What caused the current financial crisis?

The search for the cause of the Financial Crisis will soon heat up.  On April 21, 2009, Bloomberg News reported that Speaker of the House Nancy Pelosi planned to push for a Congressional inquiry of Wall Street.  (Click the “Pelosi Probe Bloomberg News Article” link on the right.) However, any Congressional investigation into the causes of the Crisis is likely to become a partisan affair, and Congress is unlikely to look into the mirror.  The search for the culprits who started this mess should cast a wide net.  “Wall Street” just doesn’t seem wide enough, and limiting the search to Manhattan Island is more likely to find only scapegoats.

Perhaps the best explanation turns to that observer of human nature, Pogo:  “We have met the enemy and he is us.” A list of causes would need to include:

  • A patchwork of regulatory agencies with competing agendas, which allowed financial firms and financial products to engage in “regulatory arbitrage” or escape regulation completely.  One over-riding theme is not “deregulation” but a massive failure of overlapping, inconsistent, and conflicting regulations.  Basel II international standards on bank capital need to be included.  Those standards allow for banks to use their own “approved” risk models to calculate how much capital needs to be maintained for varying risks of different financial investments.  (Whoops!)
  • Legislative (and some Executive) acquiescence in maintaining the patchwork to protect turf and pet priorities (e.g. Fannie Mae and Freddie Mac; Community Reinvestment Act; Congressional stonewalling attempted regulatory reform by claiming “no need to fix what isn’t broken.”)
  • Mortgage originators who underwrote mortgages without standards (e.g. those the market began calling “liar loans”) for investment bankers who could likewise transfer the risk (until the music stopped) because they had protected agency purchasers. The culprits also need to include private buyers of mortgage and other consumer debt, who, through numerous “right sizing” reorganizations, had reduced in-house research, opting instead for…
  • Over-reliance on credit rating agencies with a protected oligopoly and a strong financial incentive to assign the highest rating the bond issuer demanded.
  • Shareholders (also known as equity investors) who pressured chief executives to produce growth in financial services companies to match that of tech companies, all the while having no say about base-pay and incentive compensation packages approved by Boards of Directors who were supposedly independent, but who, in reality, were members of the same tight little country club set as the chief executives.  (My mother, a retired high school English teacher, would be appalled at that elongated sentence.)
  • Undisciplined fiscal policy with massive tax cuts (usually good, except) with no spending cuts to match.  The Republicans forgot part of Ronald Reagan’s formula:  you cut Congress’ allowance in order to cut its spending; rather, as The Economist correctly pointed out, the Republican Congress “spent like drunken sailors.”  Now, the tax and spend Democrats are back!
  • Monetary policy, which created moral hazard by consistently slashing interest rates to bail out over-leveraged trading desks and consumers and, therefore, started to feed the next bubble.  Concern grew that the equity and bond markets came to expect that the “Greenspan Put” and a new “Bernanke Put” would bail them out.
  • Currency policies of emerging market governments in an effort to keep the local currency value relative to the dollar at a level which would maintain exports (which also benefited the over-leveraged U.S. consumer.)

Bob Decker, CFA

Welcome to Torpedo Boat 92K

Objective
Torpedo Boat 92K will provide an efficient and effective way for finance and investment professionals to communicate with their elected officials and with policy makers regarding proposed legislative and regulatory solutions to the Financial Crisis. These proposals will affect the ability of financial services and investment management professionals to meet the needs of their clients.

Guiding Principles
The current Financial Crisis has underlined the need for meaningful reform of the regulatory framework in which the financial services / investment management industry operates. In the rush to address the complex issues facing the nation, finance and investment professionals have individually expressed their growing concern about the increasingly expansive role that government initiatives are playing in day-to-day decisions. The Federal Reserve and the U.S. Treasury have provided crucial facilities to address liquidity and solvency challenges faced by financial market participants. However, members of Torpedo Boat 92K are concerned that government overreach has become a real threat with unintended consequences of deepening the crisis or delaying and hampering a recovery. A guiding principle of Torpedo Boat 92K is that market mechanisms, operating within a logical and well-thought-out regulatory framework, offer the most efficient solutions to correct market imbalances. Regulations and laws that attempt to eliminate or solve every real or perceived cause of the current crisis carry a real threat of strangling financial markets, resulting in a misallocation of scarce economic resources. Legislation that is retaliatory in nature to attack isolated or rare instances of private sector overreach is especially pernicious to smoothly operating markets. This conviction of the Group’s members is not based on ivory tower or ideological theories, but it results from their years of experience in meeting the investment needs of clients.

What’s in a Name?
Like a large, heavily loaded containership, regulatory changes have already set sail. Before this cumbersome ship reaches full speed on the stormy Financial Market Sea on its way to the port of Unintended Consequences, time is of essence to fire a few shots across its bow to slow it down. The size of Federal commitments to address the Financial Crisis amounts to more than $92,000 per individual tax return filed in the United States. ($12.8 trillion as calculated by Bloomberg News divided by 138.4 million personal tax returns in 2006, the last year of data available from the IRS.)

Bob Decker, CFA