The following is an excellent excerpt from the book “THE END OF WALL STREET” by Roger Lowenstein from Chapter 20 on page 284 and I quote:
“Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief.” –Alan Greenspan, Testimony Before the House Committee on Oversight and Government Reform, October 23, 2008.
The crash put paid to the intellectual model that inspired, and to a large degree facilitated, the bubble. It spelled the end of the immodest faith in Wall Street’s ability to forecast. No better testimony exists than the extraordinary recanting of Alan Greenspan, the public official most associated with the thesis that markets are ever to be trusted. Ten days after the first round of TARP investments, Greenspan appeared in the House of Representatives to, effectively, repeal credo by which he had manged the nation’s economy for seventeen years:
“In recent decades, a vast risk management and pricing system has evolved, combining the best insights of mathematicians and finance experts supported by major advances in computer and communications technology. A Nobel Prize was awarded for the discovery of the pricing model that underpins much of the advance in derivative markets. This modern risk management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year because the data inputted into the risk management models generally covered only the past two decades, a period of euphoria. Had instead the models been fitted more appropriately to historic periods of stress, capital requirements would have been much higher and the financial world would be in far better shape today, in my judgment.”
This remarkable proclamation, close to a confession, was the intellectual counterpoint to the red ink flowing on Wall Street. Just as Fannie, Freddie, and Merrill Lynch had undone the labors of a generation—had lost, that is, all the profits and more that they had earned during the previous decade—Greenspan undermined its ideological footing. And even if he partly retracted his apologia (in the palliative that it wasn’t the models per se that failed, but the humans that applied them), he was understood to say that the new finance had failed. The boom had not just ended; it had been unmasked.
Why did it end so badly? Greenspan’s faith in the new finance was itself a culprit. The late economist Hyman Minsky observed that “success breeds a disregard of the possibility of failure. The Fed both embraced and promoted such a disregard. Greenspan’s persistent efforts to rescue the system lulled the country into believing that serious failure was behind it. His successor, [Ben] Bernanke, was too quick to believe that Greenspan had succeeded—that central bankers had truly muted the economic cycle. Each put inordinate faith in the market, and disregarded its oft-shown potential for speculative excess. Excessive optimism naturally led to excessive risk.
The Fed greatly abetted speculation in mortgages by keeping interest rates too low. Also, the various banking regulators (including the Fed) failed to prohibit inordinately risky mortgages. The latter was by far the more damaging offense. The willingness of government to abide teaser mortgages, “liar loans,” and home mortgages with zero down payments, amounted to a staggering case of regulatory neglect.
The government’s backstopping of Fannie and Freddie, along with the federal agenda of promoting home ownership, was yet another cause of the bust. Yet for all of Washington’s miscues, the direct agents of the bubble were private ones. It was the market that financed unsound mortgages and CDOs; the Fed permitted, but the market acted. The banks that failed were private; the investors who financed them were doing the glorious work of Adam Smith.
Rampant speculation (and abuse) in mortgages was surely the primary cause of the bubble, which was greatly inflated by leverage in the banking system, in particular on Wall Street. High leverage and risk-taking in general was fueled by the Street’s indulgent compensation practices.
The system of securitizing mortgages lay at the heart of Wall Street’s unholy alliance with Main Street, and several links in the chain made the process especially risky. Mortgage issuers, the parties most able to scrutinize borrowers, had no continuing stake in the outcome; the ultimate investors, dispersed around the globe, were too remote to be of any use in evaluating loans; these investors (as well as various government agencies) relied on the credit agencies to serve as a watchdog, and the agencies, being cozy with Wall Street, were abysmally lax. Wall Street’s penchant for complexity was itself a risk. Abstruse securities were more difficult to value, and multitiered pyramids of debts were far more susceptible to ruinous collapse.
Such individual malfunctions were indicative of a larger failure: the market system itself came undone. What truly failed was the postindustrial model of capitalism. The market’s tools for measuring risk simply did not work. And the most sophisticated minds on Wall Street proved no wiser than country loan officers. All in, the big Wall Street banks were stuck with an estimated 30 percent of subprime losses.
The banks’ stock prices offered unsettling evidence of how thoroughly the market failed to appraise the possibility of loss. By 2007, the banks had all disclosed massive holdings of mortgage securities, and mortgage defaults were soaring. And yet, as late as that October, Citigroup was trading near its all-time high. That investors could be so blind refuted the strange ideology that markets were somehow perfect (“strange” because the boast of perfection is never alleged with respect to other human institutions). By analogy to the political arena, American society respects the will of the voters, as well as the institution of democracy, but it limits the power of legislatures nonetheless. Market referendums are no less needful of checks and balances.
Counter to the view of its apostles, the market system of the late twentieth and early twenty-first century did not evolve in a state of nature. It evolved with its own peculiar prejudices and rites. The institution of government was nearly absent. In its place had arisen a system of market-driven models, steeped in the mathematics of the new finance. The rating agency models were typical, and they were blessed by the SEC. The new finance was flawed because its conception of risk was flawed. The banks modeled future default rates (and everything else) as though history could provide the odds with scientific certainty—as precisely as the odds in dice or cards. But markets, as was observed, are different from games of chance. The cards in history’s deck keep changing. Prior to 2007 and ’08, the odds of a nation-wide mortgage collapse would have been seen as very low, because during the previous seventy years it had never happened.
