Stress Test

McConnell is a calculating politician, and I find many of his beliefs and his methods offensive, but he can be appealingly candid. He didn’t seem to have much personal enthusiasm for financial reform, and certainly not for our vision of reform. Still, he suggested he was not burning with desire to unite his caucus in a battle against a cause that enjoyed broad public support, and risk reinforcing the Republican image as the defenders of Wall Street and the rich.

  “It’s possible that you might be able to get some of our guys, maybe five to ten, on financial reform,” he said. “Everything else, we’ll fight you. And it’s going to work for us.”

  We could worry about everything else later. We needed to pass financial reform now. The worst of the financial crisis was over, and the President wanted to sign a bill before Americans forgot just how horrifying and devastating it had been.

  TEN

  The Fight for Reform

  Financial crises cannot be reliably predicted, so they cannot be reliably prevented. They’re kind of like earthquakes that way, or they would be if earthquakes were triggered by manias and fears and human interactions. We know some of the warning signs, most notably credit booms, substantial and sustained increases in private borrowing relative to income. But we can’t outlaw stupidity or irrational exuberance or herd behavior, and we can’t anticipate with any confidence exactly when manias will turn into panics. We can’t count on fallible central bankers or regulators to stop financial booms before they become dangerous, because by the time the danger is clear, it’s often too late to defuse the problem.

  Still, governments can do a lot to reduce the damage of financial disasters, just as they can with natural disasters. In the same way building codes can require sturdier construction in fault zones or elevated structures in floodplains, strong financial regulations can limit the severity of future crises. Even though governments can’t eradicate crises, they can reduce the system’s vulnerability to crises, as well as the risk that crises will spiral out of control. This crisis wouldn’t have been so bad if the United States hadn’t been so woefully unprepared.

  The President did not want that to happen again, and neither did I. We wanted to reform the system to make it more resilient, less vulnerable, and better at providing the credit and capital economies need to grow. We wanted to address the root causes of the crisis and our inability to contain it, so that history wouldn’t repeat itself. To return to my favorite analogy, we wanted better fire prevention, fireproofing, and fire inspections, along with better-equipped firefighters for the inevitable times when our precautions wouldn’t be enough.

  The fundamental causes of this crisis were familiar and straightforward. It began with a mania—the widespread belief that devastating financial crises were a thing of the past, that future recessions would be mild, that gravity-defying home prices would never crash to earth. This was the optimism of the Great Moderation, the delusion of indefinite stability. This mania of overconfidence fueled an explosion of credit in the economy and leverage in the financial system. And much of that leverage was financed by uninsured short-term liabilities that could run at any time.

  This combination of a long rise in borrowing fueled by leverage in runnable form is the foundation of all financial crises, and it would have been dangerous in any financial system. But it was much more dangerous for us, because many of the overleveraged major firms that were borrowing short and lending long were outside our traditional banking system. These institutions were not constrained by the regulatory safeguards that applied to banks, which was why so much risk migrated in their direction, and they did not have access to the government safety net designed to contain runs on banks. The safeguards for traditional banks weren’t tough enough, either, but what made our storm into a perfect storm was nonbanks behaving like banks without bank supervision or bank protections, leaving by some measures more than half the nation’s financial activity vulnerable to a run. When the panic hit, and the run gained momentum, we did not have the ability to protect the economy until conditions were scary enough to provoke action by Congress.

  Those were the main causes of the crisis. You could say that on the front end, the long period of low interest rates in the United States and worldwide helped fuel the crisis, because it helped fuel the mania that inflated the bubble, encouraging more borrowing, more home-building, more risk-taking. This was a necessary condition, though not a sufficient condition. And on the back end, the inadequacy of our firefighting tools—our inability to manage the failure of large complex institutions in an orderly fashion, our limited authority to stop a panic outside the banking system—helped prevent us from containing the crisis. This was an accelerant.

  But the root causes, as usual, were mania, leverage, and runnable short-term financing. That’s how our financial system became that scene from It’s a Wonderful Life.

  THERE WERE all sorts of other problems in the system, and they gave rise to a variety of theories purporting to explain the crisis. The problems were so many and so varied that the crisis became a kind of Rorschach test; you could find at least some evidence to support almost any theory that confirmed your prior ideological biases, no matter where you stood on the political or economic spectrum. Some of these problems did contribute to the crisis and did magnify the damage caused by the crisis, but they were not principal causes of the crisis. They would not have been so material without the more fundamental forces of the mania—the excessive belief that past would be prologue and the good times would continue to roll—that fed the excess borrowing.

  Some critics, for example, saw the core problem as the gradual rollback and Clinton-era repeal of the Depression-era Glass-Steagall limits on bank activities, which allowed commercial banks with insured deposits to get mixed up in investment banking. But most of the firms in the center of the crisis—Bear, Lehman, AIG, Merrill, Fannie, Freddie—were basically unaffected by the repeal of Glass-Steagall, because they were not commercial banks. And traditional banking—making loans, especially real estate loans—ended up being pretty risky, too. WaMu, Wachovia, IndyMac, and hundreds of smaller institutions that blew up in the crisis were basically overextended banks and thrifts, not the far-flung financial conglomerates made possible by the disappearance of the Glass-Steagall partition. It is true that Citi and Bank of America might have been less risky and had fewer problems if they had not been allowed to build and buy vulnerable investment banks. But the most damaging failures happened to firms operating on just one side of the divide.

