“We’re exposing parts of the capital markets that most of us had never heard of,” Ethan Harris, a top Lehman Brothers economist, said last week. Robert Rubin, the former Treasury secretary and current Citigroup executive, has said that he hadn’t heard of “liquidity puts,” an obscure kind of financial contract, until they started causing big problems for Citigroup.
What Created This Monster?;
Timothy F. Geithner, a career civil servant who took over as president of the New York Fed in 2003, was trying to solve a variety of global crises while at the Treasury Department. As a Fed president, he tried to get a handle on hedge fund activities and the use of leverage on Wall Street, and he zeroed in on the credit derivatives market.
Mr. Geithner brought together leaders of Wall Street firms in a series of meetings in 2005 and 2006 to discuss credit derivatives, and he pushed many of them to clear and settle derivatives trading electronically, hoping to eliminate a large paper backlog that had clogged the system.
Even so, Mr. Geithner had one hand tied behind his back. While the Fed regulated large commercial banks like Citigroup and JPMorgan, it had no oversight on activities of the investment banks, hedge funds and other participants in the burgeoning derivatives market. And the industry and sympathetic politicians in Washington fought attempts to regulate the products, arguing that it would force the lucrative business overseas.
“Tim has been learning on the job, and he has my sympathy,” said Christopher Whalen, a managing partner of Institutional Risk Analytics, a risk management firm in Torrance, Calif. “But I don’t think he’s enough of a real practitioner to go mano-a-mano with these bankers.”
Mr. Geithner declined an interview request for this article.
In a May 2006 speech about credit derivatives, Mr. Geithner praised the benefits of the products: improved risk management and distribution, as well as enhanced market efficiency and resiliency. As he had on earlier occasions, he also warned that the “formidable complexity of measuring the scale of potential exposure” to derivatives made it hard to monitor the products and to gauge the financial vulnerability of individual banks, brokerage firms and other institutions.
“Perhaps the more difficult challenge is to capture the broader risks the institution might confront in conditions of a general deterioration in confidence in credit and an erosion in liquidity,” Mr. Geithner said in the speech. “Most crises come from the unanticipated.”
What went wrong with the economy?
Subprime crisis: causes, consequences and cures
As Venezuela’s worst banking crisis unfolded in 1994-1995 (conservative estimates of the bailout costs of that crisis are at around 18 percent of GDP), no one in that country seemed to know whose responsibility it was to supervise the financial institutions. As is usual in most banking crises, lending standards had become lax, there was interconnected lending, and there was plenty of plain old-fashioned graft. The central bank blamed the main regulatory agency (SUDEBAN), the regulatory agency blamed the deposit insurance agency (FOGADE), and everyone else blamed the central bank.
At the time of that crisis, the received wisdom was that such supervisory disarray could only happen in an emerging market; advanced economies had outgrown such chaos. We now know better.
For starters, part of the supervisory responsibilities in the US is delegated to the states, which is to say that 50 emerging markets agencies were partially responsible for the oversight of real estate lending. Supervisors failed to caution depositories as they offered potential borrowers unsuitable mortgages. They also acquiesced as complicated structures were booked off the balance sheet, even though, in the event, they were not treated as such by corporate headquarters at the first sign of stress. And after the fact, they have pointed to the other guy as responsible for the problem.
In the private sector, mortgage brokers often sought no more assurance of future repayment than a signature. That act of faith was made easier because their own compensation came from originating loans rather than how the loans played themselves out. And underwriters took that raw material of mortgages and somehow convinced themselves that the law of large numbers would make the whole better than the sum of its parts, even though many of those pieces needed double-digit house price growth to make economic sense. Credit rating agencies, encouraged by their own fee structure, listened attentively to underwriters’ assurances of the power of pooling and their ability to predict despite a limited track record. And final investors substituted the judgment of the rating agencies for their own due diligence, perhaps abetted by regulation and accounting rules that imparted special significance to those judgments.
No doubt, change is needed in both the private and public sectors. My immediate fear is that, as in most prior episodes, the initial reaction will be overdone and inefficient. Financial institutions are already tightening the terms and standards for new lending at a ferocious clip. Rating agencies, following their pro-cyclical tendencies, will overreact as well in the effort to distract the investing public from their laxness of the past few years by strict standards going forward. Similarly, bank examiners will interpret the regulations narrowly, reinforcing the natural tendencies of depositories to tighten credit availability.
And last but not least, politicians have already turned their focus toward the financial industry. If the regulation of financial institutions needs to be revisited, there are compelling arguments to pare the multitude of regulators of depository institutions and insurance companies and to restructure the supervision of rating agencies. But the outcome of hurried debate in the heat of the moment is more likely to be legislative overreach than informed policy making. It would be far better to get the job done right than get the job do