Navigating the Maelstrom
Conversations on Financial Meltdown and Regulatory Reform
How the subprime mortgage crisis became a credit crisis and threatened the U.S. financial system was the focus of Duke Law Magazine’s spring/summer 2008 cover story. The issue went to press during a tumultuous period that saw the takeover or outright failure of major financial institutions, the evaporation of credit, and a near collapse of the worldwide financial system. In October 2008 Congress passed the Emergency Economic Stabilization Act, which allowed the government to bail out failing banks and facilitated the establishment of the Troubled Asset Relief Program (TARP), followed notably — and controversially — by passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) in 2010.
Where are we four years later? On March 22, Dean David F. Levi discussed the financial crisis and steps toward recovery with Professors James Cox, Steven Schwarcz, Lawrence Baxter, and Bill Brown, all internationally recognized experts on regulation and finance and frequently quoted commentators throughout the crisis. An excerpt of their conversation follows.
Dean Levi: When we looked at [the financial crisis] before, we looked at subprime mortgages, leverage in the system, derivatives. … With a little bit of history do we have a different set of explanations than we had before, or does it look pretty much the same?
Professor Cox: What we’ve all learned in the last few years is that a government action can save the moment. What I fear is that Dodd-Frank makes that government action less likely in the future.
I think it’s amazing that the Dow-Jones average today is above 13,000 given where we were and that we have banks where they are. We got there by this huge flushing of cash into the system worldwide. Trillions of dollars within months in the fall of 2008 — around the globe it was just flushed into economies around the world. We blew through stop signs in bailing out AIG. If it had failed, it would have been, I think, 70 to 80-fold larger than Lehman. Then we passed Dodd-Frank, which makes it clearly and explicitly illegal to save AIG in the future, as I understand it, unless we again go through a stop sign and are willing to draw down on the resolution authority. Government is not good about making choices and putting people to sleep, which is what the resolution authority is all about.
So historically, our institutions served us and served us fairly well. It looks like we’re going to lose $30, maybe $40 billion of TARP money, out of the hundreds of billions that were expended. I think that’s a win-win. …
Professor Baxter: I was both amused and delighted about the prescience of [the 2008 Duke Law Magazine story]. It was right in the middle of the catastrophe before people understood how big the catastrophe was.
… Remember what happened in 2008: Countrywide, Northern Rock, Bear Stearns, IndyMac, Fannie and Freddie into conservatorship. On one day — Sept. 15, 2008 — Lehman and Merrill. These were quickly followed by the failure of WaMu, the money-market mutual fund RMC “breaking the buck,” or putting a freeze on redemptions — it was about to be a catastrophe outside of the banking system — and Wachovia was taken over by the Bank of America.
Then came the bailout legislation. … You had the TARP injections … the AIG bailout, which was massive. … [I]t would have been a catastrophe if we hadn’t done that. And then you’ve got the Fed emergency lending, which we’ve only recently learned about because it was all secret and took the courts to disclose it — an influx of billions and billions of dollars to the U.S. and foreign institutions. And then 11 of the largest banks were downgraded by the S&P on Dec. 20. So we were in one hell of a black maelstrom.
If you go back to that you realize that quite a lot of good stuff was done.
… [W]e are really only now starting to get a feel for what really happened and what we’ve done to get on top of this crazy situation which, in hindsight, is probably quite good. So we’ve moved into focusing on systemic risk — all central banks around the world are dealing with that; the Dodd-Frank Act creating the Financial Stability Oversight Council; and on the international side the Basel Committee on Banking Supervision and the Financial Stability Board focusing on this macro-economic picture and the systemic risks created by large financial institutions. I think that’s a huge advance.
We’ve enhanced consumer protection. … The jury’s out on that — we don’t even know whether that agency will survive. But we’ve sort of flailed around all over the rest of the place. We’ve given the SEC more funds and then we took them away, and we’ve got some fairly innocuous rules. But then we’ve got others — which in my mind is just a hopeless overextension of regulation in the form of, for example, the Volcker rule, where there are attempts to structure a market that will not be structured in the way that it has been.
