Eight Mistakes That Caused the Financial Crisis

Former Federal Reserve Vice Chairman Alan Blinder notes that six major human errors, all of which were highlighted and criticized at the time, caused the financial crisis. Blinder makes an important point and one that I hope the new administration takes to heart. The problems the US is experiencing right now didn't come about because capitalism isn't a good system. They came about because of misjudgment, stupidity, greed and a lack of studying financial history. You will never be able to legislate these basic human traits, but you can certainly develop a better framework and better enforce existing regulations to make sure you avoid the current disaster.

The following are Blinder's six mistakes that could have been avoided as published in the International Herald Tribune:

WILD DERIVATIVES In 1998, when Brooksley Born, then chairwoman of the Commodity Futures Trading Commission, sought to extend its regulatory reach into the derivatives world, top U.S. officials of the Treasury Department, the Federal Reserve and the Securities and Exchange Commission squelched the idea. While her specific plan may not have been ideal, does anyone doubt that the financial turmoil would have been less severe if derivatives trading had acquired a zookeeper a decade ago?

SKY-HIGH LEVERAGE The second error came in 2004, when the SEC let securities firms raise their leverage sharply. Before then, leverage of 12 to 1 was typical; afterward, it shot up to more like 33 to 1. What were the SEC and the heads of the firms thinking? Remember, under 33-to-1 leverage, a mere 3 percent decline in asset values wipes out a company. Had leverage stayed at 12 to 1, these firms wouldn't have grown as big or been as fragile.

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A SUBPRIME SURGE The next error came in stages, from 2004 to 2007, as subprime lending grew from a small corner of the mortgage market into a large, dangerous one. Lending standards fell disgracefully, and dubious transactions became common.

Why wasn't this insanity stopped? There are two answers, and each holds a lesson. One is that bank regulators were asleep at the switch. Entranced by laissez faire-y tales, they ignored warnings from those like Edward Gramlich, then a Fed governor, who saw the problem brewing years before the fall.

The other answer is that many of the worst subprime mortgages originated outside the banking system, beyond the reach of any federal regulator. That regulatory hole needs to be plugged.

FIDDLING ON FORECLOSURES The government's continuing failure to do anything large and serious to limit foreclosures is tragic. The broad contours of the foreclosure tsunami were clear more than a year ago — and people like Representative Barney Frank, Democrat of Massachusetts, and Sheila Bair, chairwoman of the Federal Deposit Insurance Corporation, were sounding alarms.

Yet the Treasury and Congress fiddled while homes burned. Why? Free-market ideology, denial and an unwillingness to commit taxpayer funds all played roles. Sadly, the problem should now be much smaller than it is.

LETTING LEHMAN GO The next whopper came in September, when Lehman Brothers, unlike Bear Stearns before it, was allowed to fail. Perhaps it was a case of misjudgment by officials who deemed Lehman neither too big nor too entangled — with other financial institutions — to fail. Or perhaps they wanted to make an offering to the moral-hazard gods. Regardless, everything fell apart after Lehman.

People in the market often say they can make money under any set of rules, as long as they know what they are. Coming just six months after Bear's rescue, the Lehman decision tossed the presumed rule book out the window. If Bear was too big to fail, how could Lehman, at twice its size, not be? If Bear was too entangled to fail, why was Lehman not?

After Lehman went over the cliff, no financial institution seemed safe. So lending froze, and the economy sank like a stone. It was a colossal error, and many people said so at the time.

TARP'S DETOUR The final major error is mismanagement of the Troubled Asset Relief Program, the $700 billion bailout fund. As I wrote here last month, decisions of Henry Paulson Jr., the former Treasury secretary, about using the TARP's first $350 billion were an inconsistent mess. Instead of pursuing the TARP's intended purposes, he used most of the funds to inject capital into banks — which he did poorly.

