17 September 2009 
Here are twenty questions I hope we can answer on the Financial Crisis Inquiry Commission (FCIC). As I said this morning in my opening statement at the commission’s first meeting, if the commission could answer these questions, I think we would significantly advance the understanding of what happened and help policymakers address the root causes of the financial and economic crisis.
I do not intend this list to be comprehensive, nor does it cover every policy area that was important to the crisis. For instance, it ignores the role of credit rating agencies, which were responsible for key information failures. This list instead focuses on what I think are the most important and difficult unresolved questions about which there is significant debate. Answers to these questions could be fit into a larger explanation of what happened.
I have preliminary views on answers to many of these questions, and perceptive readers may be able to infer my lean from some of the phrasing. I have tried to tone that down as much as possible and present these as questions that are open for legitimate debate. I hope you and my fellow commissioners find them useful. I also hope that I can develop better answers during my work on the commission.
Here then are 20 important questions about the financial and economic crisis. (Technically this is better labeled “20 topics,” since several items contain multiple sub-questions.) I invite comments, suggested additional questions (ideally framed in the same relatively open manner), and suggested answers. Please assume any input you provide is principally for my use. Commission Chairman Angelides said today his goal is to have a website and method for providing formal input to the entire commission established by the end of this month.
Credit bubble
- What were the relative contributions to a credit bubble in the U.S. of (a) changes in global savings; (b) changes in relative savings between the U.S. and other (especially developing) countries; and (c) low interest-rate policies of the Greenspan Fed? Was risk systematically underpriced in the US and other countries?
Housing finance
- To what extent did well-intentioned policies designed to encourage the expansion of homeownership contribute to a relaxation of lending standards and people buying houses they could not and would never be able to afford? If so, which specific policies contributed to this problem?
- Were housing finance problems a cause of the crisis, the primary cause of the crisis, or primarily the trigger that set off other problems?
Financial institutions (broad policy questions)
- Was this a problem of financial institutions or financial markets? To the extent that markets collapsed (like certain securitization markets), did the market mechanisms fail, or instead did the funding sources just dry up?
- What definitions of “too big and interconnected to fail suddenly” did policymakers and regulators use, and how did those change over time? What’s the best way to define this test, and should it be set in advance by rule or left as a judgment call based on the specific situation?
- Did the capital purchase program of TARP work? Was it the right decision to use taxpayer funds to provide public capital to the largest financial institutions to prevent systemic failure? In retrospect, was the decision to use TARP resources for direct equity investment rather than to buy troubled assets a wise one? Was $700 B a reasonable number given the circumstances?
- Why did the stress tests work? Was it because investors had a common set of benchmarks, or because market participants perceived a bank’s inclusion in the stress test as an indication that it was too big to fail? Did the stress tests create a new implied government guarantee around 19 of the largest U.S. financial institutions?
- The Gramm-Leach-Bliley Act allowed companies to merge commercial and investment banking activities. Did this contribute to extremely high leverage levels and place the financial system at risk? The removal of that same firewall also allowed the Fed to quickly approve Goldman Sachs’ and Morgan Stanley’s conversions into Bank Holding Companies, providing them protection during the height of the crisis. Was removal of the firewall net good or bad?
Failures and near-failures of particular financial institutions
- To what extent did three aspects of Fannie Mae and Freddie Mac: (a) their policy-induced dominant position in mortgage securitization; (b) their large retained portfolios of mortgage-based assets and (c) their regulatory treatment as equivalent to US government debt; cause or contribute to three resultant failures: (i) the insolvency of Fannie and Freddie; (ii) the lowering of credit standards for mortgages; and (iii) the failure or anticipated failure of other financial institutions?
- Was there a legally and economically viable option available to save Lehman? If so, based on what we know now, should Lehman have been saved?
- Did the intersection of mark-to-market accounting and relatively inflexible capital standards substantially contribute to the demise of any particular financial institution?
- In September and October 2008, leaders of several large financial institutions told the Administration that “the shorts” were trying to cause their apparently healthy institutions to fail. These leaders argued the SEC should reinstate the uptick rule to make this behavior more difficult. Were the shorts trying to bring down these institutions? If so, was their behavior illegal or inappropriate? And did the SEC’s reinstatement of the rule have any impact?
