Summer Rerun: Ban “No One Could Have Foreseen the Crisis”

This post first appeared on April 10, 2008

Floyd Norris of the New York Times, in an otherwise fine piece, “It’s a Crisis, And Ideas Are Scarce” has a paragraph that set my teeth on edge. But let’s deal with the parts that have merit first, and hold the rant in abeyance.

Norris uses the Paul Volcker’s speech at the Economic Club of New York this week as a point of departure, covering it in more detail than other commentators:

Paul Volcker, the former Federal Reserve chairman whose legacy has not crumbled since he left office, was right this week when he said the financial engineers had created “a demonstrably fragile financial system that has produced unimaginable wealth for some, while repeatedly risking a cascading breakdown of the system as a whole.”….

“Any return to heavily regulated, bank-dominated, nationally insulated markets is pure nostalgia, not possible in this world of sophisticated financial techniques made possible by the wonders of electronic technology,” he said.

In any case, the banks are not all that healthy anyway, thanks to their losses from the strange securities created under the new system…..

Regulation needs to be strengthened, particularly for investment banks. Providing a safety net brings, in Mr. Volcker’s words, “a direct responsibility for oversight and regulation.” He forecast that “investment banks are going to end up with a leverage ratio imposed upon them.” And one lesson of this disaster is that having parallel financial institutions — one regulated and one not — simply drives activity to the unregulated area, at least until something blows up….

It is also clear that the efforts being made to cut back American regulation, in the name of making our markets more competitive, are attempts to deal with the wrong issue. To quote Mr. Volcker again, “For financial regulation in general, competition in regulatory laxity cannot be a tolerable approach.”….

Mr. Volcker, who knows how inflation can get out of hand, said the current situation reminds him of the early 1970’s, when inflation began to accelerate. The Fed’s moves to slash short-term interest rates and bail out Wall Street, however necessary they may be, could easily raise inflation and cause more damage to the weak dollar.

Volcker puts his finger on the central problem, the the securitization model, aka “originate and distribute,” has broken down. New issuance volumes are off dramatically in all product areas. But what is more troubling is that many types of securitized products depended on credit enhancement, and that does not appear to be coming back anytime soon, if ever (at least in anywhere near the same volumes). Note how many “rescue the housing market” plans rely on federal guarantees (Fannie, Freddie, FHA), an indirect acknowledgment of the problem.

Yet the consensus view, which increasingly appears to be wishful thinking, is securitization will come back once the credit crisis is past the acute phase. Yet look at the elements that appear irretrievably damaged: monolines, key providers of credit touch-ups, have renounced the structured finance business. Credit default swaps, another important source of credit improvement, are suffering from a shortage of protection-writers (among them the bond guarantors) and other former sources of credit enhancement (hedge funds and investment banks) are now correctly regarded as less secure. That leaves overcollateralization as the only readily available means for creating the desirable AAA tranches out of pools of less than stellar assets. It isn’t yet clear what that means for the structured credit business going forward,

In addition, with rating agency reputations in tatters and many investors burned by buying pseudo AAA paper, it may be a very long time before investor confidence is restored. It may not occur in the absence of reforms that have teeth.

Yet even the astute Volcker does not appear to have considered the possibility that the securitization process will remain largely non-operative until root-and-branch re-regulation is in place to entice investors back into the pool (no pun intended). That implies that in the meantime, on-balance-sheet credit intermediation will assume a large role. But that requires far more financial firm capital (the resulting bigger balance sheets dictate larger equity bases) precisely at a time when losses are shrinking bank capital and new equity is costly and hard to procure.

Now to the offending part. From Norris:

At the same time, there is a limit to the usefulness of finger-pointing. Most of the critics — myself included — did not anticipate the severity of the credit collapse, and we should not act as if the executives and regulators who failed to prevent it were blind or stupid. Rather than go into self-defensive crouches, those people need to use hindsight to ameliorate the mess.

I can’t fathom where Norris’ concern about an excess of “finger pointing” (except perhaps at Greenspan) comes from. If anything, there has been too little, rather than too much, investigation of how we got where we are.

Consider the contrast. In 1987, after the stock market crash, the so-called Brady Commission (formally, the Presidential Task Force on Market Mechanisms) was established a bit more than two weeks after the crisis. Admittedly, the stock market meltdown was a discrete event, while our credit crisis has been an slow-moving train wreck. Nevertheless, the Brady Commission working oars were not part of the regulatory apparatus; its executive director was a Harvard Business School finance professor, Robert Glauber; the staffers came heavily from the private sector. This gave them the freedom to look at deficient practices without incurring the ill will of people in their field.

By contrast, consider Bernanke’s in a speech yesterday, “Addressing Weaknesses in the Global Financial Markets,” of the measures taken to understand the roots of our current financial mess:

In the United States, policymakers’ efforts to identify the sources of the financial turmoil and the appropriate public- and private-sector responses have been coordinated through the President’s Working Group on Financial Markets (PWG), chaired by the Secretary of the Treasury. The group’s other principals include the heads of the Securities and Exchange Commission (SEC), the Commodity Futures Trading Commission, and the Board of Governors of the Federal Reserve System. With the support of the staff of the respective agencies, the PWG began to address these issues last fall, as the severity of the financial turmoil became increasingly apparent; in mid-March, we issued a brief statement outlining our tentative conclusions and policy recommendations.1 At the international level, the Financial Stability Forum (FSF), whose membership consists of central bankers, regulators, and finance ministers from many countries, including the United States, will also soon release a report on the causes of and potential responses to the turmoil.

There has been no independent investigation by people who had access to the key actors and relevant documents. No matter how well intended the regulators and government officials looking into the credit crunch might be, it simply isn’t human nature to point fingers at oneself.

Similarly, I don’t place much stock in Norris’ “I didn’t think it would get this bad, therefore no one should be held accountable for missing it.” With all due respect, Norris may be well connected, but that is not the same as being an insider (see Daniel Ellsberg’s book Secrets for long-form treatment of this topic). And there were few Cassandras with far less access than Norris who did see this coming. We shouldn’t shy away from understanding why those who should have known better chose instead the convenient path of wishful thinking and willful denial.