To illustrate what might have been, consider Fed programs to buy commercial paper and mortgage-backed securities. These facilities do roughly what TARP was supposed to do: buy troubled assets. And they have breathed some life into those moribund markets. The lesson for the new Treasury secretary is clear: use TARP money to buy troubled assets and to mitigate foreclosures.

I would add to Blinder's list 1) Alan Greenspan's desire to manage the economy to maintain his political popularity and 2) the mismanagement at the SEC in terms of eliminating the uptick rule.

Alan Greenspan needs to take blame for lowering interest rates to irrationally low levels during the 2002 and 2003 recession. The artificially low interest rates allowed homeowners to flood into Adjustable Rate Mortgages that were significantly cheaper than long term mortgages. It also allowed housing speculators to leverage up on cheap money. This spurred on an already strong housing market into bubble status. The fact that Greenspan was blind to the consequences despite repeated warnings that a housing bubble was forming, is inexcusable. Greenspan blatantly ignored the central banker's job to "take away the punch bowl just when the party starts getting interesting." Instead, he added fuel to the fire by keeping rates low even as an economic recovery was taking hold in order to appease politicians and the President. Greenspan will go down in history as the worst and most politically influenced Fed Chairman in history.

In addition to allowing bank leverage to go unchecked, the SEC also added to the crisis by repealing the uptick rule and allowing markets to operate unchecked. The uptick rule was enacted in 1933, after regulators witnessed the destruction that short raids could have on investor confidence. The regulators seemed to think these rules, enacted during the most horrific economic collapse in our history, were "quaint" and difficult to enforce. However, they served a very important purpose - to slow down the market so investors and regulators could adjust to rapidly changing conditions.

So with that, I propose eight human errors led to the current crisis. All of them could have been avoided had the powers in charge understood economic history and followed the strong precedents set before them. Theses errors can be fixed without enacting major socialist legislation, imposing trade barriers or placing undue burden on a very fragile economy.

Comments

[john s. gordon:]

i like the idea of a zookeeper for the derivatives trading zoo.

yes restore the uptick rule.
> jack

Jan 28 08:27 AM

[katec:]

I agree with john s gordon.....the "zookeeper for derivatives" is a great idea!

It is a shame that no one with all the economic "savvy" of Hank Paulson or Tim Geitner did not see the impact of letting Lehman fail would have!?!??!!?

Restore the uptick rule, please!

Jan 28 11:08 AM

[1234987:]

Its wonderful to recognize a problem, now fix it!! B part of the solution.

Housing solution!

I, Remove 2 million homes from the MLS (for Sale) that financial institutions currently have
for Sale. Any Institution that received TARP funds will be required to first offer the home
to the RTC for purchase. RTC will not purchase any home above $417,000. No Jumbos.

2, Government Resolution Trust will purchase these homes from these institutions for 20%
less than original first Mortgage amount. No negotiating.

3, 600 billion dollars to buy these homes (app $300,000 each average) will come from the sale
of long term 30 year bonds. (Currently app 3-5%) issued by Government.

4. RTC will send these homes to the local HUD offices for disposition thru voucher program
(rentals). $5000 will accompany each home for repairs & upkeep. eventually as the MLS
system reaches certain inventory levels (i.e. 30-60 days) HUD will be allowed to place these
homes on the sale market. If the inventory increases HUD will remove homes accordingly.
This will be a local HUD market decision, differing from region to region. Rental Income will
help cover expenses such as maintenance, insurance and property taxes.


Pro's:


Supply/demand economics will create a bottom in the housing market once 2 million homes
for sale are removed. Prices will start to increase.

Local governments will see a bottom in declining values and revenue will increase as values
slowly stabilize and slowly increase.

Individual homeowners as well as other sellers will find a housing market ready and able
to absorb the inventory.

Banks will now have a fresh source of funds to lend on homes that are not declining in value.

Banks will be able to clean balance sheets of hard to liquidate assets.