The regulators
- Several heavily regulated large financial institutions failed both because they were highly leveraged and because they made bad bets. Did regulatory examiners miss both elements? If they didn’t miss them, why did regulators allow these institutions to place themselves and the financial system at so much risk?
- To what extent did banking regulators’ reliance on the banks to monitor their own operations and activities contribute to the crisis?
- Was there specific real-time information that policymakers or regulators lacked about (a) hedge funds; (b) credit default swaps; or (c) other unregulated financial institutions and “dark markets” that would have been helpful in identifying particular problems before they occurred or changed policy reactions during the crisis?
Metrics
- How did different definitions of Tier I capital contribute to the crisis? Did different parts of the financial system with more stringent definitions perform better?
- Is there an economically best summary measure of a financial institution’s leverage? How did that metric compare for the largest financial institutions in mid-2008 to historic norms? How did it compare to other countries?
Executive compensation
- How does one define “excessive risk-taking,” and what specific compensation structures contributed to it? Did these compensation structures cause problems across-the-board, or only in firms with other problems?
Where are we now, and where should we be?
- Other than the absence of one large investment bank, how are the financial system and incentives and behavior in large financial institutions today different from September 1, 2008? (h/t James Aitken)
- Should policymakers try to restore the levels and types of lending and funding flows that existed 13 months ago, or is there a lower and different “new normal”?
(photo credit: Oberazzi)
Well, I suppose considering who has created the commission it would be impolite to add:
21. What elements of legislation other than the GLB and what informal interventions into regulatory matters by members of Congress contributed to any errors of policy or crisis response identified above? What was the role of lobbyists for industries and specific institutions in any of these counterproductive activities?
1.Defer to John B. Taylor.
2.The relaxation of lending standards was caused in part by mortgage securitization regulation providing for disclosure favoring the sell side over the buy side. Mortgage securities listed on EDGAR to satisfy registration requirements (despite conflicting rules encouraging their treatment as private securities) comprise a vast collection of examples of instruments full of data in forms not useful to investors. The lessons of structured disclosure with respect public companies learned in the 20th century were not applied to asset backed securities in the 21st century. Instead, the SEC permitted issuers to use simple ASCII text – not at all comparable in its structure to US GAAP – to register instruments representing vast future cash flows. This lack of structure limited transparency to investors willing to manually structure the data for themselves. For example, Philip Moyer, the CEO of EDGAR online, has been quoted in the media with respect to hedge funds that paid to structure this data and then profited from the possession of that information. See http://www.wired.com/techbiz/it/magazine/17-03/wp… Because of the information advantage the sell side enjoyed over the buy side, demand for mortgages to securitize flowed to mortgage originators who in turn were driven to lower lending standards – increasing risk that was only passed back up the chain in the form of difficult-to-analyze ASCII text.
3.Government policies distorting the market to favor homeownership, ranging from the home mortgage interest deduction subsidizing real property investment to the government imposed 15% or greater penalty tax on business investment (compared with capital gains exclusions for residential property) distorted market operations. Neutral and stable tax policy would mean fewer chances for political problems to cause market problems.
4.See responses to questions 2 & 3. Furthermore, it was evasion of market mechanisms, i.e., subsidizing investors who made mistakes in purchasing or holding asset backed securities, which discouraged price finding. The reluctance to permit price finding, based on the fear that market pricing would hurt large institutions, contributed to the duration of the crisis. If the existing bankruptcy system is incapable of rapidly resolving large financial institution failure, either the bankruptcy system should be made more robust or large institutions should be made smaller.
5.Unclear; however, primary dealer status was thought by some to be an important consideration.
6.No. No. No. No. The panic caused by seeking such an unprecedented amount was counterproductive.
7.The stress tests were not in the long-term national interest. The better solution would have been public disclosure of all material information with respect to the public financial institutions. There should be no “too big to fail” exemption from the securities laws.
8.In the absence of adequate disclosure of financial instruments in which companies invested, yes. The 20th century disclosure framework proved inadequate for 21st century financial instruments. The flight to regulatory safety was convenient in light of the failure of disclosure.