We also have banks that are bigger than ever before. We have claimed that we have put an end to such bailouts as AIG and the banks, but I think if you read the conditions under which they can be approved, again, those conditions will always be satisfied in the middle of a maelstrom such as the one we were in: the president has to authorize it and there has to be joint agreement between the Treasury and the Fed. Of course they’re going to agree if they’re faced with another AIG and if they think another Lehman is going to happen.
… But if you step back and look at the big picture over, say, decades, we are really going through a very predictable event with a predictable cost. All crises have something running between 165 percent and 450 percent of GDP cost to them. In other words, these crises are far bigger in their costs than they look. TARP funds may have been paid back, but the cost in terms of unemployment, for example, is catastrophic. It has slowed GDP growth and so on.
Professor Brown: … [W]e’ve just shifted the hubris from the banking sector to the government sector. At one point we thought that the banks could regulate themselves. We thought they had the incentive to regulate themselves, and what we didn’t fully appreciate is that they didn’t have the built-in incentives to regulate themselves. And now we’ve shifted it to the government.
I don’t believe that we can presciently regulate these markets in real time, and we purport to think that we can. …[W]e will always be coming up with new types of derivatives that will reach beyond any sort of regulatory oversight. I think we’ve gone into an even worse crisis.
It’s like this: In 1987, it was yelling “fire” in a crowded theatre. In 1998 during the Russian debt and Long Term Capital Management crises, it was the same theatre, except there were 10 people in every seat because of leverage. In 2008 it was the same theatre, but there were 100 people in every seat. This time, the leverage effects were compounded by complex financial derivatives. We keep allowing leverage to creep into the system. It doesn’t matter if it’s ’08, ’98, or ’87; the problem was leverage.
The sidekick to the leverage problem is the transparency problem. We have not forced transparency to the level that we should have forced it. In fact, we blinked back in the middle of the crisis; the accounting profession pulled back on that. And when the accounting profession pulled back on its enforcement of the transparency rules late in the first quarter of 2009, the stock market actually found its bottom within a week.
Professor Schwarcz: I agree that leverage can be very problematic if it’s excessive. But a very fundamental question is, why can’t banks and other financial institutions regulate themselves in a way that makes sense? If it is not sensible for these institutions to have so much leverage, why do they have it, and why does government have to be paternalistic?
I think there are at least two explanations. One explanation is conflicts of interest — not only conflicts between owners and managers of financial institutions but, I believe more importantly, intra-firm conflicts between senior managers and middle managers. The problem is that middle managers, such as vice presidents and senior analysts, are almost always paid under short-term compensation schemes, misaligning their interests with the long-term interests of the firm.
Complexity is greatly exacerbating this conflict. Financial markets and products have become so complex, for example, that senior managers don’t always fully understand what technically sophisticated middle managers are doing. Thus, as the value-at-risk (VaR) model for measuring investment-portfolio risk became more accepted, financial firms began compensating middle managers not only for generating profits but also for generating profits with low risks, as measured by VaR. Secondary managers turned to investment products with low VaR risk profile, like credit default swaps that generate small gains but only rarely have losses. They knew, but did not always explain to their superiors, that any losses that might eventually occur would be huge.
Another explanation is an externality problem. Financial institutions individually may well decide to engage in profitable financial transactions even though doing so could increase risk to third parties and the financial system itself, because much of the harm from a possible systemic collapse would be externalized onto other market participants as well as onto ordinary citizens impacted by the collapse. Thus, a financial institution that books a deal and engages in a transaction is going to get a fee; it’s going to get an immediate gratification, 100 percent, for closing the transaction. Most likely the systemic impact won’t occur, and even if it does, a good chunk of the cost is going to be externalized outside the firm.
