Causes of the circa-2000 financial failure

Although major financial failures did not become readily visible until 2007–08,
the failure was preordained by earlier events and decisions.
One important necessary condition for the failure was
the 1999 repeal of the Glass-Steagall Act.
For this and other reasons,
it makes sense to give the date for the failure
as the rather vague “circa 2000”.

Lawrence G. McDonald’s
A Colossal Failure of Common Sense
The Inside Story of the Collapse of Lehman Brothers

[Here is an excerpt from the prologue, pages 3–7; emphasis is added.]

The story begins
in the heady, formative years of the Clinton [42] presidency
on a rose-colored quest to change the world, to help the poor,
and ended in the poisonous heartland of world financial disaster.

Roberta Achtenberg, the daughter of a Russian-born owner
of a Los Angeles neighborhood grocery store,
was plucked by President Clinton from relative obscurity in 1993
and elevated to the position of
assistant secretary of the Department of Housing and Urban Development.
Roberta and Bill were united in their desire
to increase home ownership in poor and minority communities.

And despite a barrage of objections led by Senator Jesse Helms,
who referred to Achtenberg as the “damn lesbian,”
the lady took up her appointment in the new administration,
citing innate racism as
one of the main reasons why
banks were reluctant to lend to those without funds.

In the ensuing couple of year,
Roberta Achtenberg harnessed all of [her] formidable energy
on the massed ranks of United States bankers,
sometimes threatening, sometimes berating, sometimes bullying—
anything to persuade the banks to provide mortgages
to people who might not have been up to the challenge of coping with
upfront down payments and regular monthly payments.

Between 1993 and 1999,
more than two million such clients became new homeowners.
In her two-year tenure as assistant secretary,
she set up a national grid of offices staffed by attorneys and investigators.
Their principal aim was to enforce the laws against the banks,
the laws that dealt with discrimination.
Some of the fines leveled at banks ran into the millions,
to drive home Achtenberg’s avowed intent to utilize the law
to change the ethos of providing mortgage money in the United States of America.

Banks were compelled to jump into line,
and soon they were making thousands of loans
without any cash-down deposits whatsoever, an unprecedented situation.
Mortgage officers inside the banks were forced to bend or break their own rules
in order to achieve a good Community Reinvestment Act rating,
which would please the administration
by demonstrating generosity to underprivileged borrowers
even if they might default.
Easy mortgages were the invention of Bill Clinton’s Democrats.

However, there was, in the mid- to late 1990s, one enormous advantage:
amid general prosperity,
the housing market was strong and prices were rising steadily.
At that point in time, mortgage defaults were relatively few in number
and the securitization of mortgages,
which had such disastrous consequences
during the financial crisis that began in 2007,
barely existed.

Nonetheless, there were many beady-eyed financiers
who looked askance at this new morality
and privately yearned for the days
when bank policies were strictly conservative,
when credit was flatly denied to anyone without the proven ability to repay.

And at the center of this seething disquiet,
somewhere between
the persuasive silken-tongued members of the banking lobby and
the missionary zeal of Roberta Achtenberg,
stood William J. Clinton, whose heart, not for the first time,
may have been ruling his head.

He understood full well the goodwill he had engendered
in the new home-owning black and Hispanic communities.
But he could not fail to heed the very senior voices of warning that whispered,
There may be trouble ahead.

[I do wish to explicitly acknowledge that
the evidence seems clear that
the black community has been
the victim of predatory lending practices.]

President Clinton wanted to stay focused with the concerns of the bankers
many of whom were seriously upset by Achtenberg’s pressure
to provide shaky mortgages.
And right before the president’s eyes there was a related situation,
one that had the deepest possible roots in the American financial community.

That was the fabled Glass-Steagall Act of 1933,
the post-Wall Street crash legislation
that prevented commercial banks from merging with investment banks,
thus eliminating the opportunity for the high-rolling investment guys
to get their hands on limitless supplies of depositors’ money.
Glass-Steagall was nothing short of a barrier,
and it stayed in place for more than sixty years,
but the major U.S. banks wanted it abolished.
They’d tried by failed in 1988.
It would take another four years
for this Depression-era legislation to come once more under attack.

