Financial Crisis Inquiry Commission

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What the Financial Crisis Commission Should Ask
New York Times Dealbook Column, 2010-01-12

Questions anyone?

On Wednesday, the first hearing of the Financial Crisis Inquiry Commission —
what many are calling this century’s equivalent of
a Pecora-style investigation that scrutinized the market crash of 1929
[Wikipedia, Google] —
will take place in Washington.

Wall Street’s top brass are planning to be there
(and yes, they are flying down the night before so they don’t miss it):
Lloyd C. Blankfein of Goldman Sachs,
Jamie Dimon of JPMorgan Chase,
John J. Mack of Morgan Stanley and
Brian T. Moynihan of Bank of America.

The hearing, of course, will partly be political theater.
There will be finger-pointing.
But if the committee uses its inquiry for its stated purpose —
“hearing testimony on the causes and current state of the crisis” —
it may help direct the national conversation
and steer the current reform efforts.

In the spirit of trying to help start some lively discussions,
here are some questions they might consider asking:

Mr. Blankfein, your firm, and others,
created and sold bundles of mortgages known as collateralized debt obligations
that it simultaneously sold short, or bet against.

These C.D.O.’s turned out to be bad investments for the people who bought them,
but your short bets paid off for Goldman Sachs.

In the process of selling them to institutional investors, however,
your firm lobbied ratings agencies to assign them high ratings as solid bets —
even as your firm planned on shorting them.

Could you explain
how Goldman bet against these C.D.O.’s
while simultaneously trying to persuade ratings agencies and investors
that they were good investments?

Were they designed from the outset
to be shorted by Goldman and possibly select clients?
And were those clients involved in helping design these transactions?
What explicit disclosures did you make to Standard & Poor’s and Moody’s
about your plans to short these instruments?
And should we continue to allow transactions in which
you’re betting against what you’re also selling?
[Without full disclosure of this situation.]

Mr. Dimon, during the final week before Lehman Brothers collapsed,
your firm asked Lehman to post billions of dollars in collateral
and threatened to stop clearing Lehman’s trades if it didn’t do so.
That demand had the effect of depleting Lehman’s capital base,
just when it desperately needed that capital
to return funds to investors who were asking for their money back.

JPMorgan clearly was trying to protect itself.
But could you explain what impact you believe
that “collateral call” had on Lehman’s failure
and the ensuing market crisis?

This one is for the entire group.
All of your firms are involved in some form of proprietary trading,
or using your own capital to make financial bets,
not unlike hedge funds and other private investors.
As the recent crisis has shown,
these bets can go catastrophically wrong
and endanger the global financial system.

Given that the government sent a clear signal in the crisis
that it would not let the biggest firms fail,
why should taxpayers guarantee this sort of trading?
Why should the government backstop
what amounts to giant hedge funds inside the walls of your firms?
How is such trading helpful to the broader financial system?

A question for all the executives about bonuses:
We keep hearing that you plan to pay out billions in bonuses this year.
Given that they come out of profits that, to a large degree,
seem to be the result of
government programs to prop up and stimulate the banking sector,
do you think they are deserved, even if they are in stock?
And, while we’re on the topic, given the market crisis of 2008,
were you all overpaid in 2007?

Again, for the group:
Over the last year,
your firms have actively used the Federal Reserve’s discount window
to exchange various investments (including C.D.O.’s) for cash.
You probably have a better idea than most about
what those assets now sitting on the Fed’s balance sheet are worth.

Given the growing calls for regular audits of the Fed
(an idea being resisted by the likes of the chairman, Ben Bernanke),
do you think the demands for such audits are warranted?

This question is for Mr. Mack.
In November, in a surprisingly candid moment, you publicly declared,
“Regulators have to be much more involved.”
You then added, “We cannot control ourselves.”
Can you elaborate on those comments?
Is Wall Street inherently incapable of policing itself —
a view contrary to what most of your peers have argued?

Mr. Blankfein.
Your firm, like other banks on this panel,
was paid in full by the American International Group
on various financial contracts,
thanks to the government’s bailout.
You can understand how this has whipped up
no small amount of fury and questions over
why A.I.G. and the government did not try to renegotiate those contracts.