I also want to tie into what Jim was saying before. I think the most disastrous thing that Dodd-Frank does is to modify Section 13(3) of the Federal Reserve Act so that the Fed cannot save failing financial firms. The rationale for that modification was to avoid moral hazard (that is, risky behavior motivated by the Section 13(3) safety net) on the part of financial institutions that considered themselves too big to fail. What is unfortunate about this, however, is that we sometimes need a safety net.
A better approach, I think, would be to try to internalize the cost of the safety net — such as by creating a systemic risk fund and internalizing its cost by requiring systemically risky firms to contribute to the fund, much like the FDIC requires banks to contribute to the deposit insurance fund. That not only would internalize those externalities but also would remove the incentive of large firms to externalize these types of systemic costs. You might even be able to trigger a degree of cross-monitoring among financial institutions, so the institutions responsible for contributing money to the fund would monitor each other. That would be something that I think would be very, very good.
Levi: Leverage and the other problems we experienced in 2008 — maybe too big to fail — are these susceptible to regulatory solutions?
Cox: My feeling is that we would be reluctant to do that, because it gets into operations and we like to let business have its head. So we tend to chip around it and worry about things like transparency and incentives instead of trying to put limitations on leverage.
Moreover, as Bill points out, the pressure that Congress brought to bear, in response to lobbying forces, on the accounting standard setters who were trying to introduce more discipline into the valuation of the assets and the transparency issues again, I think, reflected that our political process is amenable to inputs and pressure and that we’re not going to be very good about setting leverage levels and such. So we’ll just chip away at the edges. And that’s what we’ve done.
Brown: Leverage happens through borrowing. Most people don’t fully appreciate that leverage also happens naturally through derivatives. It’s part of them. If someone buys an option for $10 million that actually controls $100 million of securities, leverage is happening. … And the more complex [derivatives] are, the more leverage actually arises. We have an area right now where you actually have infinite leverage and we routinely tolerate that every day — and that is the futures exchanges in Chicago.
I can start a day with no position. Then, at a later point in the day, I can have a $10 billion position in the market, and as long as I close it out by the end of the day, I do not have to post any margin. While I get to receive gains and pay losses, I do not have to post margin. That is infinite leverage. There are major participants in the market who do this. And while we might have heard of some of these participants, most are virtually unknown. Think about it. Unknown participants are controlling large positions and posting no margins.
A thinly capitalized high-frequency trading firm might have have intra-day positions open with several different Wall Street brokers. If all of a sudden a major market disruption occurred, as it did on 9/11, and the markets were closed down, we’d be in bad shape — especially if there were several of these trading ghosts in the same boat. And then we’d be focused on rescuing these firms and all the people to whom they owed their margin. Instead, we should be fixing the problem today.
We allow this stuff to happen. This is beyond the SEC’s purview right now. I’m predicting that the next crisis will involve high-frequency trading, and it will bring this country to its knees such that we will think that what we just went through was a picnic.
Levi: I’m trying to get a sense of where the four of you are on the optimism/pessimism scale. Jim, you’re feeling that we came through something and we came through in OK shape perhaps?
Cox: OK shape, but the question is, did we learn enough lessons from the past that we can go forward and do what we need to so this doesn’t happen again? … The little I’ve read about Dodd-Frank makes me think we’ve only made modest steps in that direction. We’ve been able to increase the fees that go into the FDIC so we can protect depositors a little bit more going forward, but at the same time, the real risks that are out there are what Bill was talking about — it’s in the futures markets, the options, and most importantly the swap markets. My understanding about what’s happened there is that the Volcker rule notwithstanding, we’ve not made many changes and there’s still a huge amount of risk in the marketplace.
Brown: Let’s be really clear here. The best regulation that you could ever have for financial institutions is to turn them back into partnerships.
Baxter: That’s a powerful point. One of the big problems is other people’s money. Financing the operation through debt is a major problem.
But the problem goes even deeper. And that’s why, rather than saying I’m optimistic or pessimistic, I’m fatalistic. These problems are now being driven by very big macro events, one of which is the massive rise in sovereign debt.