Lending/leverage/credi... markets will slowly begin to return to normal. Applications will
increase, appraisals, home inspections, title work, all types of stimulating activity for business.

As home prices stabilize and increase the local HUD agency selling homes over a 3-7 year time
frame will see prices rise for properties purchased by the RTC. HUD will only be required to
return to RTC the original amount of the purchase price plus the 20%. Or the original amount of the
selling banks first mortgage.

Once the RTC is closed and all homes sold, all losses (if any) will be covered proportionately
by the selling institutions. All financial Institutions selling homes to the RTC will share the loss
at the RTC as a percentage of total homes purchased and homes sold to the RTC. That percentage
will be the Banks percentage for covered losses. These losses will be paid by the banks over a 30 year period liquidating the original bonds sold to finance the purchase.

Other agenda items:

Mark to Market accounting will only apply to non performing assets.

Spend 50 billion each year for the next 3 years rebuilding infrastructure. Bridges, Roads, tunnels,
water plants, dams, levies anything to create jobs.
Stimulus checks for $300 only help pay a credit card bill once.

Any comments?

Jan 28 11:15 AM

[JK Corcoran:]

I find your article interesting, but it misses a major point concerning the subprime "market". There is a major political fumble throughout starting with Jimmy Carter starting the CRA Act which boils down to requiring banks to lend to customers who cannot repay their loans in order to get government approval to expand the bank. This rule was taken by Barney Frank and his "special friend" at Fannie Mae and expanded by requiring Fannie and Freddie to expand their portfolios to 50% CRA credits. By artificially establishing a secondary sales market for these credits, they encouraged abuse by non banks and banks through an apparent reduction of risk through the sales of the "securitized" mortgages. These pretty much went non recourse after six months, and many began underwriting with this as a way out of the credit. So perhaps the government should be a ninth item, don't you think?

Jan 28 11:16 AM

[austrian63:]

Blinder's article is so shallow that it should alarm all who read it. Blinder is a former vice chairman of the FRS and his thinking, or lack thereof, is the status quo among the elites who run America's crony capitalist, free-market-NOT, system.

All six mistakes Blinder cites were made possible and probable by artificially low interest rates and credit expansion managed and promulgated by the Federal Reserve. He lists six symptoms of the financial flu we now have without ever identifying the cause of the sickness, the virus of cheap and easy credit used to grow (inflate) the economy over the past 20 years. The arrogant belief that beaurocrats(sp) can "manage" the economy by fine tuning monetary policy has never worked and will never work.

The policies that got us here (Greenspan, Clinton, Bush, et. al) are now being sold as the cure only the names have changed (Bernanke, Geitner(sp), Obama, et.al.). But have faith in the herd mentality that got us here as I am sure more artificially low interest rates (ZIRP) and more deficit spending by governments, businesses and households will get us out of this jam!

Jan 28 12:47 PM

[notsosmart:]

this article is a waste of time.most dumb-dumbs in this country could not care less as to the causes.legacy fortunes were made & are parked in switzerland,lichtenste... the most important thing now for the 201k crowd is who is going to win the super bowl. they dont realize that made-off is a piker compared to the gov & wall st.its all ponzi.not to worry our new tax cheat sec of treas will keep the fleecing of the sheeples going.

Jan 28 01:05 PM

[auto44:]

BARNEY FRANK SOUNDING THE ALARM, ARE YOU KIDDING!!!!!!!!!!!

Jan 28 01:31 PM

[auto44:]

I don't think low interest rates are anywhere near as damaging as loaning money to folks who could not repay it and then having rating agencies give the loans high marks. If you think you have been screwed,how would it feel to you to buy loans rated AAA and find out the were totally bogus. This crap was sold all over the world. A lot of people need to go to jail who aren't their yet.

Jan 28 01:42 PM

[JK Corcoran:]

Of course he is! How else do you take the blame focus off yourself. Basic politics 101!!