Because your firm was the largest beneficiary of the government’s decision,
did you or any of your employees
lobby the Fed, Treasury or any other government agency
for this “100 cents on a dollar” payout?
If so, [please] enlighten us about those conversations.

This is for Mr. Moynihan.
Please explain — and no jargon, please —
why your firm believed
it didn’t have to disclose mounting losses at Merrill Lynch
ahead of a shareholder vote in December 2008.
After all, investigations into the matter suggest
company executives knew of the $4.5 billion loss Merrill suffered in October
before that vote.

And why, just a week or so after you became general counsel,
did Bank of America decide to tell the government about those same losses
that it chose not to tell shareholders about?

To Mr. Dimon and Mr. Moynihan:
Your industry has vigorously opposed creating a consumer protection agency.
But it’s clear that
your millions of retail customers weren’t adequately protected,
leading to hardship and heartbreak across the nation.
Because you oppose creating such a regulator,
what should be done to ensure these problems don’t happen again?

Voices That Dominate Wall Street Take a Meeker Tone on Capitol Hill
New York Times, 2010-01-14

[Also see:
Dealbook Blog: For Bankers, Hearing Requires Walking a Fine Line
Dealbook Blog: Bankers Face Tough Questions at Crisis Hearing and
The Caucus Blog: Scene Two From the Bankers’ Lineup]

Wall St. Ethos Under Scrutiny at Hearing
New York Times, 2010-01-14

[Here Sorkin reports on how the four bankers responded to
the questions that were asked, as opposed to the questions he proposed.]

The 10 members of the panel,
brows furrowed and some furiously taking notes,
squared off against the Wall Street chiefs in Washington
over the billions in bonuses,
and who was really to blame for bringing the financial system to its knees.

But the hearing shifted to new ground when
Phil Angelides [Wikipedia, Google],
chairman of the group, the Financial Crisis Inquiry Commission,
bore in on Lloyd C. Blankfein, Goldman Sachs’s chairman.

He asked Mr. Blankfein to explain how his firm could have
sold bundles of troubled mortgages
at the same time it placed bets with Goldman’s own money
that their value would fall.

Mr. Blankfein tried a variation of the tagline used by the Syms clothing chain:
“An educated consumer is our best customer.”
He said that Goldman’s clients knew what they were buying
and that his firm was simply providing a customer service.

[“Just providing a service”?
Is he representing that his firm
did nothing to encourage its clients to buy those investment vehicles
his firm was betting against?
I.e., that it acted like a discount broker, providing no advice on the matter?
If so, its fees should have been minimal, like those of discount brokers are.
If its fees were not low, but high,
just what did GS claim it was providing its customers to justify those high fees?]

“These are professional investors who want this exposure,” Mr. Blankfein said.

But Mr. Angelides had his comeback:
“It sounds to me a little bit like
selling a car with faulty brakes
and then buying an insurance policy on the buyer of those cars.”

The exchange was particularly revealing because
it laid bare an essential truth about the Wall Street ethos:
if there’s a buyer — no matter how sophisticated —
there’s always a seller.

[That’s news?
I’ve never had any professional training in these matters,
but even so that’s about as obvious and essential to know as it can be.]

Maybe that’s fine within the confines of Wall Street.
But it didn’t work so well
when people wanted to buy homes they clearly could not afford
and banks were quick to provide them with mortgages.

And it didn’t work so well when
companies sought to finance enormous takeovers
by leveraging their balance sheets to dizzying heights
and banks were happy to provide them with the debt.

Mr. Angelides also dismissed Mr. Blankfein’s line about “professional investors”
by saying that
those same investors represented the savings of teachers and police officers.

After the hearing,
Mr. Angelides said he was frustrated with Mr. Blankfein’s answer.
“Mr. Blankfein himself never admitted that
there was any responsibility of Goldman Sachs
to make sure the products themselves were good products,” he said.
“That’s very troublesome.”

[That’s really the wrong argument to make here.
The key issue is
whether GS was representing to its customers that the products were good
when internally they knew (or thought) they were not.
I’m not a lawyer, and I don’t know the legal term to use here,
but that situation would clearly be wrong.]

Mr. Blankfein took the brunt of other lines of questioning,
and when the hearing shifted to more predictable exchanges,
he was clearly more comfortable.
The executives, for the most part,
had figured out how to avoid directly apologizing,
despite the commission’s best efforts
to pry some admission of guilt out of them.