As long as you’ve got these funding means, you have to have very large financial institutions to make the markets in sovereign debt — to invest in that government debt. And that means that you’ll never get rid of very big, zombie, inefficient financial institutions, as long as you’ve got very big, zombie, inefficient governments that simply are spending more than we are generating by way of income. So that’s the first macro element that’s going to continue driving this problem. And we see it in full color in Europe right now, but it’s only a matter of time until it catches up with us.
You’ve got a split in the world between debtor nations and creditor nations. The U.S. used to be a creditor nation but it’s now a debtor nation. And then you’ve got a further split between debtor nations that can print money, such as the U.S. and the U.K. and those that can’t, such as the Eurozone. And that’s why we’re seeing the problem emerging first there.
The other big force is an expectation that’s become cultural in business, which is a return on equity. So the expectation is a return on equity of 15 to 20 percent. That’s what’s causing the kind of action that Bill talks about. It’s a desperation in businesses to reach those levels. … The institutions have to keep [returns] coming in at that level or they will go down. There will be a withdrawal of capital from them.
Brown: I think we will all be surprised that when this book is written five years from now, it is the private sector that will have bailed us out. … I think the private sector has cash balances unlike any government.
Schwarcz: Lawrence has identified a very important collective action problem among firms. … You have firms that are engaging in very risky behavior to get a return, because if they don’t, other firms will get the return and investors will withdraw their money. But aren’t collective action problems exactly the types of problems that governments can solve and should be solving? So how can we structure legislation to achieve that?
Baxter: We start with transparency. We pretend we have transparency but, for example, it’s very hard to get to the truth on the leverage ratio of any institution. Why? Because of all the monkey business that goes on with weighting the assets. What gets a zero-risk weighting? Sovereign debt. Why? We’ve just seen sovereign debt cause problems everywhere. And when a sovereign defaults, the default is a disguised one, like devaluation of the currency, but the result is ultimately the same thing. And we give sovereign debt a zero weighting. Well, there’s a co-dependency, I think, that exists. And so it’s very hard for the market to tell what’s going on and to distinguish accurately between one institution as opposed to another. Until you do that, you continue to have this debate.
Schwarcz: Another part of the problem is that we’ve tranched everything and split up all the risk so finely that we’ve created what I refer to as a marginalization of risk. Any given financial market participant, even financial institutions, may have so little at stake in any given deal that it doesn’t take the time to engage in sufficient due diligence.
Brown: Let’s face it, it wouldn’t be a problem except for leverage.
Schwarcz: … But leverage is a two-edged sword. Limiting leverage is great in terms of being conservative. On the other hand, a firm is less competitive if its leverage is too limited. We don’t know what should be appropriate for any given firm, and we’re competing in a global economy.
Baxter: I agree. I think it’s better to go with the risk, but then create a system that is resilient when it runs into trouble. The problem is that we’ve developed a system where we can’t stand failure because [the banks are] too big to liquidate in a manageable fashion. But I agree with you. I don’t think we can stop bubbles up front.
Schwarcz: A piece I did a couple of years ago that was published in the Washington University Law Review uses chaos theory to analyze regulation of complex financial markets and products. Usually associated with very complex engineering systems, chaos theory posits the system inevitably will break down. You therefore have to manage for the breakdown to mitigate its consequences. There are ways to do that in the financial system. One of the ways was Section 13(3) of the Federal Reserve Act, which Dodd-Frank modified. … That was probably the most important way to mitigate consequences, and yet it was effectively deleted.
Also, we’ve never had that kind of protection — mitigating systemic consequences — for financial markets. What the recent crisis has clearly shown is that it’s not enough to protect banks or even financial institutions; we also need to protect financial markets because markets can be the triggers and transmitters of systemic collapse.
For example, although the recent financial crisis is often associated with Lehman’s collapse, the problem wasn’t that collapse per se. The problem was that Lehman had a lot of very highly leveraged mortgage-backed securities, which had a relatively small component of subprime risk. Once the mortgage-backed securities market collapsed, parties lost faith in Lehman’s ability to repay them. Furthermore, the investor community lost confidence in credit ratings and debt markets, effectively cutting off lending and impacting the real economy.
