Eight Mistakes That Caused the Financial Crisis

Jan.28.09 | About: SPDR S&P (SPY)

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.

Greenspan and BushAlan 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.