“Whatever we did, it didn’t work out well,” Mr. Blankfein said.
“We regret the consequence that people have lost money.”
(John J. Mack, Morgan Stanley’s chairman,
who has been the most outspoken about the need for regulation,
had apologized at a Congressional hearing last year.)

All of them suggested that reform was necessary,
including detailed explanations of
how they might put into effect changes to compensation plans
and making the sale of derivatives more transparent.

But it was unclear whether it was just lip service.
“If the leaders of Wall Street believe regulation is needed,
as they stated today before the Financial Crisis Inquiry Commission,
then they should tell their lobbyists because
they are fighting every serious regulatory change and improvement
being considered by Congress,”
John Taylor, president of the National Community Reinvestment Coalition,
said in a statement after the hearing.

Mr. Taylor also said
the banks should be held more accountable for what they sell.

“If the leaders of Wall Street
did not consider the possibility of housing prices dropping
in their own stress tests and due diligence,” he added,
“if they did not know that
the F.B.I. had been raising red flags about mortgage fraud since 2004, and
if they did not know that high-cost, no-doc, interest-only loans
were being made right and left to anyone,
then their spirited defense of their employees falls flat.”

“Based on what we heard today,” he added,
“they should be firing people, not giving them bonuses.”

To be sure, Mr. Blankfein was correct in saying that his firm
had sold the bundles of mortgages,
or synthetic collateralized debt obligations,
only to sophisticated professional investors
who managed large amounts of money and had an appetite for the securities.

He was trying to distinguish them from individual retail investors.
And those investors probably should have known better.
But, of course,
those investors also relied on rating agencies to evaluate these securities —
and as it turns out, the ratings were often way off.

For years, most financial regulation has been focused on
protecting the individual investor
(though its effectiveness is obviously questionable),
leaving professionals and wealthy investors
to take whatever risks they choose.

But if we learned anything in this crisis,
it is that most of the sophisticated financial professionals in the world
were no better at predicting the market than some amateur investors.
Even Mr. Blankfein highlighted that he did not see the crisis coming.

[Why would anyone take
Blankfein’s assertions as to what he did and did not see coming
at face value?]

“I remember being teased at a shareholders meeting in ’07
and being asked what inning we were at in the crisis,” said Mr. Blankfein.
“I said we were in the seventh inning of the crisis.
As it turned out, we were in the second inning.”

The Causes and Current State of the Financial Crisis
Statement of Sheila C. Bair, Chairman, Federal Deposit Insurance Corporation
before the Financial Crisis Inquiry Commission, 2010-01-14

[The conclusion;
emphasis and comments have been added by the author of the current document.]


In my testimony today, I have discussed some of
the financial sector developments
that fueled a speculative boom in housing that ended badly—
for consumers, savers, financial institutions, and our entire economy.
As the committee examines the causes of the financial crisis,
it should also consider
long-standing features of the broader economy
that may have contributed to the excesses that led to the crisis.

This crisis represents the culmination of a decades-long process by which

our national policies have distorted economic activity
away from savings
and toward consumption,

away from investment in our industrial base and public infrastructure
and toward housing,

away from the real sectors of our economy
and toward the financial sector.

No single policy is responsible for these distortions,
and no one reform can restore balance to our economy.
We need to examine national policies from a long-term view
and ask whether they will create the incentives that will lead to
improved and sustainable standards of living for our citizens over time.

For example,
federal tax policy has long favored
investment in owner-occupied housing
and the consumption of housing services.

The government-sponsored housing enterprises have also used
the implicit backing of the government
to lower the cost of mortgage credit
and stimulate demand for housing and housing-linked debt.
In political terms, these policies have proven to be highly popular.
Who will stand up to say they are against homeownership?
Yet, we have failed to recognize that
there are both opportunity costs and downside risks
associated with these policies.
Policies that channel capital towards housing
necessarily divert capital from other investments,
such as plant and equipment, technology, and education—
investments that are also necessary for
long-term economic growth and improved standards of living.