Brown: … I remember something the Reserve Bank of New Zealand published in the spring of 2007, which told me we were getting ready to go for a tumble. In a nutshell, it showed that we had five times more in derivatives on debt than we had in all underlying debt itself. This is leverage on leverage. It was nuts!
Levi: So it’s January 2013. You get a call and the president — whoever it is — asks you for two recommendations. What would those two things be?
Brown: You impose margin and capital requirements not on the basis of what’s on the books at 5 p.m. You put it on the maximum position of what’s on the books during the entire trading day. That’s the futures market and proprietary trades. It hits prop trading right square in the nose, because it says, “We don’t care what you’re doing as much as we care about the extent to which you’re doing it.”
And put all investment banks back into partnerships. Put all this stuff back into partnerships and determine what risk actually can be taken. Make commercial banks inviolate, and anything else has to be in some form of partnership.
I do think that on the innovation side, there is demand for bullet-proof institutions. I think there’s demand for trading structures that are bullet proof. I think there’s demand for a lot of it. So I look at it and say, “Hey, this could very well be a market opportunity.” And if you can innovate and pull together a group of people who will innovate to solve some of these problems, you will have a product that people want.
Baxter: I’m with Bill. Reduce leverage in the system as fast as possible — but I am skeptical whether you can pull it off. The other solution would be adjusting expectations of the public to the prospective debts we are continuing to incur, in the form of escalating retirement benefits, medical benefits, etc. … You’d have to be prepared to be thrown out at the end of it. But I think that’s where the fundamental priorities are — we’ve gotten way ahead of ourselves.
Obviously I like innovation, too. Because if you can grow the real economy, and you can grow productivity, you’ve solved the problem. But you have to grow it really fast to catch up with what we’re incurring.
Brown: We’ve seen the ability, though, of innovation not to need government intervention.
Levi: You like Bill’s two suggestions but you don’t think they’re very practical. You would like the president to downwardly adjust people’s expectations for the return on their savings for their retirement and their pensions. And you want to stimulate innovation.
Cox: We have to grow the pie.
Baxter: And I can’t see any other way than innovation and corporate revival.
Schwarcz: I don’t think we’re going to be able to prevent problems ex ante. I think we have to try to muddle through, letting the private sector do what it can. If there’s a real screw-up, let’s provide some safety nets that do not create moral hazard. As mentioned, I think we can begin to do that through a privatized systemic risk fund.
Cox: My two wishes are structural: To return that part of Glass-Steagall that separated the depository institutions from the rest of them, and then to selectively bust [certain financial institutions] up into much smaller groups. If we’re going to continue to buy the implicit guarantee of home ownership for loans, then we’d better make sure it’s happening through organizations that compete against each other on quality and performance.
So I would continue to have that implicit guarantee, but I would have a much smaller Freddie and Fannie, and then I would like to have the depository institutions smaller too. … It doesn’t seem to make any sense to me why we would want to have depository institutions have any relationship to either underwriting or trading desks. Period. I think that change could be made fairly easily and not create a lot of disruption.
Levi: Final thoughts?
Cox: It’s interesting how many of these answers come back to not the political will, but the political ability to accomplish things. If there’s not a lot of hope there for political change, there’s not a lot of hope for the financial system.
Baxter: Maybe the election helps. Maybe it’s time for a showdown with the election.
Schwarcz: We’ve talked a lot about transparency. I think things have gotten so complex in the financial system that transparency — at least complete transparency — is just not going to happen. … We’re far beyond the realm of what we as individual human beings can fully assimilate. We may even be beyond the realm of what financial institutions, at least on a cost-benefit basis, can feasibly understand.
Baxter: We’ve gone way beyond a lapse of due diligence into an impossibility of due diligence.
Schwarcz: But the silver lining is that it’s a really interesting time for us to be academics in this area.