Views on improving the integrity of global capital markets
31 January 2011

FCIC Blames Human Action and Inaction

Posted In: Uncategorized

The Financial Crisis Inquiry Commission released its 600-page-plus assessment of what caused the 2008 market debacle to little fanfare Thursday morning. The findings in the politically divided report range from the obvious to the oblivious while failing to shed new light on what happened or what caused the fear of that dreadful autumn. But since the Dodd-Frank bill, which the report was supposed to inform, was signed into law nine-and-a-half months ago, it is unclear what, if any, purpose the report serves.

First, some full disclosure. I, along with colleague Linda Rittenhouse, spoke to the Commission staff as they were moving into their offices in downtown Washington in January 2010. The discussion largely focused on the role that credit rating agencies (CRAs) played in the crisis and their effects on investment decisions, though CRAs didn’t warrant a mention in the final report.

While the report meets the civility test (no name calling), it nevertheless reflects the partisan divide in Washington. Just six of the 10 commissioners signed the main report. Three others joined forces to draft a separate dissenting opinion that cited 10 essential causes. And in a 95-page rebuttal to the main report, the 10th panelist, Peter Wallison of the American Enterprise Institute, a free-enterprise think tank, argues that government housing policy was the root cause of the debacle.

“It was the result of human action and inaction ….”

It was the main report that received what little attention was given to the report, and it begins by stating the obvious: “The crisis was the result of human action and inaction ….” Might it have been otherwise? To be fair, the text continues by noting that the crisis wasn’t the result of a natural disaster or computer failure, and some regulators have suggested that the debacle was something that couldn’t have been prevented, force majeure, if you will.

One human inaction cited as “devastating” was the “pervasive permissiveness” of regulators at the time. Few would argue with the idea that banking regulators were asleep at the wheel as depository institutions like Washington Mutual, IndyMac, Golden West Financial, Citibank, and others accumulated massive concentrations of increasingly toxic mortgage-related assets both on and off their balance sheets.

Breakdown in Accountability and Ethics

Likewise, the report authors are spot on when they recognize the breakdown in accountability and ethics in the marketplace. It notes not just the well-documented failures of credit rating agencies, bankers and bank senior managers, investment bankers, and mortgage brokers, but also the too-big-to-fail mentality of investors and bankers alike, as well as the many borrowers who borrowed without either the capacity or the intention of repaying.

Finally, the authors recognize the corporate governance failures at large financial institutions, about which CFA Institute testified before Congress last year. They note the decline in mortgage underwriting standards, the compensation structures that rewarded short-term performance instead of long-term results, the inconsistent government response as the crisis unfolded, and the excessive leverage of financial institutions all as significant factors in the crisis.

Missing the Big Picture

For all the findings that the authors get right, however, there are just as many that they get wrong. They take the Fed’s word that the “recourse rule” — which heavily discounted the amount of capital banks had to hold against the senior tranches of securitized loans compared with what they had to hold against whole loans on their balance sheet — had no effect on the decisions of bankers to invest so heavily in mortgage-backed instruments.

But the biggest lapse in judgment is the main report’s claim that while Fannie Mae and Freddie Mac “contributed to the crisis,” they “were not a primary cause.” This is remarkable given that each had invested more than $2 trillion in one way or another in the same U.S. residential mortgage market — nearly half of the $9 trillion first mortgage market — where the crisis began. Moreover, both institutions were supported by a razor-thin layer of equity capital and a perceived government guarantee that permitted them to borrow at rates that no other institution could match. Both were rife with accounting, governance, and compensation problems, as documented in a 2005 paper by Harvard Law School Professor Lucian Bebchuk on the governance and financial reporting failures at Fannie Mae. In other words, these two institutions displayed all the problems the commission attributes to the financial crisis of 2008. Yet they were not seen as a primary cause. Try figuring that one out.

Ironically, the timing of the report’s release may give it a chance at relevance and influence because it comes just as the 112th Congress considers what, if any, part of Dodd-Frank needs revising. I wouldn’t hold my breath, though. More likely, the partisan divide in the report will ensure that this review will have all the influence on financial reform that the now-forgotten White House Commission on Fiscal Responsibility and Reform has had on budgetary matters.

About the Author(s)
Jim Allen, CFA

Jim Allen, CFA, is head of Americas capital markets policy at CFA Institute. The capital markets group develops and promotes capital markets positions, policies, and standards.

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