Wall Street Does Not Bear Sole Responsibility For Subprime Crisis

by: Roger Ehrenberg

So I had a little cameo yesterday on NPR's On Point program titled The Mortgage Bailout Debate. On the air at the same time as me were Robert Shiller (Yale, author of Irrational Exuberance, you know the guy) and Robert Kuttner of The American Prospect. Two very smart guys. The tone of the discussion swayed from "How could those bankers have gotten paid millions of dollars only to get bailed out; how come the heads of the Wall Street firms haven't lost their jobs?" to "There are some fundamental flaws in our regulatory system that need to be addressed." Clearly a mix of populist rhetoric and economic substance, which I guess is necessary to both engage listeners and further the learning process. But I'd like to say what I would have liked to have said if I had more time to spar with the Bobs on-air.

First, let's take a step back. What were some of the forces that gave rise to the subprime mess in the first place? Here is my own short list (in no particular order):

  1. Cheap debt a/k/a accomodative Fed policy
  2. Abundant investor liquidity
  3. Lack of sensible know-your-customer standards in mortgage origination
  4. CDO investors who didn't do their homework and/or relied on rating agencies
  5. Bank investors who didn't do their homework and understand the potential impact of off-balance sheet vehicles
  6. Rating agencies lack of experience in dealing with CDO credits of such complexity
  7. Poor accounting rule-making

Now if you look at this list and then say 'How many of these problems did Wall Street create?", my answer would be "precious few." What Wall Street is exceptionally good at is taking advantage of the rules. They make sure they know the rules very, very well, better than any other constituency on the planet. Then they innovate, develop, structure and sell based upon delivering customers (be they issuers or investors) value in a form that enables them to make money. Risk sharing and mitigation. New asset classes for investment. Greater liquidity. These are all good things.

Say what you want about Wall Street, but one thing I haven't heard in the sea of criticisms of late are the words "illegal" or "fraud." That's because they did nothing wrong. They did what the current screwed-up regulatory construct (hello, Congress?) and the markets (hello, what,-me-worry? investors?) allowed them to do. So take a look in the mirror before throwing stones, all ye critics. Because odds are that you play a part in this crisis as well.

Mr. Kuttner made the comment that "SIVs were new and invented by Citigroup, I think." Wrong. SIVs and their intended use has been around in a variety of forms for decades. Operating leases, sale/leasebacks, asset defeasance transactions - these are all geared around keeping assets off the balance sheet. The thing is, analysts (at least those who are sentient beings) know this, and good ones properly capitalize these off-balance sheet exposures effectively undo this accounting imagery in their models. Investors should be doing this as well, and if they don't, too bad. Problem is when investors who are stewards of mutual funds, pension funds and other fiduciary vehicles do dumb things it is everyone who suffers. Not just Wall Street. Main Street.

Mr. Shiller made a point I agree with very strongly, that our fractured, decentralized regulatory infrastructure is woefully inadequate given the rapidly increasing scale, complexity and globalization of our financial markets. We do need a single set of rules for areas where market inefficiencies necessitate regulation, and one which both Bobs mentioned and which I agree with relates to underwriting standards. I am personally less concerned with the standards themselves than I am the "Know your customer" concept that already exists at retail brokerages both outside and inside Wall Street firms. This same concept needs to be enforced on mortgage originators, in order that customers will only be shown products that are appropriate given their income, job stability, etc., because it is clear that there were widespread abuses of people originating paper that never should have been written in the first place. And coordination of regulation between states and the Federal government is critical for clarity, which will make regulation easier and facilitate innovation.

So if you were to draw a picture of the problem with arrows and a big SIV in the middle, you've got loans in on the left, some good, some bad, into the SIV, and then CDO paper out. Retail investors need better protection on the left, in my opinion via know-your-customer and product appropriateness standards. CDO investors, many of whom relied on ratings agencies to make their purchases, need the confidence to be able to trust the integrity of the agencies and the quality of their analytical work.

Right now, both issues are in question. That said, investors need to do their homework, over and above an implicit "seal of approval" from the rating agencies. And none of this addresses the accounting rules, which still enable off-balance sheet structures that defy both economics and logic. That is a post for another day.

I am glad these issues are being hashed out in public. I just wish that they were more dispassionate in their approach, leave the populist rhetoric to the side and to focus on the underlying problems that need to be fixed. Because there is a whole lot of fixing to do, and griping about Wall Street salaries is not going to get us there.