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The two most common examples of actual deregulation was the Gramm-Leach-Blily Act of 1999 which effectively repealed the Glass-Steagall Act of 1933, and the Commodities Futures Modernization Act of 2000 which removed the regulation of OTC derivatives among “sophisticated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.

If you have the cue ball and just one other ball on the pool table lined up for shot in the corner pocket, AND you are a reasonable competent pool player then you can determine with some degree of accuracy and consistency that you will have a high degree of probability of sinking that shot.  If the shot is not lined up perfectly and you must hits the ball at some angle or if you must bank the shot off the side bumpers, then the possibility of missing the shot escalates.

Now add another ball between you and the target ball, and the risk of missing the shot escalates enormously especially if the second ball is off center. By the time you add several balls to the table the likelihood of making the shot drops to near zero. The analogy is that the more variables you add to a system the less you are able to predict with any certainty.

You can predict with great certainty that you will miss the shot when several balls or variables are added to the scenario because the uncertainties and variables are very visible.  If there were several balls on the table and they were invisible, then you would look at the table and discern that you had a much greater chance of making the shot that you would actually have.

In retrospect the collapse of the financial system showed plenty of visible signs of impending doom.  There were several prominent analyst who warned us. One of them was Nassim Nicholas Taleb, author of The Black Swan (the pool table analogy is partially from that book).

The handicappers used risk models with two large defects.  The models were created in a world where all the pool balls were visible, where the chances of gain and loss were subject to measurement and where the amount that could be lost was somewhat limited even if possibly severe.  Taleb called this world Mediocristan. These models were applied to a world where the pool balls could become invisible, where risks were less subject to being known and measured and where the losses could prove fatal to the system.  It is foolish to decree with some delusional certainty that there is only a one per cent chance of a loss without considering the size of the potential loss.

It was foolish to apply game theory to a world void of the fundamental assumptions of the theory and it was even more foolish to consider risk of loss without considering the amount.

Why do we use such flawed thinking?  We seek the comfort of order where there is none. We are reluctant to admit that we do not know.  The more complicated our systems get (not just financial systems) the more we depend on intellectuals and academics for the answers.  These people do not thrive by focusing on what they do not know.

To use another analogy from Taleb’s book, it is like being lost in the Alps and using a map of the Pyrenees because that is the only map you have, and it is thus better than nothing.  No it isn’t: you are far better to use your own eyes and senses than a flawed model.

Rather than replace one horribly flawed model with another we need to recognize that we are in a game with invisible balls, unknowable risks, and with risks that can kill the host.  Much of the risk can be addressed by eliminating excessive and dangerous debt. More can be done by breaking larger units into smaller units but we must also reduce or eliminate interrelated risks.  We are no better off with smaller units so related than they will all go up and down together.  The last crisis saw unhealthy large institutions tied to every other large institution with activity so interrelated that it behaved like a single diseased entity.

The new Frank Dodd Financial reform addresses none of this. It assumes that we can compensate for the miserable failure of regulations and regulators with more regulators and regulations.  In 2006 Barney Frank angrily denounced those who warned Congress of the looming dangers  in Fannie Mae and Freddie Mac. Fannie and Freddie were exempt from most regulatory oversight from the Treasury, the SEC , and the FDIC; they were regulated by Congress themselves with Frank and Dodd in the most responsible positions as head of the House and Senate Banking Committees.

The monumental failure of Fannie and Freddie was at the center of the financial collapse, yet both are exempt from the financial reform package.

Those who believe that in light of the severity of the collapse that we must do “something” are still lost in the mountains and they are still using the wrong map.

The default belief  of our economic history of the last 100 years has been an acceptance of the dynamic growth of capitalism punctuated by excesses of market greed that have to be corrected by the singular wisdom of government regulation.

On closer examination many of those moments of market greed and excess look more like incompetent government meddling caused the problem.

During the Depression of 1929 we saw 10,000 banks collapse in the United States. Yet during that same period the number of bank failures in Canada were zero.  Was Canada spared the depression that engulfed the United States? No, but Canada was spared a regulation that prevented banks from crossing state lines.

Bending to pressure to protect local banks from encountering big business center banks, they got relief and protection from the Federal government in the restriction of interstate competition.  But that also severely limited their flexibility in dealing with a crisis, a limit that did not exist in Canada where risks were spread over larger areas and underutilized assets could be easily relocated.

Yet to respond to the bank failures that the government largely caused they created the FDIC (Federal Deposit Insurance Corporation).  FDR opposed the FDIC because he saw it would create a sanction for reckless behavior and penalize prudently run banks.  FDR capitulated in a compromise and the FDIC began by insuring deposits for $2500 in 1934. It was raised to $5,000 in 1935, $10,000 in 1950 (Truman), $15,000 in 1966 (Johnson), $20,000 in 1968 (LBJ again), $40,000 in 1974 (Nixon), and then $100,000 under Jimmy Carter in 1980.  Bush raised it to $250,000 before he left office, but it is due to revert back to $100,000 in 2013.