9.The distortion of the supply and demand curves with government policies resulted in the sort of unpredictable valuations and volatility one might expect when arbitrary policies replace market forces.
10.The most effective way to save Lehman would have been to permit Bear Stearns to enter an expedited bankruptcy proceeding in which the judge was given equitable powers to claw back compensation, at his discretion, over several years. Whether Lehman could have deleveraged quickly enough to save itself remains uncertain, although management would likely have been more interested in making arrangements with more solvent parties in an effort to minimize the impact of its weakened holdings.
11.It depends what the alternative to mark-to-market was. Using traditional cost accounting from the outset might have lessened the crisis; using models might have worsened it. However, since GAAP-style disclosure didn’t extend to an estimated 20,000 asset backed securities with notional values comparable to small public companies, the crisis cake was baked in an oven separate from the fair market value debate.
12.Some short sellers were merely trying to profit; others may have been illegally manipulating the market. The latter can only be proven in a court of law by a preponderance of the evidence; not an appropriate topic for this forum.
13.They probably did not miss the first element; in fact, I understand large financial institutions were in compliance with the Basel requirements in effect at the time. Regulators are not necessarily trained to evaluate the quality of bets. As a product of sophisticated European consideration, the Basel requirements were probably too readily accepted as a matter of convenience, when in the event, only a fully informed open market is up to the task of pricing large complex risks.
14.Self-monitoring facilitated excess risk but stronger government monitoring may have resulted in suboptimal risk. Risk is generally probability times consequence. Government is poor at anticipating the probability of a particular financial risk event. It is better equipped to measure the potential consequence of a risk event. In the future, policy should focus on limiting the consequences of particular risk of the events by, for example, ensuring that large financial instruments are subject to disclosure that enables investors in the open market to price that risk.
15.It would have been helpful to know that hedge funds had used XBRL to ascertain the risk of mortgage-backed securities well before the general market became aware of those risks. It would have been helpful to have similar information about other securities and financial instruments. However, it remains doubtful regulators could have acted on that information, particularly given the politics of home ownership. It seems more likely that exposing that information the market would have successfully identified problems before the consequences of delayed discovery grew as large as they did.
16.Defer to SEC Office of Economic Analysis.
17.Defer to SEC Office of Economic Analysis.
18.Excessive risk-taking is activity in which there is a material probability of a consequence that has not been adequately disclosed to investors who would suffer material harm from the consequence. Perhaps the most significant contributor to compensation structures that reward risk-taking is tax policy that encourages the use of short term stock options as compensation at the expense of cash and other compensation. Equalizing the treatment of cash and options compensation (by eliminating the arbitrary $1 million cap on corporate deductibility of cash compensation) would enable shareholders, through their boards of directors, to establish deferred cash compensation for employees based on long-term company performance.
19.The substantially weakened balance sheets of the United States and of the Federal Reserve disadvantage large U.S. financial institutions relative to global competitors. Incentives for personal and professional development are weaker given the future tax burden likely to stem from crisis policies. As President Reagan said, “Tax rates are prices—prices for working, saving, and investing. And when you raise the price of these productive activities, you get less of them and more activity in the underground economy, tax shelters, and leisure pursuits.”
20.Government policymakers should ensure that public markets have access to all information necessary to restore securitization at an efficient level of lending and funding flow. Government policymakers are incapable of determining what that proper level of lending and flow should be. Only a free and informed market can do that.
I like Paul Wilkinson's answer to question 2, and I think it suggests a reformulation of your question there. You focus too much on one area that I suspect contributed very little to the crisis and you sound like you're echoing a right-wing talking point. Instead, focus in this area more on low interest-rate policies of the Greenspan Fed (as you mention in question 1, but not in the housing finance section) and on all the chain of securitization, credit default swaps, and other mechanisms whereby banks could make bad loans and feel that they were protected from the consequences of default (and so on up the chain as the mortgages were traded).
I think #5 and 6 are key questions – along with the question of what should be done with regulations (or antitrust law, or other tools) to prevent organizations from becoming too big and interconnected to fail and thereby getting billions or even trillions of dollars of free insurance for their risks. Going forward, we've seen some of the big players get even bigger in the past year, and we need to figure out what to do to make sure there is no bank that is too big to fail.
