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Wednesday, January 26, 2011 2:35 AM


FCIC Investigation Misses the "Big Picture" Cause of the Crisis; Next Financial Crisis Brewing Already


The Financial Crisis Inquiry Commission (FCIC) held 19 days of hearings interviewing 700 witnesses and just released a 576-page book of its findings. The FCIC concluded the Financial Crisis Was Avoidable.

The 2008 financial crisis was an “avoidable” disaster caused by widespread failures in government regulation, corporate mismanagement and heedless risk-taking by Wall Street, according to the conclusions of a federal inquiry.

The commission that investigated the crisis casts a wide net of blame, faulting two administrations, the Federal Reserve and other regulators for permitting a calamitous concoction: shoddy mortgage lending, the excessive packaging and sale of loans to investors and risky bets on securities backed by the loans.

“The greatest tragedy would be to accept the refrain that no one could have seen this coming and thus nothing could have been done,” the panel wrote in the report’s conclusions, which were read by The New York Times. “If we accept this notion, it will happen again.”
What Caused the Financial Crisis

Barry Ritholtz at the Big Picture Blog discusses "causes" mentioned in the New York Times article above. Please consider Barry's article What Caused the Financial Crisis

  • Alan Greenspan’s malfeasance — his refusal to perform his regulatory duties because he did not believe in them — allowed the credit bubble to expand, driving housing prices to dangerously unsustainable levels; Greenspan’s advocacy for financial deregulation was a “pivotal failure to stem the flow of toxic mortgages” and “the prime example” of government negligence;
  • Ben S. Bernanke failed to foresee the crisis;
  • The Bush administration’s “inconsistent response” — saving Bear, but allowing Lehman to crater — “added to the uncertainty and panic in the financial markets.”
  • Bush Treasury secretary Henry M. Paulson Jr. wrongly predicted in 2007 that subprime meltdown would be contained.
  • The Clinton White House, including then Treasury Secretary Lawrence Summers, made a crucial error in “shielding over-the-counter derivatives from regulation [CFMA]. This was “a key turning point in the march toward the financial crisis.”
  • Then NY Fed President, now Treasury secretary Timothy F. Geithner failed to “clamp down on excesses by Citigroup in the lead-up to the crisis;” Further, a month before Lehman’s collapse, Geithner was still in the dark about Lehman’s derivative exposure;
  • Low interest rates brought about by the Fed after the 2001 recession “created increased risks” but were not chiefly to blame, according to the FCIC (I place some more weight on Ultra-low rates than they do);
  • The financial sector spent $2.7 billion on lobbying from 1999 to 2008, while individuals and committees affiliated with the industry made more than $1 billion in campaign contributions. The impact of which an incestuous relationship between bankers and regulators, Congress and bankers, and classic regulatory capture by the industry.
  • The credit-rating agencies “cogs in the wheel of financial destruction.”
  • The Securities and Exchange Commission allowed the 5 biggest banks to ramp up their leverage, hold insufficient capital, and engage in risky practices.
  • Leverage at the nation’s five largest investment banks was wildly excessive: They kept only $1 in capital to cover losses for about every $40 in assets;
  • The Office of the Comptroller of the Currency along with the Office of Thrift Supervision, “federally pre-empted” (blocked) state regulators from reining in lending abuses;
  • The report documents “questionable practices by mortgage lenders and careless betting by banks;”
  • The report portrays the “bumbling incompetence among corporate chieftains” as to the risk and operations of their own firms:

Missing the Big Picture


I cannot dispute any of those points. They are all correct. Yet every one of them happened as a failure "of" regulation, not a failure "to" regulate.

The actual cause of the financial crisis is easy to explain.
  1. Loose monetary policies at the Fed
  2. Fractional Reserve Lending
  3. Congress willing to spend more money that it takes in

Had there not been Fractional Reserve Lending, and had the Fed not cut interest rates to absurd levels while fostering a "too big to fail" attitude at banks, this would not have happened. Perpetual Congressional budget deficits and the Fed's willingness to finance those deficits too cheaply is icing on the "what happened" cake.

To expect smart regulation from those who did not see it coming, the Fed and nearly all of Congress, is preposterous.

Moreover, had there been (by some miracle) regulation to prevent the housing collapse, liquidity would have flowed somewhere else and there would have been a bubble in some other thing.

Regulatory Failures

  • Regulation created the Fed
  • Regulation created Fannie and Freddie
  • Regulation created FDIC
  • Regulation changed the way rating agencies did business

Every one of those is a failure "of" regulation, not a failure "to" regulate. The US government has no business sponsoring housing and if there was no Fannie or Freddie, there would be nothing to regulate in the first place.

Look at what solar energy regulation produced in France. The story is not financially earth-shaking. But it is typical of what one should expect from regulation.

Bear in mind I am not against all regulation. I certainly do not want people shouting fire in movie theaters or polluters to poison my water. Laws against robbing banks are quite fine too.

I even agree with Glass-Steagall because the intent to to build a firewall to prevent fraud. However, and as a side note, Glass-Steagall would not have done anything to prevent this crisis.

Glass-Steagall would not have stopped securitizations, rating agency fraud, liar loans, excessive leverage or anything else of merit.

In short, regulation designed to preserve property rights, human rights, and safety are fertile grounds for reasonable types of regulation that have a high probability of success and will do minimal damage if written poorly.

Cogs in the Wheel of Financial Destruction

Please note the allegation that credit-rating agencies were “cogs in the wheel of financial destruction.” I agree with that idea completely.

However, the rating agency cog is one of the biggest failures "of" regulation you can find. I discussed the issue at length in Time To Break Up The Credit Rating Cartel.