President Clinton understood the ramifications,
and he was wary of the reform,
wary of seeming to be allied with the power brokers
of the biggest banks in the country.
He understood
the complexities of the Glass-Steagall Act, its origins, and its purposes—
principally to prevent some diabolical investment house
from plunging in big on a corporation like Enron
and going down with a zillion dollars of small depositors’ cash.
No part of that did President [Clinton] need.

On one hand was the belief of the main U.S. clearing banks that
such mergers would strengthen the whole financial industry
by increasing opportunities for hefty profits.
But there were many people running small banks who were fearful that
a repeal of Glass-Steagall would ultimately lead to
large conglomerates crushing the life out of the minnows.

President Clinton always kept a weather eye on history,
and he was aware the commercial banks,
with their overenthusiastic investments in the stock market,
had essentially taken the rap for the crash of 1929.
They were accused of crossing a forbidden line,
of buying stock in corporations for resale to the public.
It had been too risky,
and the pursuit of huge profits had clouded their judgment.

The man who had stood firmly in the path of the gathering storm of the 1930s
was Virginia senator Carter Glass,
a former treasury secretary and the founder of the U.S. Federal Reserve System.
The somewhat stern Democratic newspaper proprietor was determined that
the commercial banks and the investment banks should be kept forever apart.

He was supported by the chairman of the House Banking and Currency Committee,
Alabama congressman Henry Bascom Steagall,
and it was their rigid legal barricade
that did much to solve Wall Street’s greatest-ever crisis.
The biggest banks were thenceforth prevented
from speculating heavily in the stock markets.
But even then, a lot of people thought it was a harsh and restrictive law.

With President Clinton in office for only three years,
the major banks once more marshaled their forces
to try for a third time to repeal Glass-Steagall,
and once more it all came to nothing,
with the nation’s small banks fighting tooth and nail
to hold back a system they thought might engulf them.
But in 1996 they failed once more.

In the early spring of 1998, however, a Wall Street detonator exploded,
sending a sharp signal that
the market was willing to go it alone despite the politicians.
On April 6 Citicorp announced a merger with Travelers Insurance,
a large corporation that owned and controlled
the investment bank Smith Barney.
The merger would create a vast conglomerate
involved with banking, insurance, and securities,
plainly in defiance of Glass-Steagall.

The House scrambled to put a reform bill together,
but the issue died in the Senate
after it became clear that President Clinton had many concerns
and was almost certain to veto it.
The $70 billion merger between Citicorp and Travelers
went right ahead regardless.
The result was a banking giant,
the largest financial conglomerate in the world,
and it was empowered to
sell securities, take deposits, make loans, underwrite stocks,
sell insurance, and operate an enormous variety of financial activities,
all under one name:

The deal was obviously illegal,
but Citigroup had five years to get the law changed,
and they had very deep pockets.
Senators harrumphed,
and the president, concerned for the nation’s smaller banks, worried.

However, the most powerful banking lobbies in the country
wanted Glass-Steagall repealed,
and they bombarded politicians with millions of dollars worth of contributions.
They cajoled and pressured Congress
to end this old-fashioned Depression-era law.
Inevitably they won.
In November 1999, the necessary bills were passed
54–44 in the Senate and 343–86 in the House of Representatives.
In the ensuing days the final bipartisan bill sailed through
the Senate 90–8 with one abstention, and
the House, 362–57 with fifteen abstentions.
[For division of Congress by party: general, 106th only.]
Those margins made it vetoproof.
I remember the day well.
All my life my dad had been telling me that
history inevitably repeats itself.
And here I was listening to a group of guys telling me
it was all different now,
that everything was so much more sophisticated,
“doorstep of the twenty-first century” and all that,
so much more advanced than 1933.

Oh, yeah?
Well, I never bought it.
It’s never different.
I knew that Glass-Steagall had been put in place very deliberately
to protect customer bank deposits and
prevent any crises from becoming interconnected
and forming a house of cards or a row of dominoes.