Jan 28 01:44 PM

[Duude:]

I used to think Alan Blinder was a smart guy, now I wonder if his middle name might be 'is'. How could he ignore the moral hazard we built into our mortgage system? You can't liberalize GSE rules for holding sub-prime crap, then block oversight through a totally corrupt congressional banking committee and expect everything will be fine. As for Barney Frank---he's one of the instigators of this whole failed infrastructure. He sure didn't sound any alarms back in 2004 when he blocked any attempt at oversight of the GSEs. Add to that the SEC allowing banks to leverage up like they were European banks, ridiculously low interest rates, an unquenchable European demand for American financial derivatives, a legislative and Executive branch that were gungho on the ever increasing percent of families owning homes, the invention of the credit default swap which was initially meant as insurance against a risk portfolio, loan originators that attempted to capitalize on the moral hazard embedded in the loan securitization market, credit agencies that admittedly would insure a securitized cow with a AAA rating and a hot real estate market and you pretty much deserve what that might bring you.

Jan 28 05:51 PM

[mathgeek:]

I think Blinder is pretty close

Derivatives:

I think the problem is not some vague need for regulation, but rather to ensure that complex structures not be used to arbitrage away from basic princples... in other words, if it looks like a duck, and quacks like a duck, it should be subject to the same regulations as a duck... this point goes far beyond just derivatives per se, but a host of alternative structures (SIVs,auction rate securities... even money market funds) who's basic purpose is to avoid capital rules.

Leverage:

Excess leverage is clearly one of the greatest core causes... and for the most part it isn't leverage of commerical banks, but the leverage of a variety of other financial participants... particularly investment banks but also hedge funds and others... the real core banking problem is supplying excess leverage. Hedge funds can and should be able to lose as much as they want... of their own money. The most shocking regulatory failure will ultimately allowing banks to lend hedge funds 90% of their capital (or more) with relatively modest capital requirements for the lending bank.

Subprime:

I think painting subprime lending with such a broad brush is a mistake, and we lose sight of the core issue, which was that subprime and alt-a mortgage lending stopped worrying about capacity to repay. One of dark secrets of this business at its worse is that lenders were basically harvesting fees from people by repeatedly refinancing, eating away at equity in home... knowing that the borrower could not repay out of their income, but depending on the fact that they could... and did... refinance, over and over again. While not as cynical, it also allowed for mortgage originators to profit from house flipping at the hight of the boom... essentially providing bridge financing to house flippers, in the guise of a mortgage loan. The bottom line is, there is a good reason why capacity to repay is an important mortgage underwriting criteria... as the owners of these loans are re-discovering to their anguish.

Forclosures

Limiting forclosures was a missed opportunity, but perhaps not in the way suggested. Simple minded approaches would have either failed or created worse problems; Nonetheless, it is a fair point that there are structural issues that could have been addressed. There are structural reasons why mortgage servicers foreclose and sell (even at distressed prices) when it might be more economically rational to take a different action (work-out mortgage, convert to rental, etc.). This is mostly a case of what is rational in normal circumstances becoming collectively irrational, but with no system or structure in place, there is no way to change the "normal" course of action to something that makes more sense... especially since doing something different requires a re-negotiation of who bears how much of the economic loss that has occured.

Lehman

Yes.

TARP

It was a good decision to inject capital rather than buy bad assets... this creates a multiplier effect that gives more "bang for the buck"... it would have been ideal if this was done with stronger incentives to lend, however.

Hopefully the remainder of the TARP funds will be used effectively to buy up bad assets. The devil has always been in the details... what valuation to place on what the government buys, and given that the quantity of bad assets out there is far greater than the funds available... how to deterimine which assets to buy become sticky questions for which there are no easy answers... which is almost certainly part of the reason that the Bush administration chose to leave the inevitably controversial decisions to the Obama white house.

Jan 28 10:20 PM

[Graham and ...:]

Brooksley Born. Derivatives' "zookeeper." YESSS!

Jun 03 09:51 AM