  Some on the right have tried to blame the crisis on Democraticled efforts to combat discrimination against low-income and minority borrowers, such as the Community Reinvestment Act of 1977 or Fannie and Freddie’s affordable housing programs. But the erosion in underwriting standards, the rush to provide credit to Americans who couldn’t have gotten it in the past, was led by consumer finance companies and other nonbank lenders that did not have to comply with the Community Reinvestment Act—which, after all, discouraged redlining for nearly three decades before the crisis. These firms took credit risks because they wanted to, not because they had to; they believed rising home prices would protect them from losses, and their investors were eager to finance their risk-taking. Fannie and Freddie lost a lot of market share to these exuberant private lenders, and while they did belatedly join the party, the overall quality of the mortgages they bought and guaranteed was significantly stronger than the industry average.

  Another popular villain was size, the notion that crises happen when big financial institutions get too big. In an ideal world, the government would be indifferent to the failures of banks, and that is harder when banks are bigger. But the Great Depression began with a cascade of failures of small banks. Bear Stearns wasn’t even one of America’s fifteen largest financial firms in March 2008; it was still so interconnected with the financial system that its failure at that fragile moment would have caused panic in the derivatives markets, the repo markets, and the financial markets in general, just as we saw later with L
ehman. In a system vulnerable to panic following a long credit boom, even relatively small institutions can cause systemic damage when they fail in messy ways. Big banks, of course, can cause even more damage—which is why they should be subject to tougher regulations—but they are also better equipped to absorb losses that would kill a small bank. And if big firms such as JPMorgan, Bank of America, and Wells Fargo hadn’t been big enough to absorb failing firms such as Bear, WaMu, Countrywide, Merrill, and Wachovia, our crisis would have been much worse.

  Related to the theory that size caused the crisis was the theory that moral hazard caused the crisis, that “too-big-to-fail” banks took on so much risk because they knew the government would bail them out if they got in trouble. There was certainly moral hazard in our system. Traditional banks did enjoy a mix of explicit and implicit government protection, advantages that were not sufficiently offset by constraints on their risk-taking. But that wasn’t our main problem. Again, the worst of the crisis took place outside the traditional banking system, where private financial markets had willingly financed huge amounts of leverage in more loosely supervised firms such as Bear, Lehman, and AIG. Those firms had no reason to expect emergency assistance, and neither did their shareholders or creditors, because the U.S. government had no history of intervening to rescue nonbanks. There was no precedent for guarantees of money market funds or government support for the commercial paper market, either. In fact, even after we helped JPMorgan acquire Bear, the financial markets continued to pull back from the surviving investment banks. The prospect of a similar “rescue” was not much comfort to other systemic firms or potential investors; Bear ceased to exist and its shareholders lost a fortune. The moral hazard theorists simply underestimated the mania, the power of Hyman Minsky’s theory, which I first read in 2007, that stability can breed instability.

  That said, moral hazard was a legitimate problem. Fannie and Freddie exploited their access to cheap capital—a result of the widespread (and ultimately correct) assumption that the government would stand behind their obligations—to take on way too much leverage and risk, a classic example of moral hazard. The large banks also enjoyed lower-cost financing because of their access to a government safety net, which was one reason they got so large. And there was a real danger that moral hazard created by our actions to resolve this crisis could plant the seeds of a future crisis. I still didn’t think firehouses caused fires—as Stan Fischer put it during the emerging-market crises, condoms don’t cause sex—but resolutions of financial crises always create some moral hazard, and I wanted our reforms to limit moral hazard going forward.

  It was also tempting, and intuitively satisfying, to blame the crisis on the deceit and fraud and other misbehavior that flourished during the boom—duplicitous brokers luring borrowers into mortgages they couldn’t afford, Bernie Madoff types running wild, securities firms dumping toxic products on unsuspecting clients. These abuses were terrible and unfair, but they were more a feature of the mania than a significant cause of the crisis, fueled by the dominant belief that risk-taking was no longer particularly risky. Promises of easy money seemed plausible in those days, because a lot of easy money was being made. Wei Xiong, a Princeton economist, told me later about a study he coauthored analyzing the personal housing transactions of those involved in the mortgage securitization business during the boom. They got caught up in the frenzy like everyone else, buying bigger homes for themselves and speculating in the real estate market even as prices defied gravity. Throughout the financial system, “insiders” were putting their own money where their mouths were; many of them ultimately lost a lot of money doing so.