Carter Glass’s bill had successfully kept the dominoes apart
for more than half a century after his death.

And now that was all about to end.
They were moving the pieces, pressing one against the other.
I remember my concern as I watched the television news on November 12, 1999.
The action on the screen was flying in the face of everything my dad had told me.
I was watching President Clinton step up, possibly against his better judgment,
and sign into law the brand-new
Financial Services Modernization Act (also known as Gramm-Leach-Bliley),
repealing Glass-Steagall.
In less than a decade, this act would be directly responsible for
bringing the entire world to the brink of financial ruin.

Miscellaneous Articles


The Last Temptation of Risk
by Barry Eichengreen
National Interest, May/June 2009

[The second from last paragraph; emphasis is added.]

The late twentieth century was the heyday of deductive economics.
Talented and facile theorists set the intellectual agenda.
Their very facility enabled them to
build models with virtually any implication,
which meant that
policy makers could pick and choose at their convenience.
Theory turned out to be too malleable, in other words,
to provide reliable guidance for policy.


How Did Economists Get It So Wrong?
New York Times Magazine, 2009-09-06

[Krugman obviously knows a lot, and is, of course,
very highly regarded by many of his peers in today’s “elite,”
but is he trustworthy?
Academics often prod themselves to be humble by reminding themselves that
“Ph.D” can mean “piled higher and deeper,”
and that to earn a Ph.D. often requires
knowing more and more about less and less.

In this long (~6800 word) article Krugman tells us
more than probably most of us want to know
about some historical aspects of modern economics,
but is he capable (or willing) to address the key issues,
rather than obfuscating them with a lot of technicalities
(which, trust me, is something many of today’s overeducated class
is more than willing to do)?

For example, in Krugman’s discussion (a section is shown below in its entirety)
it seems to me that he fails to point out
the fundamental fact that should have shown anyone
that the rise in house prices was surely a bubble,
the increasing divergence between median house prices and median income.
Ultimately, the mortgage must be paid for.
Financial gimmicks and refinancing can only continue for a finite amount of time.
At some point in time, those ever-rising mortgage payments must be paid by
real household income.
Krugman totally fails to mention this basic and relevant fact.
Why, Paul, why?]


In recent, rueful economics discussions,
an all-purpose punch line has become
“nobody could have predicted. . . .”
It’s what you say with regard to disasters that
could have been predicted,
should have been predicted
and actually were predicted
by a few economists who were scoffed at for their pains.

Take, for example,
the precipitous rise and fall of housing prices.
Some economists, notably Robert Shiller, did identify the bubble
and warn of painful consequences if it were to burst.
Yet key policy makers failed to see the obvious.
In 2004, Alan Greenspan dismissed talk of a housing bubble:
“a national severe price distortion,” he declared, was “most unlikely.”
Home-price increases, Ben Bernanke said in 2005,
“largely reflect strong economic fundamentals.”

[Again, I don’t get it.
How can ballooning house prices be sustained
without income rising to support them?
Without income to support those astronomical mortgages,
new buyers were priced out of the market,
the speculative fever burst,
and prices fell.
If that isn’t a fundamental, what on earth is?]

How did they miss the bubble?
To be fair, interest rates were unusually low,
possibly explaining part of the price rise.
It may be that Greenspan and Bernanke also wanted to celebrate
the Fed’s success in pulling the economy out of the 2001 recession;
conceding that much of that success
rested on the creation of a monstrous bubble
would have placed a damper on the festivities.

But there was something else going on:
a general belief that bubbles just don’t happen.
What’s striking, when you reread Greenspan’s assurances,
is that they weren’t based on evidence —
they were based on the a priori assertion that
there simply can’t be a bubble in housing.
And the finance theorists were even more adamant on this point.
In a 2007 interview,
Eugene Fama, the father of the efficient-market hypothesis, declared that
“the word ‘bubble’ drives me nuts,”
and went on to explain why we can trust the housing market:
“Housing markets are less liquid,
but people are very careful when they buy houses.
It’s typically the biggest investment they’re going to make,
so they look around very carefully and they compare prices.
The bidding process is very detailed.”