8. I heard people talking a lot about Gramm in the days after the crisis, but not so much lately. I don't think it's likely that we'd reverse that change, so rather than analyzing what it contributed to the current situation, let's think about what we can do to mitigate the additional risks it brought while retaining any benefits we can. (That is, don't worry about whether it's net positive, since we're not going to reverse it, but rather worry about how to create a more stable system given its existence).
I think #13-15 are the key points because what I hope most of all comes from this commission is some good recommendations about regulations that will be effective and not too costly. On the other hand, I fear that we will create regulations that would have stopped the previous crisis, have a lot of cost in some dimension or other, and are of course useless in whatever the next crisis might be that's coming down the road.
Thanks for your work on this commission and for your openness in sharing all of this on your blog. I hope your recommendation of getting information out before the final report 15 months from now bears some fruit and that you can have input into the legislative debates when this issue gets hot again (perhaps after a health care bill passes?)
12.5: Who were the 10 largest "naked" short sellers of financial firms prior to the collapse of Lehman? Were naked shorts a significant portion of all short selling during this period?
There's an excellent, to the point, question, unlike Mr. Hennessey's bullshit, vague, non-committal "explorations", since "naked short-selling" is more blatantly illegal. It seems at least a strong possiblity that Mr. Hennessey wants to cover up shortcomings of the Republicans in general and George W. Bush and his administration in specific, by asking these more obscure questions instead of ones that make people and organizations more accountable. Is Mr. Hennessey an Ayn Rand devotee?
Dunno know if you've seen this Arnold Kling paper yet (I have sent it home to digest over the weekend). H/T: Russ Roberts (on 9/16/09) at cafehayek.com:
http://mercatus.org/PublicationDetails.aspx?id=28…
It may be helpful to view the crisis as 2 distinct stages. First: a long-simmering housing problem, that was unwinding somewhat painfully in the financial industry but without major effects on the larger economy. Second: in mid 2008 and especially Sep/Oct, the Fed made major errors by not meeting the public's demand for money, and then paying interest on reserves — which kept the huge (and needed) increase in the money supply from actually reaching the public. (Banks just sat on the money to earn risk-free interest.) Key source for this view: Prof. Scott Sumner. The FAQ on his blog is a good place to start.
If the Fed had done its job, the economy might have lumbered along with stats comparable to early/mid 2008. I'll take high oil prices over high unemployment! Also, if the Fed could have prevented much of the spillover from the financial sector to the economy as a whole, it provides more freedom to let companies fail. Ultimately, that's a much better way to "regulate". Actions have consequences.
I second Mr. Stockman’s question #21. The government, as such a large and influential party to our economy, cannot help but to have an effect.
Two more questions:
1) Have you read Rothbard, Mises, and Hayek?
2) Are you familiar with the Austrian Business Cycle Theory?
Presumably they will answer negatively to both. Which means they haven’t a clue, what, how, or why the crisis happened. Worse, they will have no clue as to the solution.
>>> it ignores the role of credit rating agencies
No small detail, that.
If the credit rating agencies had performed their duties correctly, this would never have happened. I mean, how do you miss something this MASSIVE and still get to call yourself a credit rating agency? They should all be decertified and new ones should be alllowed to take their place, funded by an independent organization via a small fee attached to every NYSE and OTC trade.
Re 2: If "we" allow corporations, of any sort, to become "too big to fail", what's the point of having anti-trust laws?
Re 2: If "we" allow corporations, of any sort, to become "too big to fail", what's the point of having anti-trust laws?
' To what extent did well-intentioned policies designed to encourage the expansion of homeownership contribute to a relaxation of lending standards and people buying houses they could not and would never be able to afford?'
I realize you're trying to be non-confrontational here, Keith, but 'well-intentioned' is conceding half the argument. When I look at the CRA (and its later iterations), it looks designed to be a license to extort. Which is what it became in practice.
Anyone who thinks Lehman could have been saved should specify exactly what legal authority could have been used. Obviously, TARP was not yet available. Do such people think Treasury can spend money without congressional authorization? The Fed, by law, can lend only on a secured basis. Did Lehman have adequate security to support repayment of a loan from the Fed?
