proposed following the 2008 financial crisis do not address the causes of the crisis. The big money has been effective in removing the regulation that would make the system reasonably safe. I'll post more details on the proposed regulation at a later time but at this time I would have to say that with the changes made in response to the 2008 crisis that the financial system is even more at risk than previously.