Indeed, home buyers generally do carefully compare prices —
that is,
they compare the price of their potential purchase
with the prices of other houses.
But this says nothing about whether the overall price of houses is justified.
It’s ketchup economics, again:
because a two-quart bottle of ketchup costs twice as much as a one-quart bottle,
finance theorists declare that the price of ketchup must be right.

In short, the belief in efficient financial markets
blinded many if not most economists
to the emergence of the biggest financial bubble in history.
And efficient-market theory also played a significant role
in inflating that bubble in the first place.

Now that the undiagnosed bubble has burst,
the true riskiness of supposedly safe assets has been revealed
and the financial system has demonstrated its fragility.
U.S. households have seen $13 trillion in wealth evaporate.
More than six million jobs have been lost,
and the unemployment rate appears headed for its highest level since 1940.
So what guidance does modern economics have to offer
in our current predicament?
And should we trust it?

[And here’s another excerpt from Krugman’s article, this time from Part III:]

The elegance and apparent usefulness of the new theory
led to a string of Nobel prizes for its creators,
and many of the theory’s adepts also received more mundane rewards:
Armed with their new models and formidable math skills —
the more arcane uses of CAPM require physicist-level computations —
mild-mannered business-school professors could and did
become Wall Street rocket scientists, earning Wall Street paychecks.

To be fair,
finance theorists didn’t accept the efficient-market hypothesis
merely because it was elegant, convenient and lucrative.
They also produced a great deal of statistical evidence,
which at first seemed strongly supportive.
But this evidence was of an oddly limited form.
Finance economists rarely asked
the seemingly obvious (though not easily answered) question of
whether asset prices made sense
given real-world fundamentals like earnings.

[Look, it is not the job of “financial economists”
to ask all those hard but appropriate questions.
It is the job of the management team for which they work
to insure that those questions get asked, and answered.]

they asked only whether asset prices made sense given other asset prices.
Larry Summers, now the top economic adviser in the Obama administration,
once mocked finance professors with a parable about “ketchup economists”
who “have shown that
two-quart bottles of ketchup invariably sell for exactly twice as much
as one-quart bottles of ketchup,”
and conclude from this that the ketchup market is perfectly efficient.

But neither this mockery
nor more polite critiques from economists like Robert Shiller of Yale
had much effect.
Finance theorists continued to believe that their models were essentially right,
and so did many people making real-world decisions.
Not least among these was Alan Greenspan,
who was then the Fed chairman
and a long-time supporter of financial deregulation
whose rejection of calls to rein in subprime lending
or address the ever-inflating housing bubble
rested in large part on the belief that
modern financial economics had everything under control.
There was a telling moment in 2005,
at a conference held to honor Greenspan’s tenure at the Fed.
One brave attendee, Raghuram Rajan (of the University of Chicago, surprisingly),
presented a paper warning that
the financial system was taking on potentially dangerous levels of risk.
He was mocked by almost all present —
including, by the way, Larry Summers,
who dismissed his warnings as “misguided.”

[High level math certainly has its attractions,
but everyone must realize that it is only a theory,
without any certain grounding in reality.
The questions that must be asked of any mathematical theory include:

  • Is it relevant?

  • What are its predicates and assumptions?

  • What was the original empirical set of observations
    on which the theory was based?

  • Are those observations, the “data set” if you will,
    still appropriate to today’s world?
Beauty and elegance of theory are wonderful,
but they have very little bearing on
the relevance of the theory to the real world.

A question I wonder in all this is:
Where was Dick Cheney?
He surely had business experience as CEO of Halliburton,
and should have had practical instincts.
As to his level of paranoia,
surely no one could hold a candle to his desire
to protect America against the threat from terrorism,
especially coming from the Muslim world.
He has said, regarding why his administration did not do more
to prevent the meltdown from occurring,
essentially that “No one told us.”
Come on.
Anyone with an ounce of sense knew that
the housing prices were at a level that could not be sustained.
Did none in the surely wide-reaching set of his friends and advisors,
people who could get his ear and his confidence,
not have the sense to warn him of what was coming?
If so, that shows how isolated from reality our political system is.]