As the housing boom gathered steam in this decade, there is little doubt that
large-scale government housing subsidies
only encouraged more residential investment.
These policies amplified the boom as well as the resulting bust.
In the end, government housing policy failed to deliver on its promise
to promote homeownership and long-term prosperity.
Where homeownership was once regarded
as a tool for building household wealth,
it has instead consumed the wealth of many households.
[That seems unfair.
It was not homeownership per se
that caused the financial distress of those underwater homeowners,
rather their decision to buy more house than they could afford,
or to refinance and convert equity into disposable cash.
I.e., irresponsible homeownership.]

At present, foreclosures are nearing 3 million per year
and the rise of housing-linked debt has resulted in
more than 15 million households owing more than their home is worth.

But this is not the only example of well-intentioned policies
that have distorted economic activity in potentially harmful ways.
For example, the preferential tax rate on capital gains,
which is designed to promote long-term capital investment,
has been exploited by private equity and hedge fund managers
to reduce the effective tax rate on the outsized incomes earned by
the relatively few who work in these industries.
while the establishment of emergency backstops to contain financial crises
can help to limit damage to the wider economy in the short-run,
without needed reforms these policies
will promote financial activity and risk-taking
at the expense of other sectors of the economy.

Corporate sector practices also had the effect of distorting of decision-making
away from long-term profitability and stability
and toward short-term gains with insufficient regard for risk.
For example, performance bonuses and equity-based compensation
should have aligned the financial interests of shareholders and managers.
Instead, we now see—especially in the financial sector—
that they frequently had the effect of
promoting short-term thinking and excessive risk-taking
that bred instability in our financial system.
Meaningful reform of these practices will be essential
to promote better long-term decision-making in the U.S. corporate sector.

Whatever the reasons,
our financial sector has grown disproportionately
in relation to the rest of our economy over time.

Whereas the financial sector claimed
less than 15 percent of total U.S. corporate profits in the 1950s and 1960s,
its share grew to
25 percent in the 1990s and
34 percent in the most recent decade through 2008.
The financial services industry produces intermediate products
that are not directly consumed—
transactions services and products
that channel savings into investment capital.
While these services are essential to our modern economy,
the excesses of the last decade represented
a costly diversion of resources from other sectors of the economy.
We must avoid policies that encourage such distortions in economic activity.

Fixing regulation will only accomplish so much.
Longer term, we must develop a more strategic approach
that utilizes all available policy tools—
fiscal, monetary, and regulatory—
to lead us toward
a longer-term, more stable, and more widely-shared prosperity.

Testimony Concerning the State of the Financial Crisis
by Chairman Mary L. Schapiro
U.S. Securities and Exchange Commission
Before the Financial Crisis Inquiry Commission

A Call for More Regulation at Fiscal Crisis Inquiry
New York Times, 2010-01-15

[My question (I’m sure there’s an answer, I just don’t know what it is):
How come Fed Chairman Bernanke wasn’t there (instead of Attorney General Holder)?
The Fed chairman seems a better pairing with the FDIC and SEC chairmen.]

Leaders of SEC and FDIC say agencies' failings contributed to financial crisis
By Brady Dennis
Washington Post, 2010-01-15

The Show Must Not Go On
New York Times Editorial, 2010-01-17 (Sunday)

A Bomb Squad for Wall Street
New York Times Opinionator Blog, 2010-01-21

Financial Crisis Commission Needs to Get to Work
by Tom Matzzie
Huffington Post, 2010-03-03


Financial Crisis Was Avoidable, Inquiry Finds
New York Times, 2011-01-26

Crisis Panel’s Report Parsed Far and Wide
New York Times, 2011-01-27

Dissenters Fault Report on Crisis in Finance
New York Times, 2011-01-27

Everyone Was to Blame, Crisis Commission Finds
New York Times Dealbook, 2011-01-27

In Postcrisis Report, a Weak Light on Complex Transactions
New York Times Dealbook, 2011-02-02

he report from the Financial Crisis Inquiry Commission has been assailed as a confusing mishmash — poorly organized, unclear about what’s new and weakened by conclusions that are at once obvious and unsatisfying. The problems of the commission were evident from the start: its mandate was too broad, its timetable too short, its budget too small and its commissioners too partisan.

Those criticisms are true, but overdone.

The report is full of fascinating information, rich detail and fine documentary evidence. The commission should be celebrated for putting more than 1,100 documents online for anyone to search.

For me, the report’s biggest failing is its timidity in engaging the most important question looming over the crash:
What did Wall Street know and when did it know it?


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