BY MATTHEW HUTCHINS
One year and trillions of dollars of government intervention after the financial crisis, experts on financial regulation at Harvard Law School assembled to assess the its causes and effects and to provide insight into what reforms are needed to effectively regulate financial institutions. Moderated by Prof. Howell Jackson ’82, the panel included: Geoff Miller, the Comfort Professor of Law at NYU; Allen Ferrell ’95, Greenfield Professor of Securities Law; Elizabeth Warren, Leo Gottlieb Professor and Chair of the Congressional TARP Oversight Panel; and Hal Scott, Nomura Professor of International Financial Systems.
Looking backwards, the events of September and October of 2008 were characterized by widespread uncertainty and unprecedented extensions of the Federal Government’s authority to support financial markets. On September 7th, Fannie Mae and Freddie Mac were both taken into government conservatorship, giving the United States a 79.9% stake in each entity. One week later, Lehman Brothers failed and entered bankruptcy, Merrill Lynch was ushered into an acquisition by Bank of America, and AIG was bailed out, with the government again taking 79.9% ownership. By the end of the month, the Reserve Primary Fund “broke the buck”, precipitating a Federal Reserve plan to guarantee the fund’s assets, Wachovia was being acquired by Wells Fargo, the stock market was in free fall, the TARP bailout had failed a key vote in the House, and the short-term credit market or “Repo” market had frozen, causing credit-default swap spreads to skyrocket. The prevailing atmosphere of hopelessness led to the TARP program being authorized on a second vote, beginning a process of government support that would ultimately bring relative stability. Prof. Hal Scott, who laid out the timeline of the crisis for the audience, noted that the macro-level stability today must be considered in light of the dire circumstances. “If the alternative was that banks fail and precipitate an economic collapse, then we had no alternative.”
But Prof. Miller pointed out that the impossibility of proving the counterfactual scenario will prove to be the source of imponderable riddles as we look back in history. “What would have happened if we didn’t rescue Bear Stearns? What would have happened if we had rescued Lehman?” Prof. Miller sees a mixed result from the government interventions that stabilized financial markets. Positive consequences include the stabilization of financial markets, the restoration of functioning credit markets, the signs that “green shoots” are emerging and foretelling of economic recovery, and the potential for positive regulatory reforms. On the other hand, the US, UK, and Euro zone have together spent more than one sixth of their collective GDP on financial rescue packages, there is a possibility of inflation if liquidity is restored, moral hazard is a major concern as financial institutions take risks with public funds, and further financial problems linger on the horizon as commercial real estate seems poised to undergo the same collapse which occurred in subprime housing finance.
Professor Warren is skeptical and warns that there is an alternative view of the present situation, that “The green shoots have been glued onto a dead plant.” She looks back to the financial crisis and the “too big to fail phenomenon” and sees a sector today which has become even more consolidated and more vulnerable to systemic risks. Under the surface, the toxic assets damaged balance sheets at major institutions remain on their books, the stress test has become obsolete due to unemployment that has grown faster than projected, the financial stimulus programs have basically run their course, and the commercial real estate market threatens to drop another bomb shell.
So, who is to blame for the calamity we continue to face? Prof. Miller says that a short list might include the names of figures like Bill Clinton, George Bush, bankers, homeowners, Barney Frank and others, but the central focus of blame should land on three people in particular: “Alan Greenspan, Alan Greenspan, and Alan Greenspan.”
According to Prof. Miller, the growth of the financial bubble, which inflated real estate markets and precipitated an unsustainable model of finance, was largely due to the unjustified policy of the Federal Reserve to maintain low interest rates. “It rained credit for 40 days and 40 nights, and when you get that much credit it’s going to find its way to the sea. It just happened to find its way there through the river of subprime mortgages, but if it hadn’t been that it would have been commercial real estate or something else.”
Professors Ferrell and Scott were less critical of Mr. Greenspan in their assessment of central bank policy and the causes of the bubble. Prof. Ferrell noted that loose monetary policy in the United States was a function of very large capital inflows that had been caused by fixed exchange rate systems around the world, and that the only tool the Fed had to maintain full employment in the face of such capital inflows was to lower interest rates. Prof. Scott expressed doubts about Prof. Miller’s revisionism, asking, “What would have happened to Alan Greenspan if he had said, ‘Hey, this is a bubble, I’m going to crush this thing.’ It’s always easier after the fact to say it was a bubble than to actually stop a bubble in progress, because people will not necessarily agree that it’s a bubble.”
But Prof. Warren agreed with Prof. Miller that Greenspan’s policies were indeed a precipitating cause. “I don’t see Alan Greenspan as a man pushed by forces.” She argues that, looking backwards, there is evidence that Greenspan’s policies were designed to shift systemic risk from financial institutions to families by encouraging variable rate mortgages and the extraction of equity from homes for investment and consumption. Now she believes that families have been put in a double bind, burdened by an overwhelming amount of debt and at the same time held responsible as taxpayers for the public debt being assumed by the government in order to support the financial system.
Worst of all to Prof. Warren is the moral turpitude of the business model adopted by financial system. She sees the predominant shift in the industry over the last decade as being from the transparent pricing of risk to the adoption of a set of “tricks and traps” designed to lure in consumers and then punish them arbitrarily with fees and penalty interest rates. “A business model that is built on fooling people about what credit costs is a bad business model for families and ultimately for businesses too, because good products get lost in the shuffle.” Furthermore, the executives and experts who profited off the implementation of the present system have largely been rewarded not for value-producing innovation but rather for the repackaging and aggregation of risk in opaque instruments. “We have built a pricing model that encourages deception and fraud in the name of the next, fancier thing.”
The future of the financial system remains cloudy, with the shape of future reforms obscured by the failures of the current regulatory framework to avert a major catastrophe. According to Prof. Scott, capital requirements will be one of the crucial tools used by regulators to construct a more stable foundation for core institutions. “We’ve got to get capital regulation right, and this is very very hard. To expect regulators to set the price for risk is daunting.” One of the key problems is that the pricing of risk, a function which has largely been entrusted to analysts in the market, has not been matched by the projection of what capital requirements to hold against such risk. Prof. Ferrell sees both the SEC, with its lack of financial savvy, and the Fed, with its myopic reliance on markets, as too specialized to handle the task of reform. Prof. Miller is convinced that the debates spawned by the crisis will result in a new architecture being developed for finance. “Life, in the form of legislation and regulation, is going to take shape from this cosmi
c soup of the financial crisis, and we are not completely sure what form it is going to take. But five years from now the regulation of financial institutions is going to be significantly different than it has been.”