Washington – the Congress, the executive branch and the regulatory agencies – failed us in five major ways [during the financial crisis of 2008-2009]. First, the wrong lessons were drawn from the banking and S&L crises of the 1980s and the wrong reforms were put into place. Second, government fiscal policies were irresponsible and monetary policies too accommodative over the past decade, which helped feed a speculative boom and crash in the housing markets. Third, the government collectively turned a blind eye toward – or in some cases encouraged – excessive risk taking during the fifteen year period between the two crises. Fourth, the government seriously mishandled the latest crisis, which led to a worldwide panic and near collapse of the financial markets. Finally, I believe the government is misreading the causes of the latest crisis and is failing to implement the right reforms. I’ll touch on each of these topics today.
Before going further I want to make clear that by focusing on the government’s failures before, during and after the crisis I do not intend to absolve the private sector. I believe greed, poorly structured compensation practices, excessive risk taking, inadequate risk management systems, and ineffective corporate governance played significant roles leading up to the crisis.
This post is based on William Isaac’s keynote address at the FDIC’s and PRMIA’s Global Risk Conference. He is the author of the book, “Senseless Panic: How Washington Failed America.”
I’m not focusing on these private sector issues today because we can’t do much about them except through proper regulation of financial institutions, which takes me back to the government and its regulation of finance.
Someone once said that greed is like gravity in that both are forces of nature. Properly controlled and regulated, greed makes our free enterprise system work and creates a higher standard of living. If the government does not properly regulate the aviation industry, gravity takes over and airplanes fall from the sky. The fault is not gravity’s, it is poor regulation. If government does not properly regulate finance, greed inevitably results in speculation, excessive risk taking, bubbles and ultimately severe and painful corrections.
Several major factors led to the banking and S&L crises of the 1980s. The government decided to fight the war in Vietnam and implement the Great Society programs without paying for them. These actions, coupled with accommodative monetary policies, unleashed inflation during the 1970s.
Financial institutions, still operating under the regulatory constraints imposed on them during the Great Depression, were not prepared to deal with what was about to come. S&Ls were stuck in an unsustainable business model that required them to focus on long-term, fixed-rate lending to the highly cyclical real estate industry. Banks were tightly regulated in the services they could offer and the geographic areas they could serve. The interest rates banks and thrifts could pay for deposits were set by law.
President Jimmy Carter appointed Paul Volcker as Chairman of the Federal Reserve in 1979 with the mandate to get inflation under control. The Fed raised rates to an astonishing 21-½ percent. Inflation was brought under control but at great cost. A depression in the agricultural sector, a crash in the energy sector, a deep two-year recession with unemployment reaching 11 percent, and a collapse of the real estate sector ensued. Banks, thrifts and their borrowers were caught in a severe squeeze and hemorrhaged red ink.
With one notable exception, things were handled well during this crisis. Nearly 3,000 banks and thrifts failed during the 1980s, including many of the largest in the country (Continental Illinois and nine out of the ten largest banks in Texas, for example) without causing the public or the markets to lose confidence and panic.
The one major problem that I believe was not handled well was resolution of the S&L crisis. Rather than facing up to the S&L crisis in the mid-1980s, when it could have been cleaned up at an estimated cost of $15 billion, government leaders from both parties deferred action in the hope that given time the S&L industry could restructure itself and grow its way out of its problems.
Regulatory accounting principles were adopted to mask the problems and allow S&Ls to grow. S&Ls were granted authority to expand into businesses they did not have the capital or the management to support. By time government leaders decided to confront the S&L problems in 1989, the cost of the clean-up had escalated ten-fold to $150 billion.
Having spent $150 billion of taxpayer money to clean up the S&L mess, the politicians had to find someone to blame other than themselves. Greedy bankers and incompetent regulators were the easiest targets. Sound familiar?
We moved to a regulatory regime that diminished the regulators’ ability to use judgment and placed excessive reliance on markets and models to regulate financial institutions. Mark-to-market accounting was put into place over the objections of the Fed, the FDIC and the Treasury who argued that it would be highly pro-cyclical, would lead to excessive volatility in bank earnings and capital, and would create severe credit contractions.
Prompt Corrective Action was enacted to limit the ability of regulators to work with troubled institutions they believed could be turned around. Highly complex, unreliable and pro-cyclical models were put into place to determine capital adequacy and loan loss reserves. The FDIC’s ability to respond to financial crises was curbed and politicized by requiring the Fed, the Treasury and the President to authorize the use of the FDIC’s emergency authority.
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