Wayne O’Leary

Subprime Meltdown

The Regulatory Failure

(Second of two parts. See the first part here.)

In the several years leading up to today’s credit crisis, the US financial-services industry, capitalizing on a decade of deregulation and merger mania, and what The Economist called “the multifarious debt instruments concocted in the laboratories of Wall Street and the City of London,” produced staggering bank profits ($134 billion in 2005 alone) with no apparent end in sight. The combined annual earnings for its leading investment banks beggared the imagination, tripling in one four-year period to an average of 22%. In 2006, just before the fall, returns on equity (profits as a percentage of bank capital) reached a 60-year high.

The wild ride was fun while it lasted—until, that is, the realization began to dawn that the entire edifice was a house of debt built on a foundation of near-worthless subprime mortgages. By the end of 2006, investment banks had issued $489 billion in CDOs (collateralized debt obligations), two-thirds of them consisting of mortgage-backed securities and other structured credit products nearly impossible to convert into liquid assets. A year later, three-quarters of all the secured loans in America had been bundled and sold as securitized debts.

Not to worry, advised the gurus of high finance; they were masters of “risk management.” All of the highly leveraged investment banks had so-called risk-management systems, based on computer modeling, that would supposedly prevent any big losses from high-stakes securities trading. There’s a saying about computers: garbage in, garbage out. But the investment bankers, backed by the business schools that produced them, saw risk as a source of profit, not a throw of the dice involving the nation’s financial system. Besides, no competitive bank executive was going to pull back and lose business to rivals.

Like the elephantine size that diffused responsibility and rendered modern banks unresponsive to developing problems, their risk-management systems had become so complex and unwieldy the banks themselves didn’t understand them. This couldn’t be admitted, of course. Bank CEOs were so well paid everyone assumed they must know what they were doing, and those in charge weren’t about to disabuse anybody of that notion. In 2006, E. Stanley O’Neal, CEO at Merrill Lynch, received $48 million in cash, stocks, and stock options; James Cayne, CEO at Bear Stearns, took home $40 million; and Charles (“Chuck”) Paine, CEO at Citigroup, pocketed $27 million. These outlandish salaries encouraged risk-taking (to get them) and managerial empire-building (to justify them); they contributed to the hubris that said those at the top were masters of their convoluted universe.

When the end came, the company heads whose complacency and inattention in the face of risk brought down the house of debt rode off into the sunset with their personal accounts intact. Merrill Lynch’s O’Neal departed in October of last year with a $162 million retirement package. His and his colleagues’ messes were left to someone else to clean up, which brings us to the final responsible parties who failed when the economy was on the line, the public regulators.

Throughout the lengthy run-up to the current financial crisis, the regulator-in-chief was Federal Reserve Chairman Alan Greenspan, whose term in office (1987-2006) overlapped almost exactly the era of deregulation that precipitated it. The chairman, a philosophically rigid laissez-faire conservative appointed by Ronald Reagan (and reappointed twice by Democrat Bill Clinton, who deserves his share of the blame for what transpired), was in tune from the start with bank deregulation.

The 1999 repeal of the Glass-Stegall Act separating commercial banking from securities underwriting Greenspan called “a milestone of business legislation” that was “long overdue;” it restored “needed flexibility” to the financial sector, he declared in his 2007 memoir The Age of Turbulence. What the big bankers ultimately did with that flexibility does not concern him, even now. The subsequent mergers and acquisitions that unbalanced the banking system he sees as “a vital part of competition and creative destruction.”

When the inevitable dislocations of an increasingly unregulated financial market finally reached the crisis point midway through the Bush administration, the esteemed Fed chairman was, in regulatory terms, missing in action; worse than that, he was an active accomplice. In 2004, speaking to the Credit Union National Association, Greenspan actually encouraged home buyers to take out adjustable-rate mortgages, on the grounds they would save money. A year later, he was celebrating the devilishly Byzantine banking instruments that would soon produce disaster as leading to a “more flexible, efficient, and hence resilient financial system.” Last year, in Age of Turbulence, America’s purported economic genius dismissed concerns about rising business and household debt. “Rising debt,” he solemnly proclaimed, “goes hand in hand with progress.” The subprime boom, which had not yet imploded as he wrote, was worth the financial risk, the retiring chairman advised, because it would increase homeownership.

In February 2006, the sainted Greenspan, who presided over the deregulation of the banking system, the dot-com boom and bust, and the creation of the housing bubble, skipped town one step ahead of the impending collapse. Fellow economists, including former Fed board members, are now skewering him after the fact for lax bank supervision and for excessively low interest rates in 2003-04 that fueled the hyperinflation in real estate and spawned the subprime mortgages responsible for the credit crisis. For 20 years, there was simply no regulatory cop on the beat at the Federal Reserve.

Sadly, there still isn’t. Ben Bernanke, Greenspan’s replacement, is another Republican monetarist with a soft spot for corporate investment bankers. His answer to the prevailing problem amounts to bailouts when necessary (e.g. Bear Stearns) and a $400 billion slush fund (half of the Fed’s assets) for troubled securities traders to tap at below-market interest, without any compensating government oversight. It’s a perfect solution for wayward investment bankers: low-cost federal loans on demand, but no federal regulation.

In the final analysis, there is no one culprit responsible for the still-evolving financial crisis. Instead, there is ample blame to go around: a public that heard what it wanted to hear about cheap credit, two political administrations in thrall to conservative theories of economics, a banking industry consumed by avarice and foolish optimism, and a regulatory system captured by the very forces it was supposed to regulate. Now, the bill has come due.

See the first part here.

Wayne O’Leary is a writer in Orono, Maine.

From The Progressive Populist, July 1-15, 2008

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