And, now with the benefit of hindsight, we can see that Lehman was insolvent. It's senior debt is trading at 10-15 cents of its face value. All of Lehman's $30 billion of stockholders' equity value has been wiped out.. How could a loan from government save an insolvent institution?
A general problem with capitalism, not solved in any developed system, is the problem of possible over-investment. Over investment means the investors are going to lose money. For 30 years in California, you "couldn't lose money on real estate". Every investor wants to invest in a high possible return/ can't lose money bet. House buying for "investment" was speculation — the finance crisis was because the finance industry became addicted to profits from funding house speculators.
Any future concept of a solution must clearly specify the Credit Ratings folk, whose ratings are explicitly used in Tier 1 capital ratio calculations. When the house construction bubble popped in 2006, ALL mortgage backed securities should have immediately lost AAA ratings. And they probably should have dropped a rating every quarter, with those holding such securities realizing that they are speculating.
On Financial Institutions — why is the hodge-podge ad hoc regulations better than a bankruptcy for all the top financial firms? Then the speculator/investors would get equity in Lehman, Goldman, AIG, etc, instead of the cash money they expected, and the top managers of all the firms would likely be booted (as they should) but certainly be denied bonuses.
Why did these top firms need to be saved? Was there any house building firm with profitable projects that was unable to find financing?
The Fed was willing to buy some commercial paper — why not just have an emergency where the Fed agrees to loan to any company that had borrowed more than some limit ($100mil?) in the past two years, the same loan amount, at only 1% more interest? The key thing the REAL economy needs from banks are loans. But banks, to loan money, need projects with a likely positive rate of return. I haven't read of such projects that have been unfunded. The idea is the banks are 'sitting on the money', which seems likely true, but it also seems likely that companies laying off people don't need new loans for expansion.
There has been NO, NONE, actual negative effect on the Real Economy from the death of Lehman, and it's not clear that in a massive deflationary environment that there would have been much loss of finance ability to loan for production if all the Big Banks that speculated in mortgage securities had their equity wiped and debts converted to equity.
Saving/ converting the insolvent Big Banks (no less insolvent than Lehman) should have been the job for bankruptcy courts, perhaps with the Fed/ Treasury/ gov't as an additional temporary investor AFTER going into receivership (and ALL bonuses are stopped).
It looks to me that the non-bankruptcy bailout was to use gov't tax collected cash so as to make sure the rich fat cat banker speculators don't lose after making the bad investments that they freely chose to make.
The Long Term Capital Management precedent should also be noted — why weren't there changes made then to make sure Big Companies could fail less disruptively? We NEED the freedom to make investment decisions that might fail. We need to keep the principle that those who would have made profits on the upside, are those who pay on the downside; including if they bought insurance from insurance sellers who also go belly up.
Keith,
Can you post some information about what milestones / deliverables we can expect from the Financial Crisis Inquiry Commission and what the expected timeline will be?
Also, could you give some insight into how the research / investigation process will work? Specifically, I would like to understand how policy research / analysis will be conducted / evaluated by the commission. Will it be based on economic theory, new analysis of existing market data provided by government agencies, formal / informal interviews with key subject matter experts in the finance industry, etc.
On a final note, I noticed in a lot of your questions you used language such as "did X work", "did Y contribute to the financial crisis", etc. I am interested in better understanding how the commission will attempt to answer this causal questions. How will the commission evaluate whether actions such as TARP funding were necessary / sufficient actions (i.e. how do we know that banks would not have corrected the issue on their own)? How will the commission assign relative weights to the contributing factors. I think this second issue will become especially political. In my discussions with Republicans and Democrats, there is an intellectual divide over whether the crisis was caused by a "push" of excessively risky financial derivatives into the market by Wall Street (the Democrat point of view) or a "pull" by the government entities subsidizing and encouraging risk to promote political agendas (the Republican point of view, focusing especially on Fannie Mae, Freddie Mac and the federal reserve).
I'm looking forward to hearing your discussions on the commission's progress.
