William Hurt plays hank Paulson in HBO's Too Big to Fail

When those who point fingers seek blame for the financial crisis of 2008 (we are yet to have an official historical name for this disaster) the common refrain is deregulation of the financial industry, but some examination seems to be that we were buried in regulation in many areas while bereft in others.

The two most common examples of actual deregulation was the Gramm-Leach-Blily Act of 1999 which effectively repealed the Glass-Steagall Act of 1933, and the Commodities Futures Modernization Act of 2000 which removed the regulation of OTC derivatives among “sophisticated individuals” from the Commodities Futures Trading Commission (CFTC) and the Commodity Exchange Act of 1936.

While partisans commonly blamed Bush for the deregulation that many believe caused the crisis, both of these bills were signed by Bill Clinton.  Yet these laws were largely supported by both parties and Republican Senator Phil Gramm had a leadership role in both.

At the time there were a lot of factors in the market that led both parties to believe these reforms were wise.  It is not entirely certain how significantly these reforms contributed to the depth of the crisis.  Canada, for example, experienced similar deregulations without nearly as severe a consequence.

What strikes me about the background of the deregulation in the Commodities Futures Modernization Act is how complicated the entire system was and how many different regulatory agencies we had.  The FDIC, the SEC, the CFTC, Fannie Mae, Freddie Mac, The Treasury and the Federal Reserve all had spheres of authority.   Banks regulated by the FDIC generated mortgages that were securitized by investment banks regulated by the SEC.  These mortgages were insured by Fannie Mae and Freddie Mac and were often insured by futures products that were regulated by the CFTC.  While the Treasury under Paulson took control when a meltdown was imminent, the Treasury was not normally directed to oversee the  coordination of the other agencies.  Nor was the Fed.

Watching the HBO production of  Andrew Sorkin’s Too Big To Fail, Paulson was taken by surprise by the collapse of AIG.  Within days of announcing that the era of bailouts was over while Lehman Brothers was allowed to go bankrupt, Paulson announced the bailout of AIG.  He really had no choice.  As Barney Frank observed we actually had a free market if only for a few days.

While the list of failures certainly included regulatory failures it certainly was not from want of regulatory agencies.  While some contend that the agencies were not properly staffed to regulate properly, it seems that the bigger problems were the lack of commitment from the leaders of the agencies, the lack of understanding of risk on the part of the legislators and the firms who capitalized on the changes in the law, and most of all, the complicated and decentralized structure of our regulatory agencies.  With multiple agencies overseeing different sectors of the financial system that were becoming increasingly interrelated it seems highly probable that some significant factors would fall between the cracks.  The risk posed by the massive positions taken by AIG to insure risky mortgages found a crack.

There seems to be a need for some centralized coordination of the financial system and the related agencies, but the perspective needs to come from outside normal government channels.  I doubt this would be enough to overcome congressional hubris is passing laws they do not understand, or enough to overcome the political influence of huge financial institutions.  The Fed for all of its flaws is the closest we have come to a financial authority that is removed from political influence, but that may not be saying much.

The real enemy may not be greed, but complexity.  Our regulatory structure may be unsuitable for the level of complexity we allowed. Some of our brightest and most experienced professionals seemed incapable of understanding the risk we were incurring.

While the players and regulators were struggling to get investors to commit capital to the major banks to avoid a meltdown, Warren Buffet was called upon several times.  He consistently turned them down because the assets were too complicated to understand, and he did not trust most players on Wall Street. But he was finally offered a deal he could not refuse.

Warren was offered $5 billion worth of preferred stock in Goldman Sachs, the Cadillac of the Wall Street firms, with a 10% yield ($500 million annually), convertible into Goldman stock at $115 a share, 8% below the then current price.

That is why cash is king

Info from Too Big To Fail by Andrew Ross Sorkin

(this was published previously in the Macon Telegraph)

Being in the middle of a record economic crisis presents a rare learning opportunity.  Several books are worthwhile for those seeking to understand what just happened.

Too Big to Fail by Andrew Ross Sorkin details the action of the Fed under Benanke and Treasury under Paulson during the crisis period between August and December.  While Geitner as head of the New York Fed was also featured the central player of this crisis was Hank Paulson.

Monumental decisions involving billions of dollars of assets were made in days, sometimes hours.  Both Paulson and Geitner had a sense that the market was due for a correction long before the crisis hit, but they probably did not see it coming as fast and as broad as it did. Bernanke noted that just as there are no atheists in foxholes there are no ideologues in economic crisis either. Neither Republicans or Democrats wanted to bail out Wall Street , but the crisis dictated actions that were against the grain of capitalists of both parties.