  But even if predatory behavior wasn’t the main cause of the crisis, even if some toxic products were sold without a full understanding of their toxicity, ordinary Americans deserved more protection from predatory behavior and toxic products. The financial crisis exposed our system of consumer protection as a dysfunctional mess, leaving ordinary Americans way too vulnerable to fraud and other malfeasance, while leaving the financial system vulnerable to sudden crises of confidence. Many borrowers, especially in subprime markets, bit off more than they could chew because they didn’t understand the absurdly complex and opaque terms of their financial arrangements, or were actively channeled into the riskiest deals. Underwriting standards deteriorated dramatically, producing flimsy loans that were quickly packaged into complex securities; the eagerness of investors to buy them does not excuse the shoddiness of the products.

  This was another area where our weak and disjointed regulatory system, riddled with gaps and evasion opportunities, cried out for reform. Government oversight just hadn’t kept up with the fast-growing and fast-changing frontiers of finance, from the exotic innovations in mortgage markets to the explosion of complex derivatives. The financial cops weren’t authorized to patrol the system’s worst neighborhoods, and they weren’t aggressive enough about using the authority they had. While we clearly needed better safeguards against systemic risk in these new frontiers outside the traditional banking system, we also needed to make sure individual Americans weren’t left vulnerable to predation and abuse there.

  But again, the most powerful theory of the crisis was simple. It started with a long mania of overconfidence, the widespread belief that house prices would not fall, that recessions would be mild, that markets would remain liquid. The mania fueled too much borrowing, too much leverage, and too much runnable short-term financing, with too much of it happening outside the traditional banking system. Borrowers took too many risks; creditors and investors were way too willing to finance those risks; the government failed to rein in those risks, and then was unable to act quickly or forcefully enough when the panic hit. Meanwhile, the actions the government finally took to end the crisis created new dangers of moral hazard. And our Wild West system of consumer protection was a national disgrace. The question was what to do about this mess.

  I DIDN’T think there was much we could do about manias and beliefs. We couldn’t ban fads or mandate judicious thinking. But there was a lot we could do about our other vulnerabilities, starting with stronger shock absorbers across the entire financial system.

  I always thought our top reform priority should be more conservative rules requiring financial institutions to hold more capital, take on less leverage—the flip side of capital—and maintain more liquidity. The rules would have to be applied broadly and globally, to prevent risk from migrating from banks to nonbanks and from U.S. firms to foreign firms. By forcing financial institutions to maintain a larger cushion of capital to protect themselves from potential losses, restricting their ability to borrow to finance risky investments, and making sure they could meet their short-term obligations if their funding ever dried up, we would limit their vulnerability to runs, while also limiting the system’s vulnerability to contagion if a major firm did fail. We couldn’t squelch the natural cat-and-mouse game between innovation and regulation, but more conservative capital and liquidity requirements could provide a baseline of safety, especially if we built in the capacity to expand their scope over time, and if we required financial firms to take periodic stress tests based on genuinely dark scenarios. The crisis was a reminder that they wouldn’t prepare for a storm while the sun was shining unless regulators forced them.

  In addition to the shock absorbers for individual firms, I thought we also needed stronger shock absorbers in the markets where firms were connected, such as tri-party repo and especially derivatives. By requiring more collateral (or “margin”) behind trades, we could limit leverage in the system, while also limiting the systemic damage from the failure of individual firms.

  Derivatives didn’t cause the crisis, and they even played a useful role helping businesses, farmers, banks, and investors to hedge risk before and during the crisis. But in the midst of the panic, derivatives did help make it worse. The derivatives dealers who demanded more collateral to protect themselves against the rising risks of default helped increase those risks. T
he complicated spaghetti of the derivatives market magnified the fear and uncertainty caused by the implosion of major derivatives traders such as Bear, Lehman, and AIG. We needed to make derivatives trading more transparent, while requiring firms to collect and post more collateral in advance to avoid the vicious dynamics of margin spirals. And we needed to require “central clearing” for most derivatives trades, establishing an intermediary with a strong financial foundation that would stand between counterparties so that a default by one firm was less likely to set off a cascade of additional defaults. Lee Sachs had pushed this idea inside the Clinton administration, and I had taken up the cause at the New York Fed, where our plumbing work with the Fourteen Families laid the foundation for central clearing.

  Those ideas were all financial equivalents of requiring fire-resistant building materials or smoke-activated sprinklers. But they wouldn’t mean much without more effective fire inspectors and stronger enforcement of the fire code. Our current oversight regime, with its competing fiefdoms and overlapping jurisdictions and perverse incentives encouraging firms to shop around for friendly regulators, was an anarchic mess. Vast swaths of the financial system had no one in charge. Others were swarming with regulators engaged in tribal warfare. I often compared the situation to the wild frontiers of the Afghanistan-Pakistan border region or the Balkans a century ago. We needed a simpler structure that would make sure the more conservative rules we envisioned were applied more evenly and more broadly across the financial system, with clearer accountability for monitoring risk within every major firm and especially across the entire system.

  At the same time, we needed a dramatic overhaul of our inadequate and fragmented consumer protection regime. The rules governing consumer finance were too weak. The authority for enforcing them was spread across seven federal agencies and fifty states. Thousands of companies were extending credit with no meaningful oversight, from payday lenders to auto dealers, leaving Americans unprotected from abuse. President Obama believed he had been elected to fix problems like that.