Misunderstanding the Last Financial Crisis

I wanted to address a glaring error in a David Leonhardt NYT Sunday Magazine article, titled Heading Off the Next Financial Crisis,

In the column, Leonhardt wrote:

“But there was a fatal flaw in the new system. The banks’ new competitors received scant oversight. They were not directly bound by Roosevelt’s restrictions. “We had this entire system of outside banks that had no meaningful constraints on capital and leverage,” Geithner says. Investment banks like Lehman Brothers were able to make big profits in part by leveraging themselves more than traditional banks. To use the down-payment analogy again, it was as if Lehman were allowed to put down only 3 percent of a house’s purchase price while traditional banks were still making larger down payments. When the house’s value then rose by just 3 percent, Lehman doubled its investment. A.I.G., similarly, created a highly leveraged derivatives business that regulators essentially ignored…

The deregulation of the last few decades has come in for a lot of blame for the current financial crisis. It deserves some blame, too. If Citigroup and Bank of America were still operating under the New Deal rules, they might not have flirted with bankruptcy. But take a minute to think about which firms had the biggest problems. They were the shadow banks: stand-alone investment banks like Lehman, Bear Stearns and Merrill Lynch; and other firms, like A.I.G., that were not banks at all. They were never fully covered by the New Deal regulation, and they were not the ones most affected by the deregulation.” (emphasis added).

This is not precisely right.

And as applied to AIG, it is absolutely, totally wrong.

Thanks to the The Commodity Futures Modernization Act of 2000 (CFMA), the universe of structured derivatives were completely exempt from ALL regulation. Whether it was Collateralized Debt Obligations (CDOs) or Credit Default Swaps (CDSs), the CFMA put them into the world of shadow banking.

How? The CFMA mandated it.  No supervision was allowed, no reserve requirements for potential future payouts were mandated, no exchange listing requirements were put into effect, all capital minimums were legally ignored, there was no required disclosures of counter-parties. Derivatives were treated differently from every other financial asset — stocks, bonds, options, futures. They were uniquely unregulated.

Indeed, even state insurance regulators were prevented from oversight — including normal  reserve requirements. That was how AIG Financial Products was able to ramp up their derivative exposure to more than three trillion dollars.  This was directly due to radical deregulation.

Even the most basic reserves would have kept their derivative exposure to much more modest numbers. With absolutely zero capital requirements, AIG FP went wild. Tom Savage, the president of FP, summed up what the lack of reserve requirements meant to the firm: “The models suggested that the risk was so remote that the fees were almost free money. Just put it on your books and enjoy.”

To the tune of $3 trillion dollars.

All in all, this wasn’t so much a case of Washington DC failing to keep up with Wall Street, rather, it was a case of DC actively granting what Wall Street (Enron, AIG and other derivative traders) wanted — precisely zero oversight.

Hence, it was deregulation that made the AIG disaster possible.

As to the investment houses (Bear, LEH, MER, etc.), all you need to do is look one step upstream in the securitized mortgage process. There, you see the impact of the radical deregulation mindset.

Consider the mass of subprime loans that the investment houses were securitizing. The majority of these came from non-bank lenders. These were the firms that Fed Chair Alan Greenspan described as innovators.

He elected not to regulate them. I called this “Nonfeasance” in Bailout Nation. No lending standards: Zero income checks, ignore the debt load, eliminate LTV, even fail to do a simple simple FICO credit check. Just a lend-to-anyone-then-sell-to-securitizers business model.

Securitization wasn’t the problem, it was simply Garbage in, Garbage out. Had Greenspan required nonbank lenders to maintain normal lending standards (As was his official duty), much of the crisis could have been avoided. At the very least, all of the subprime related loans, derivatives, and default swaps built on top of these garbage mortgages would have been dramatically reduced.


Bottom line: Radical Deregulation is what allowed most of the worst actions to take place. This wasn’t a case of DC failing to keep up with Wall Street — its more accurate to observe that DC rolled over for Wall Street, and gave the Street precisely what it asked for.


Heading Off the Next Financial Crisis
NYT, March 22, 2010

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