I agree with Tom Grey’s take on the “too big to fail” idea. Lehman was totally an investment bank –but it still caused destabilization of commercial banks by its fall. Obviously, there is more here than just regulatory issues. For my money, all this goes back to the Credit Modernization Act. Look at it carefully and you will see how deceptive it is in terms of it effects—and how it did indeed grossly contribute to this whole situation and the bank failures. Lehman was involved in all sorts of shady interlocking unnamed subsidiaries—-actually running sister companies under different names and in different states, so that you had to really dig to figure out the relationships between two or three or four or…..mortgage companies that APPEARED to be totally separate, but were actually owned by the same bank—Lehman. Here’s an example — A couple gets a federal disaster loan from FEMA, and gets behind in their payments. BEFORE they are in any real trouble, they get several cards in the mail from different mortgage companies urging them to refinance now! Reduce your monthly payment! Save your house! —-Huh? How did these mortgage companies know they were having any trouble? Because these “other” mortgage companies were actually unnamed subsidiaries of Lehman and Lehman was trying to sucker the disaster victims into refinancing at double or triple their disaster loan rates on 30 year mortgages. Lehman pockets hundreds of thousands more over the life of the mortgage and the disaster victims get drawn into this, thinking that this wonderful new mortgage company has “helped” them by reducing their monthly payments. Reminded me of Shearson-Lehman—remember that? They were telling all their clients to buy stocks in companies that they had invested in, ran up the wall, then sold out their own investments and let their investors take the fall? I did a table dance the night Lehman went down. Good riddance. Anyway, repealing/reworking the Credit Modernization Act would be a good place to start and requiring all bank subsidiaries to be clearly named and listed on all mortgages they finance would be two good suggestions.
What were ACORN and SEIU’s roles in intimidating and extorting banks?
Which banks did they intimidate and extort?
What was the extent of Obama’s and the Progressive caucus involvment in ACORN and SEIU’s activities?
What Real Estate firms overpriced the homes that they were selling relative to the comps on the homes. How much was this over pricing and how much did Real Estate sales people financially benefit by artificically inflating housing prices.
On 9/12/08 approximately 500 billion dollars were pulled from the investment houses and banks in the US. Who or what pulled this money out and why?
ACORN has already helped finance $44 Billion in housing loans to illegal aliens using EIN numbers instead of social security numbers to process the loans. Duh….
If you are serious about finding the problems and curing them—-look at the Credit Modernization Act as the genesis of this recent debacle, but go deeper and use your subpoena power to do an initial partial audit of the Federal Reserve. The key thing that you (and we) absolutely need to know is —where are the American gold reserves? The Fed took charge of our gold reserves, apparently in "safe keeping" and as "guarantee" for our paper debt. Start following the real money. Of course, the politicians who appointed each one of the members of the Commission will want you to deal with the symptoms—the bank failures and the credit crisis—but what is needed, is evaluation of the disease.
If the members of the FCIC want to retain some semblance of credibility for themselves and for our government, the inquiry needs to proceed from the bottom up rather than the top down (your current pathway). The danger of going at it the way you are, is that you will never reach the bottom. You'll get so far in the process and then be stopped, like the Grace Commission. For that reason, start by investigating the condition of our gold reserves—where are they, how much, what condition? —then progress to review of our monetary and taxation system, which is the underlying cause, then look at the Credit Modernization Act, the actual "trigger" that released this debacle.
What you will find is that a private largely European banking cartel, the Federal Reserve, has seized America's gold reserves in exchange for paper debt. You will also find that the ONLY function of the income tax was to act as a sponge to sop up fiat currency and control inflation, so that the Fed could control the slow but steady draining of the American economy. Think of it as a clever parasite. It didn't want to kill the host outright. It wanted to feed on it for many decades—and it has. It still is. Painful as it may be to cut free of this parasitic relationship, we have no choice. The Fed must end, and one way or another, it will. We passed the point of no return in this relationship four or five years ago, when the impossibility of controlling inflation by taxation or adjustment of interest rates became apparent to Alan Greenspan. The rest is history playing out and FCIC's choices are relatively simple — you can tell the truth or you can lie.
My point to you is that the process of dismantling the Federal Reserve is now inexorable. It has died a natural death. Millions of Americans now know the truth about it, thanks largely to Michel Chossudovsky's "Three Minute Explanation". There is no going back. You might as well cut to the chase, write the obituary, and begin your inquiry with the gold reserves issues.