Ten years after Carter raised the limit we experienced the Savings and Loans meltdown, caused by the excessive risk taking in that industry. The government again intervened and created the Resolution Trust Corporation (RTC) to dispose of failed thrift institutions taken over by regulators after January 1, 1989 in an orderly manner.

The FDIC created the moral hazard FDR feared. It privatized the profits and socialized the risks.  This behavior was repeated, but on steroids, with the implicit assumption of risk by Fannie Mae and Freddie Mac.

Housing was deemed a federal priority, and helping the poorer people get into housing has been a priority since Fannie Mae was created again by FDR in 1938.  But housing prices were highest and least affordable in select areas where local ordinances had restricted supply and raised prices far more than in areas were market forces prevailed.

Tax policies such as mortgage interest deductions and preferred capital gains treatment increased the demand for housing. The Community Reinvestment Act, passed under Carter but exploited under Clinton and Bush, pressured banks to make mortgage loans to less and less qualified buyers. Fannie Mae guaranteed loans, clearing the ratings agencies which had a government protected franchise; to give higher ratings than these mortgage backed securities could have conceivably obtained on the merits of their assets. This widened the market for these securities and caused even more money to be driven into the housing market from all over the world creating the bubble that had to burst.

To compound the damage the government required a mark to market rule for valuing these mortgage loans at the worst possible time; when no market existed.  The market to market rule causes valuations to go to extremes, high and low.  This caused capital to dry up and regulations required banks to rebuild capital reserves instead of making loans. Then at a time when information was critical to valuing these securities, the government suspended short selling, a critical source of such information.

During the recent financial disaster, Canada did not exhibit near the real estate collapse we did in the United States.  In Canada they had far less exposure to sub prime loans, large down payments were still required while we all but eliminated down payments for the poorest home buyers in the name of ‘compassionate conservatism’, and mortgage borrowers in Canada were still held personally liable for their loans. Canada had tougher and more prudent lending standards, but they avoided the fiasco foisted on us by well intentioned but misguided moral supremacists on the government payroll.

The government in the U.S. inflated this bubble as eagerly as any on Wall Street, but our government “had a much bigger pump”.

Seventy five years ago we could have looked to our northern neighbor and learned better behavior instead of demonizing capitalism. Today we can learn the same lesson, but again we seek to demonize the private sector for conditions created by incompetent government regulation. Wall Street clearly has its demons to account for, but its greed was enabled and often encouraged by incompetent regulations and policy that has a long history.

As we crave more government oversight we should ask who will oversee the government that has demonstrated such spectacular failure.

Here is an idea for our times.

We create a Federal Agency called the Consumer Investment Information Corporation.

It is funded by a fee on all banks and institutions needing an independent investment rating.

It is governed by nine people; three selected from each political party representative group in the Congress, and another three selected from the first six. The last three can be academics or professional analysts.

The CIIP can hire investment services like S&P and Moody’s to rate the financial institutions. The rating service would no longer be hired and paid by the institutions they rate; they would be serving the consumer.

Over a period of say 5 years, the FDIC protection would be removed from banking institutions. During that time a CIIP rating would be given on those institutions on their relative stability and strength.  Banks could then compete on the basis of stability and financial strength. Higher rated banks could sell CD’s with lower yields since they provide value through their strength. Lower rated banks would have to pay a higher interest rate to compensate for their higher risk.

Current FDIC protection has replaced market information. Consumers do not care about the strength of their banks because they have federal insurance protection. It has encouraged reckless banking behavior. Every time the FDIC limit is raised the banking sector acts more irresponsibly.

It is time to let the market function by providing information, rather than rendering the information irrelevant by guaranteeing incompetence.

Wall Street’s financial leaders have been paraded before Congress to explain their efforts to restore stability to our financial system. Obama has turned on the populist spigot to demonize Wall Street to justify bigger taxes and fees and hip shot regulation.

Wall Street deserves the scrutiny and reform is needed.  Yet this fiasco was as much a government failure.  Fannie Mae was exempt from regulation by the SEC, FDIC and the Fed.  When Congress was solidly warned about excessive risks taken by the Fannies,they rejected calls to increase oversight, largely along party lines. Little protest is heard from the halls of Congress over some of the huge bonuses paid to Frank Raines and others at Fannie Mae while the system was imploding.

Some recent regulations such as the mark to market rules made this crisis much worse than it would have otherwise been.  Other regulations such as control  of derivatives  by the Commodities Futures Trading Commissions were removed (under Clinton) at a pivotal time. The Fed ’s monetary policy was also a factor.

A hearing to truly understand what happens and what needs to be done would have our Congressmen on the other side of the microphone.