What the bust proved, or reaffirmed, was that Wall Street is (at unpredictable moments) irregular; it is subject to uncertainty. Greenspan faulted the modelers for inputting the wrong slice of history. But the future being uncertain, there is no perfect slice, or none so reliable as to warrant the suave assurance of banks that leveraged 30 to 1.
In particular, the notion that derivatives (in the hands of AIG and such) eradicated risk, or attained a kind of ideal in apportioning risk to appropriate parties, was sorrowfully exposed. It should be recalled that when mortgage securities were introduced, they were applauded because they enabled lenders to issue loans without retaining risk. And this they did. They also created new vulnerabilities. The ability of Countrywide and WaMu [Washington Mutual] to parcel loans to Wall Street incentivized them to issue more and riskier loans than had no securitization channel existed. The perception of decreased risk to the individual firm thus increased risk for society at large.
[Hank] Paulson gave voice (on the day Lehman failed ) to the need for reform, and President Obama, as well as Congress, avidly pursued it. In general, there was greater agreement that reform was necessary than over what it should entail. Legislative attention focused on four areas:
1. Protecting consumers of financial products such as mortgages and credit cards.
2. Regulating complex instruments such as derivatives.
3. Obviating the need for future government bailouts, either by (a) keeping banks from becoming too big to fail or (b) ensuring that big banks did not assume too much risk.
4. Limiting Wall Street bonuses.
The public embraced only the last of these. Early in 2009, after revelations of continued outsized bonus payments at AIG and Merrill Lynch, an uproar ensued. Astonishingly, Merrill had paid million-dollar bonuses to approximately seven hundred employees in 2008, a year in which the firm lost $27 billion and in which both it and its acquirer were rescued with federal TARP monies. And Merrill was far from alone. Goldman’s bonus machine barely paused for breath.
Popular outrage was manifest; briefly, a vigilante spirit obtained. A bus tour organized by the Connecticut Working Families Party carried tourists through local suburbs to see the homes of bonus-recipients, as if in hopes of dragging them to the guillotine. A few of those judged complicit were actually sacked. John Thain, the Merrill chief, was denied in his quest for a $30 million bonus; his mere asking sealed his end. Ken Lewis, the Bank of America CEO with whom Thain had previously struck a match, fired him. When it emerged later that the bonuses paid by Merrill had been approved by Bank of America, Lewis resigned as well.”
(AFTER THE INVESTMENT BANKS BOUGHT OUT COUNTRYWIDE, THE HOME LOANS HAVE BEEN IMPROVED SOMEWHAT BECAUSE OF THE DODD-FRANK BILL BUT DUE TO THE FACT THAT THE BIG BANK LOBBYISTS HAVE PRETTY WELL SIDETRACKED MOST OF THAT, THERE’S A VERY GOOD CHANCE THAT WE COULD HAVE ANOTHER EVEN BIGGER BUBBLE. JUST EXACTLY WHAT THOM HARTMANN TALKED ABOUT IN HIS BOOK “THE CRASH OF 2016.” THERE HAS BEEN VIRTUALLY NO ENFORCEMENT STRICT ENOUGH TO REALLY GET THE INVESTMENT BANKERS TO CHANGE THEIR TACTICS BECAUSE THE FINES OF THE DIFFERENT INVESTMENT BANKS WERE CHARGED ARE NOT ENOUGH TO OFFSET THE HUGE PROFITS THEY ARE CONTINUING TO MAKE. THAT’S EXACTLY WHY SENATOR ELIZABETH WARREN AND ROBERT REICH THINK THAT THEY MUST REINSTATE THE GLASS-STEAGALL ACT, SEPARATING THE COMMERCIAL BANKS FROM THE INVESTMENT BANKS AND THE STOCK MARKET. IF NONE OF THIS TAKES PLACE, YOU CAN EASY SEE WHY THIS AUTHOR STATES THAT WE MIGHT BE BETTER OFF IF WE JUST DIDN’T HAVE A WALL STREET MARKET AND UNLESS IT IS SEPARATED LIKE GLASS-STEAGALL WAS UNDER THE FRANKLIN ROOSEVELT ADMINISTRATION, I THINK IT WOULD BE A GOOD IDEA BECAUSE THE MAJORITY OF THE SMALLER INVESTORS NEVER USE THE STOCK MARKET TO THE EXTENT THAT THE BIG MILLIONAIRES and BILLIONAIRES, INDIVIDUALS AND CORPORATIONS DO, MAINLY FOR TAX PURPOSES, WHERE AGAIN THE GOVERNMENT LOSES.. THESE TACTICS ARE AFFECTING OUR COUNTRY, AS WELL AS THE WORLD MARKETS.
LaVern Isely, Overtaxed Independent Middle Class Taxpayer and Public Citizen and AARP Members