Today was day one of the Financial Crisis Inquiry Commission hearings. After eight hours of hearings I have a lot of subject matter but little time for writing. So I want to highlight one important point, with more to come over the next few days.
Today the Commission heard from and asked questions of the heads of four large financial institutions that survived: Goldman Sachs, JP Morgan Chase, Morgan Stanley, and Bank of America. Bank of America survived only because of taxpayer assistance. The counterfactual for the other three is unprovable. You can’t prove that GS, JPM, or MS would have failed but for government action, and their leaders cannot prove that they did not need that assistance. That’s the problem with counterfactuals.
I commented at today’s hearing that I am even more interested in learning about the failures than about the survivors. To understand the causes of the financial and economic crisis, I place a higher priority on understanding why Bear Stearns, Lehman, Indy Mac, WaMu, Merrill, and AIG failed, and why BofA, Citi, and others would have failed but for direct government support. In our investigative work the commission needs to spend more time on failure analysis.
At the top of my failure analysis list are Fannie Mae and Freddie Mac. I think these need to be top priorities for the commission’s statutorily required firm-specific inquiries, for several reasons:
- Each failed spectacularly.
- They are enormous. Their portfolios of retained assets rival the pre-2008 federal debt in magnitude. If “too big” matters, then it applies to these two firms.
- They are central to the flow of mortgage funds. Financial firms are not just “too big to fail,” they are “too big and interconnected to fail.” I cannot think of a financial firm that is more interconnected to certain financial flows than are Fannie and Freddie.
- The expected cost to taxpayers of their failures appears to dwarf that of any other failed financial institution.
- Their failure and cost to taxpayers appear to be ongoing. The cost may be growing.
These are the primary reasons why the Commission needs to prioritize inquiring about the failure of Fannie Mae and Freddie Mac. In addition, a few salient comparisons arose from today’s hearing.
- I asked the four Chairmen/CEOs about the too big to fail question and the perception of a government guarantee for their firms. This is a well-worn debate for the GSEs. We can learn a lot about the TBTF concept from both the pre-failure behavior and the failure of Fannie and Freddie.
- I asked Kyle Bass, one of today’s witnesses on panel #2, to compare the F/F failures with other institutional failures. His answer began with something like, “I don’t know where to begin. There’s just so much.” Bass predicted taxpayer losses from these two firms could exceed $300 billion. Even if it’s “only” $100+ B of lost taxpayer money, that’s an obscene amount.
- We need to better understand the phenomenon of private profit / public risk-bearing. I’m hoping someone can answer a question I asked today: How do the retained portfolios of Fannie & Freddie contribute to their public purposes as stated in their Congressional charters? Were the profits from those portfolios used to advance the GSEs’ affordable housing goals, or to pay dividends and senior managers?
- Many of today’s questions about failed risk management apply to these firms as well. How did firms with apparently large informational advantages make such large failed bets on mortgages?
- Bass had the quote of the day: “Capitalism without bankruptcy is like Christianity without Hell.” If so, then Fannie and Freddie are in Limbo. Their future form and status is uncertain, and the commission can play an important role in this policy debate by understanding and explaining what happened with these firms and why.
- My fellow commissioner Doug Holtz-Eakin made an important point today. Since banks can hold GSE debt (aka “Agencies”) as if it were Treasury debt, you could have bet the health of your bank on the health of these two firms. Rules prevent you from holding all of your bank’s assets in the debt of General Motors, Alcoa, or Home Depot, but you’re allowed to bet the bank on Fannie/Freddie paper. This created an interdependence that I believe in August/September of 2008 required us (the Bush Administration) to preserve 100 cents on the dollar of GSE debt. At the time it appeared that if GSE debt lost any value, the domino effect on much of the global financial system would be devastating. The perception of an implicit government guarantee, combined with government rules and industry practices that encouraged Agency paper to be treated as equivalent to Treasuries, meant that when the GSEs were failing, we thought we had no alternative but to make that guarantee explicit. At the time I hated doing this, but I agreed that there was no acceptable alternative. This is a great example of how a firm’s failure was not just about bad behavior by senior managers, but resulted in part from policy decisions made in Washington.
- Some commissioners spent a lot of their question time today on compensation questions for the four CEOs. Compensation questions are not my top priority, but it seems that any compensation arguments should apply doubly in the case of these two firms that are now wards of the State. Should the senior managers of Fannie & Freddie be compensated based on private-sector or public-sector pay scales? This is a consequence of the Limbo problem.
- The same is true for political involvement. I get a lot of angry emails and comments about how the financial sector tries to influence the political process. FNM and FRE were the textbook cases of an iron triangle political strategy. These firms had comprehensive political strategies to weaken reform legislation and undercut their regulators. The commission needs to understand to what extent their political strategies and business models contributed to the financial crisis.
Today the Commission took a good hard first look at some of the most important financial firms based on Wall Street. Now we need to do the same for the two most important financial firms based in Washington.