Flaw in Free Markets: Humans
New York Times, 2009-09-15

Krugman's Scapegoats
by Richard A. Epstein
National Review, 2009-10-06

The above link is the "official" one, to the National Review archives.
For me, and I persume most others, it only gives a login screen.
A bootleg, presumably full, copy of the article
is available here at HydeParkBlvd.com,
where the article is described as follows:
“The Chicago School’s most thoughtful response to Krugman so far
comes from an unlikely source: libertarian lawyer Richard Epstein.”

Here is a paragraph from Epstein's article:

Unfortunately, it is a law of practically Newtonian inevitability that
every advance in financial technology brings with it offsetting disadvantages.
Securitization was intended to help manage banks’ risks,
but it took away an important incentive:
Banks originating mortgage-backed securities
relaxed their underwriting standards
because they knew they could count on guaranteed sales.
That deterioration in lending quality really bit when bad times hit —
but only after those securities
had insinuated themselves throughout the global economy.

The quantitative analysts (the math geeks who created the new securities)
had had to make certain assumptions about mortgage-default rates and
what changes in housing prices would do to them.
they had underestimated the volatility that regulation adds to the mix
and had failed to account for the legal protections for mortgage borrowers.
They had not done well in assessing the negative impact
that systemic delays in mortgage foreclosures would have on
underlying real-estate values.
They had not accurately priced the statutory “rights of redemption”
that in many states
allowed homeowners to reclaim properties cheaply after foreclosure.
And they had badly underestimated
how complicated it would be to renegotiate existing loans on a mass basis,
especially when many underwater homeowners
were opting simply to stop making mortgage payments
while barricading themselves in their homes with a big assist from consumer groups.


Academic Economists to Consider Ethics Code
New York Times, 2010-12-31

[How interesting.
It turns out the economics profession lacks a code of ethics.
Sounds like a point
Paul Craig Roberts (in particular), Eamonn Fingleton, and Pat Choate
have been making.

Here are some excerpts from the article.]


When the Stanford business professor Darrell Duffie
co-wrote a book on how to overhaul Wall Street regulations,
he did not mention that he sits on the board of Moody’s,
the credit rating agency.

As a commentator on the economy, Laura D’Andrea Tyson,
a former adviser to President Bill Clinton who teaches
in the business school at the University of California, Berkeley,
does not usually say that she is a director of Morgan Stanley.

And the faculty Web page of Richard H. Clarida,
a Columbia professor who was a Treasury official under President George W. Bush,
omits that he is an executive vice president at Pimco,
the giant bond fund manager.

Academic economists,
particularly those active in policy debates in Washington and Wall Street,
are facing greater scrutiny of their outside activities these days.
Faced with a run of criticism, including a popular movie,
leaders of the American Economic Association,
the world’s largest professional society for economists, founded in 1885,
are considering
a step that most other professions took a long time ago —
adopting a code of ethical standards.

The proposal, which has not been announced to the public
or to the association’s 17,000 members,
is partly a response to “Inside Job,”
a documentary film released in October
that excoriates leading academic economists
for their ties to Wall Street as consultants, advisers or corporate directors.

Universities and medical schools
have tightened disclosure requirements and conflicts of interest policies
for scientists, engineers and doctors in recent years,
and the main professional associations
for political scientists, sociologists and psychologists
have all adopted ethical codes.


The proposal is likely to raise a host of questions:
Should economists be required merely to disclose who finances their research,
as many academic journals already require?
Should they have to reveal
which corporate clients they advise, consult for or give speeches to?
Should they even be allowed to serve as corporate directors and officers,
as many business and finance professors do?

Some scholars say the discussion is long overdue.


A recent paper by Gerald Epstein and Jessica Carrick-Hagenbarth of the University of Massachusetts, Amherst,
found that
many financial economists who weighed in on
the Wall Street overhaul signed into law in July
did not prominently disclose potential conflicts of interest.


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