If Moody's, Fitch, and the S&P got business based on how accurate they were, and competition was opened up, the problem with rating agencies would go away overnight. If you read my article you will see that is the way rating agencies used to work.

However, the SEC came along, demanded that all debt be rated, and instead of getting paid on how well they did their jobs, the rating agencies got paid on the volume of business they did. This of course created an incentive to give high ratings to everything to get more business.

The only thing that needs to happen to fix the rating agency problem is for government sponsorship of rating agencies to end.

Fannie Mae and Freddie Mac

Regulation created Fannie Mae and Freddie Mac as well. The first thing any regulator in his right mind would do to Fannie and Freddie now is shut them down, yet they still exist. Does anyone even remember why these agencies were created?

Here is the reason: To foster affordable housing. Did it work?

Amazingly, now that home prices are falling, everyone wants to prop up home prices. No one really wants affordable housing nor did they ever want it. Politicians only want to appear as if they want affordable housing. That promise buys votes.

What About Leverage?

Look at the blame placed on leverage. Do we need a mountain of regulation to rein in leverage or do we need to kill Fractional Reserve Lending?

I suggest the latter.

Regulators in Bed with Those they Regulate

Here is a pair of interesting findings in the report:

  • The Office of the Comptroller of the Currency along with the Office of Thrift Supervision, federally preempted (blocked) state regulators from reining in lending abuses.
  • The Securities and Exchange Commission allowed the 5 biggest banks to ramp up their leverage, hold insufficient capital, and engage in risky practices.

You can have all the regulation in the world but it will but do a damn bit of good if the regulators get in bed with those they are supposed to regulate.

How are you supposed to fix that? A super-regulator to regulate all the regulators?

Hopefully that sounds idiotic (because it is), but that is exactly what some have proposed.

Can You Get Good Regulation in the First Place?

Before the worry about "who might get in bed with who" even comes up, there is a presumption that you can get good regulation in the first place. Can you?

Please consider these points from the report:

  • Alan Greenspan’s malfeasance — his refusal to perform his regulatory duties because he did not believe in them.
  • Ben S. Bernanke failed to foresee the crisis.
  • Bush Treasury secretary Henry M. Paulson Jr. wrongly predicted in 2007 that subprime meltdown would be contained.

Here we have an interesting situation where Greenspan, Bernanke, Paulson, and sponsors of financial institutions in Congress (notably Barney Frank), are supposed to write financial regulation that will work, when none of them could see the crisis coming, nor would they listen to anyone who did see it coming!

Yet, everyone is screaming for more regulation. The whole idea sounds preposterous because it is preposterous.

Preventing the Last Crisis

Nearly everyone is running around like headless chickens screaming for more regulation to prevent another housing crisis. They don't have to. We will not have another housing crisis like this for decades if ever, whether another piece of housing regulation is written or not.

The Next Crisis

I do not know what the next financial crisis to bring the global economy to its knees will be, but here are five likely candidates

  1. Sovereign debt crisis in Europe
  2. Sovereign debt crisis in Japan
  3. Trade wars with China
  4. Derivatives meltdown
  5. Currency wars

Please note that not a damn thing is being done about any of those except the first one. Even then, regulators are avoiding the only thing likely to offer a permanent solution: writedowns of sovereign debt. Instead the EU is inflating money supply hoping to avoid the one thing likely to help!

The problem is we have a massive amount of debt that cannot be paid back, which means that it won't be paid back.

With that we have come full circle with still more rock solid evidence that the root cause of this mess is as I stated above (with a few small refinements to take in the global nature of the crisis).

  1. Loose monetary policies by central banks worldwide
  2. Fractional Reserve Lending
  3. Governments' willingness to spend more money than they takes in

Sustainability of Exponentially Growing Systems

Finally, I have not seen any of the bloggers screaming for more regulation discuss a crucial point I made recently regarding the sustainability of exponentially growing systems. Here are the pertinent posts.


Will financial crises go away until the exponential problem is addressed? I think not, yet no one is even discussing the issue. To show you how screwed up things are, Bernanke openly endorses exponentially growing systems with his inflation-targeting proposals.

So you can write all the regulation you want and it will not do a thing if credit or price inflation (as Bernanke wants) is growing at an exponential rate.

Instead, most regulation will simply increase problems just like the creation of Fannie Mae or the humorous solar energy regulation did in France.

The rest of it will be ignored by regulators in bed with the industries they are supposed to regulate, assuming of course the regulation was written properly in the first place, which is highly unlikely given Congress and high ranking officials did not see this coming.

Regulation is the Cause of the Crisis, Not the Solution

Barry Ritholtz at the Big Picture Blog is a bright guy. He is one of the few who saw this coming. He wrote a good book about the crisis.

This post is not an attempt to take any of that away. As I said at the outset, I do not disagree with any of the points he made in his post.

My only dispute is those points miss "The Big Picture". The Big Picture is that regulation is the cause of this crisis not the solution.

The solution involves abolishing the fed and putting the US on a sound financial footing. In turn, that means we need to kill fractional reserve lending.

If we fail to do that, Bernanke specifically, and central bankers in general, will cause the next financial crisis by supporting exponentially growing systems that cannot possibly be sustained.

No regulation other than reversing the regulation that created the Fed, then abolishing fractional reserve lending can possibly prevent the next crisis.

Are Humans Smarter than Yeast?

Here is a video Bernanke needs to ponder with his 2% inflation target, and the World Economic Forum with its 4% GDP target and 6% credit growth target. After playing the video, think about China's 10% target with its economy overheating already.



Mike "Mish" Shedlock
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