Last Thursday, the Financial Crisis Inquiry Commission delivered the results of its nearly two-year-long investigation into the causes of the financial and economic crisis. At 28 pages of summary, followed by 633 pages for the actual report, the entire document is overly and unnecessarily long.
The majority commissioners reach the following conclusions:
We conclude this financial crisis was avoidable. … We conclude widespread failures in financial regulation and supervision proved devastating to the stability of the nation’s financial markets. … We conclude dramatic failures of corporate governance and risk management at many systemically important financial institutions were a key cause of this crisis. … We conclude a combination of excessive borrowing, risky investments, and lack of transparency put the financial system on a collision course with crisis. … We conclude the government was ill prepared for the crisis, and its inconsistent response added to the uncertainty and panic in the financial markets. … We conclude there was a systemic breakdown in accountability and ethics. … We conclude collapsing mortgage-lending standards and the mortgage securitization pipeline lit and spread the flame of contagion and crisis. … We conclude over-the-counter derivatives contributed significantly to this crisis. …”
Unfortunately, the report is ill-timed, since the Dodd-Frank Act is already law. Consequently, the only use of the Commission’s report is an after-the-fact justification of why the Dodd-Frank Act was necessary. Perhaps the Dodd-Frank Act is good legislation, but one cannot deny that the study of what caused the problem came out well after the solution was already decided.
The report contains dissenting views from the Republican members of the commission. This observation is usually accompanied by moans of “Why can’t we all just get along?” I must admit this was also my initial reaction. For example, a prior blog entry on this site regarding initial reports of a minority submission was somewhat dismissive of their views. However, the minority report cites substantial examples of (i) information that was ignored and (ii) a deliberative process that was not open and participative. The minority reports (there are two of them) (i) question the process by which the Commission’s majority report was planned and prepared, and (ii) explain why it is not their fault that a minority report was necessary in the first place. For process-related reasons alone, the Commissions’ majority failed.
In terms of substantive conclusions, one of the minority reports observes the following, which deserves repeating:
The majority’s approach to explaining the crisis suffers from the opposite problem– it is too broad. Not everything that went wrong during the financial crisis caused the crisis, and while some causes were essential, others had only a minor impact. Not every regulatory change related to housing or the financial system prior to the crisis was a cause. The majority’s almost 550-page report is more an account of bad events than a focused explanation of what happened and why. When everything is important, nothing is. …
Not all of these factors identified by the majority were irrelevant; they were just not essential.”
Similarly, the second dissent makes the following observation:
The majority’s report covers in detail many elements of the economy before the financial crisis that the authors did not like, but generally failed to show how practices that had gone on for many years suddenly caused a world-wide financial crisis. In the end, the majority’s report turned out to be a story about the financial crisis, rather than a report on what caused the financial crisis.”
The dissent by Peter J. Wallison included the following explanation as to the key difference between the majority report, and his explanation:
One of the most striking examples of this approach was presented by Larry Summers, the head of the White House economic council and one of the President’s key advisers. [His] response was that the financial crisis was like a forest fire and the mortgage meltdown like a “cigarette butt” thrown into a very dry forest. Was the cigarette butt, he asked, the cause of the forest fire, or was it the tinder dry condition of the forest? The e Commission majority adopted the idea that it was the tinder-dry forest. Their central argument is that the mortgage meltdown as the bubble deflated triggered the financial crisis because of the “vulnerabilities” inherent in the U.S. financial system at the time—the absence of regulation, lax regulation, predatory lending, greed on Wall Street and among participants in the securitization system, ineffective risk management, and excessive leverage, among other factors. One of the majority’s singular notions is that “30 years of deregulation” had “stripped away key safeguards” against a crisis…
The forest metaphor turns out to be an excellent way to communicate the difference between the Commission’s report and this dissenting statement. What Summers characterized as a “cigarette butt” was 27 million high risk NTMs [non-traditional mortgages] with a total value over $4.5 trillion. … The Commission’s report blames the conditions in the financial system; I blame 27 million subprime and Alt-A mortgages—half of all mortgages outstanding in the U.S. in 2008—and a number that appears to have been unknown to most if not all market participants at the time. No financial system, in my view, could have survived the failure of large numbers of high risk mortgages once the bubble began to deflate, and no market could have avoided a panic when it became clear that the number of defaults and delinquencies among these mortgages far exceeded anything that even the most sophisticated market participants expected.
This conclusion has significant policy implications. If in fact the financial crisis was caused by government housing policies, then the Dodd-Frank Act was legislative overreach and unnecessary.”
Upon reflection, it is no wonder that the Financial Crisis Inquiry Commission was unable to meet its wishful-thinking title of being nonpartisan. Perhaps the last sentence above best describes the key difference between the two sides on the Financial Crisis Inquiry Commission. For the dissenters, it was important to narrow the reasons cited in the report to those areas that really caused the problem. Those more narrow causes would then be addressed through regulation, with the status quo of “non-causes” left alone. In contrast, the majority were interested in writing about every matter that may have influenced or contributed to the problem. The result is a much longer list of causes that need to be addressed through increased regulation. Like the majority in Congress who concluded that the broader regulation contained in Dodd-Frank was necessary, the majority of the Financial Crisis Inquiry Commission concluded that there were lots of problems that needed to be solved. In turn, this results in substantial new regulation that we now call Dodd-Frank.
Now that Dodd-Frank is already law, President Obama indicates that all such regulation should be balanced. Here is a recent post about the costs of regulation to American business, and how balance might be measured.
The criticism of the government’s response necessarily is directed at (i) then-Secretary of the Treasury Pauson, (ii) Chairman of the Federal Reserve Ben Bernanke (who President Obama reappointed to a second term), and (iii) then president of the Federal Reserve Bank of New York Timothy Geithner (who now serves as President Obama’s Secretary of the Treasury). Presumably, the writers of the report were a bit concerned about whom they were attacking, and the current positions that two of these three persons continue to hold. So, the report includes the following, which I found amusing:
In making these observations, we deeply respect and appreciate the efforts made by Secretary Paulson, Chairman Bernanke, and Timothy Geithner, formerly president of the Federal Reserve Bank of New York and now treasury secretary, and so many others who labored to stabilize our financial system and our economy in the most chaotic and challenging of circumstances.”
I am not certain how deep this respect and appreciation could be, since the rest of report criticizes decisions made by these three people. One can only imagine how sharp the report’s criticism would have been if these three people were not so deeply respected and appreciated. I hope I never get deeply respected and appreciated by this same group of authors.
Personally, the Commission’s long report leaves me no smarter than before it was published. Our earlier blog entry on this subject provided a much shorter version of what caused the financial crisis. Despite its humorous approach, this blog entry is probably more useful than the overly-long book now released by the Commission.