ECONOMIC VIEW
Six errors on the path to the financial crisis
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What's a nice economy like America's doing in a place like this? As the United States descends into what is likely to be its worst postwar recession, Americans are distressed, bewildered and asking serious questions: Didn't we learn how to avoid such catastrophes decades ago? Has American-style capitalism failed us so badly that it needs a radical overhaul?
The answers, I believe, are yes and no. The capitalist system did not condemn Americans to this fate. Instead, it was largely a series of avoidable — yes, avoidable — human errors. Recognizing and understanding these errors will help fix the system so that it doesn't malfunction so badly again. And it can be done without ending capitalism as we know it.
My list of errors has six whoppers, in chronological order. I omit mistakes that became clear only in hindsight, limiting myself to those where prominent voices advocated a different course at the time. Had these six choices been different, I believe the inevitable bursting of the housing bubble would have caused far less harm.
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.
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