Paulson worked tirelessly to find appropriate merger partners for weak players like Merrill Lynch, Wachovia, and Lehman.  He almost had Barclays ready to buy Lehman when the British Financial Services Authority ( FSA) refused to approve the acquisition/merger because of the risk it brought to the British financial system.

Lehman was singular in the fact that it was not acquired or bailed out and thus had to go bankrupt.  Part of this was timing; Congress was just in no mood to bail out a Wall Street player.  Part of the reason was George Bush’s cousin who worked for Lehman and his brother Jeb’s association with the firm. Such close political relations probably worked against the interests of the firm.

In retrospect bailing our Lehman’s may have forestalled the panic that engulfed the rest of the system. With Bear Sterns gone and now Lehman’s gone, depositors wondered who was next and there began a run of the other banks like J.P Morgan and Morgan Stanley.

While Paulson’s association with Goldman was suspect the fact was he had to severe his tie and sell his stock ($485 million worth) in order to take his job at Treasury. Since his actions were so scrutinized he was careful to avoid even conversations that would indicate favoritism toward his old firm.

The most difficult decision was to bail out AIG whose credit default swaps acted as insurance against many of the cdo’s (collateralized debt obligations) that infected the financial markets. As the underlying assets plummeted in value AIG was downgraded and had to put up more capital that it could not provide.

Having to make such massive changes and decision in such short time meant that perfection was not obtainable. Barney Frank justifiably wanted some assurance that compensation to the executives would suffer from their misdeeds, but there simply was not enough time to rule of thousands of contracts during the time period that decisions had to be made.

Wall Street clearly engaged in risks it did not understand, but neither did the regulators such as Greenspan and his successor Bernanke. Complicated risk models gave the CEO’s delusional certainty, but eventually the party came crashing down for the same reason all bubbles burst;  lack of trust and confidence.

But Sorkin spends little space getting into the detail of the causes of the crash and suitably stays focused on the urgency and the actions required in response. 

For more information on the background that caused the crisis I recommend The Housing Boom and Bust by Thomas Sowell,  Financial Fiasco by Johan Norberg, most of all After the Fall: saving Capitalism from Wall Street – and Washington by Nicole Gelinas.

Sowell and Norberg focus more on the misguided Government fiscal and monetary policies that inflated the housing bubble, but Nicole Gelinas also analyzes which good regulations were unfortunately removed (and by who) and which bad ones were inappropriately applied.

A crisis of this nature required the perfect storm of many great errors to all focus their retribution at the same time. Unfortunately the media large engages in partisanship and demonization and few people will take the time to understand what happened and why.  It is complicated but engaging the problem reveals basic principles of sound policy that were violated as they were in previous bubbles.

History repeats itself but never the same way.

“Fannie and Freddie played the political game even more fiercely than their opponents, spending millions of dollars on armies of lobbyists on Capitol Hill. Each company was a revolving door for the powerful in Washington- both Republican and Democrat. Newt Gingrich and Ralph Reed, among others, worked as consultants for Fannie or Freddie; Rahm Emanuel was a board member of Freddie.”

“By the 1990’s, Fannie’s chief executive could boast, without much exaggeration, that “we are the equivalent of a Federal Reserve system for housing.”  At their pinnacle the two mortgage giants- neither of them and originator of loans- owned or guaranteed some 55 percent of the $11 trillion U.S. mortgage market.  Beginning in the 1980’s, the two companies also became important conduits for the business of mortgage- backed securities.  Wall Street loved the fees it collected from securitizing all kinds of debt, from car loans to credit card receivables, and Fannie’s and Freddie’s portfolio of mortgages were the biggest honeypot around.”

“But in 1999, under pressure from the Clinton administration, Fannie and Freddie began underwriting subprime mortgages. The move was presented in the press as a way to put  homes within the reach of countless Americans, but providing loans to people who wouldn’t ordinarily qualify for them was an inherently risky business.”

From Too Big To Fail by Andrew Ross Sorkin

“In moving, even tentatively, into this new area of lending (subprime) Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government -subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980’s”  (New York Times in 1999)

“The success of the two companies (Fannie and Freddie) in both the financial and political arena inevitably fostered a culture of arrogance. “We always won, we took no prisoners and we faced little organized political opposition,” Daniel Mudd, then president of Fannie Mae, wrote in a 2004 memo to his boss. That overconfidence led both companies eventually to move into derivatives and to employ aggressive accounting measures. They were later found by regulators to have manipulated their earnings, and both were forced to restate years of results.  The CEOs of both companies were ousted.”

From Too Big To Fail by Andrew Ross Sorkin