Research AreasFinance, Jobs & MacroeconomicsSAFER Financial ReformCommission ActivitiesComments on Apr 7-9 FCIC Hearings

Third Public Hearings: Subprime Lending and Securitization and Government-Sponsored Enterprises (GSEs)

Comments: April 9, 2010
Tom Schlesinger

On April 5, 1960 William McChesney Martin appeared before a Senate subcommittee to testify about the first proposal for a federal truth in lending law.  Introducing his presentation (pdf) the Fed chairman praised the measure’s goal as “a commendable social and economic objective.”  And he concluded by saying “caveat emptor can scarcely operate in the absence of knowledge by the potential buyer and debtor.”  But in between, Martin devoted the core of his testimony to declaring that the administration of such a law “would not constitute an appropriate activity” for the central bank.  Even worse, Martin warned, consumer protection would be “alien to our existing activities.” 

In fact, the Federal Reserve System was no stranger to implementing and enforcing detailed regulations on retail credit transactions.  During World War II the central bank had assumed responsibility for a far-reaching regime of consumer credit controls.  Following the conflict it eagerly sought an extension of that authority.  But industry opposition to the controls and (more importantly) restoration of the Fed’s power to conduct independent monetary policy decisively altered the System’s perspective on credit regulation of all kinds. From 1960 through enactment of the Truth in Lending Act in 1967, Martin’s Fed steadfastly resisted any role in administering the law that would become the cornerstone of disclosure-based protection of financial consumers at the federal level.  Eventually the central bank relented.  But in the beginning, in his April 1960 testimony, Chairman Martin suggested that Congress might “recast the (truth in lending) bill as a criminal statute, not designed for administration by a regulatory authority and to be enforced by regular law enforcement agencies." 

Fifty years and two days later, Martin’s words hung tellingly over his successor Alan Greenspan’s appearance before the Financial Crisis Inquiry Commission.  Greenspan came to defend the Fed’s indefensibly slow-footed and half-hearted response to abuses that helped inflate bubbles in the home-mortgage and housing markets.  And for three hours he glibly fended off the Commission’s questions like a man in midseason Humphrey-Hawkins form.  The former Fed chairman asserted that “almost all” observers had underestimated risks that left the financial sector “chronically undercapitalized” over the past 50 years.  He ducked behind the central bank’s lack of supervisory enforcement authority in the mortgage lending arena.  And he recited with evident relish the alleged limitations of regulators, beginning with their vulnerability to forecast errors and ending with their supposed inability to “use the bully pulpit to manage asset prices…calibrate regulation and supervision in response to movements in asset prices…[and] fully eliminate the possibility of future crises.”

Faced with the bromides that have dominated mainstream economic thought and government supervisory practices for the past quarter-century, the Angelides Commission wilted.  Hobbled by the internal competition between its Republican and Democratic members to establish a crisis narrative, the panel failed to mount a sustained, in-depth line of inquiry.  Members neither coordinated nor built upon each other’s questions.  To her credit, Commissioner Brooksley Born pointedly asked Greenspan to what degree his libertarian views affected the central bank’s performance of its overall supervisory responsibilities.  But for the most part her colleagues focused relentlessly on specifics such as the Fed’s exercise of its HOEPA authority.  As a result the Commission essentially passed on the doctrinal assumptions underpinning the Federal Reserve’s oversight model.  And it ignored the central bank’s historic reluctance to police consumer and mortgage loan markets. 

Without an understanding of the deep institutional roots of that reluctance, both the Commission and the public likely will find it difficult to fully account for – let alone remedy – the System’s susceptibility to permissive practices.  But the FCIC still has time to right itself.  And it may yet refocus the regulatory reform debate on some first-order issues that have long remained dormant.  For example, if fraud has become as pervasive in financial markets as some experts contend (and Alan Greenspan acknowledges (pdf)), perhaps the time has come to reconsider William McChesney Martin’s thought about vesting a much larger share of protection for financial consumers in the criminal justice system.

The Greenspan appearance did demonstrate that the FCIC has unearthed interesting and potentially important information about regulators’ practices.  In their questions, Commissioners made reference to the level of Federal Reserve supervisory personnel at specific regulated institutions, to the number of referrals the Justice Department received from the central bank and to the results of internal peer reviews of the New York Fed’s supervisory capacities.  Some documents containing this information were selectively released to the press on April 7.  But they were not posted to the Commission’s web site and FCIC has not yet announced its intentions regarding release of investigative materials to the public.  Absent timely and widespread access to such resources, the Commission’s hearings likely will continue to fall far short of their potential for public education.

April 12, 2010
At the FCIC Hearings: The Greenspan Blame Game
Jennifer Taub

Were one to design a board game concerning the Global Financial Crisis (GFC), a central source of inspiration might be Alan Greenspan’s April 7th testimony before the Financial Crisis Inquiry Commission (FCIC - video - testimony). Modeled on the popular board game, “Clue,” this new game “Get a Clue,” would attempt to locate who nearly killed our economy? where they did it? and with what weapons?

However, if Maestro Greenspan were advising us on the design of the game, one could imagine the odd result.  There would be a spinner, to help drive the action forward. The arrow would rotate above a circle, divided up into six wedges. And, each player would spin the dial, waiting to see where the arrow would land. 

In the Greenspan Game, all six of the pie slice options would be images of those to whom he attributed blame. We’d see an image of the Capitol Building, to symbolize how Congress was to blame – as Greenspan claims they would have “clamped down” on the Fed if the Fed tried to clamped down on predatory lending practices. Another wedge would feature the S&P and Moody’s to indicate the credit rating agencies share of fault. One wedge would feature a picture of a pension fund manager with a bag of cash, looking at a ticking time bomb emblazoned with a “AAA” rating. On another wedge we’d see the CEOs of Fannie Mae and Freddie Mac, loading up their portfolios with risky securities.  The next wedge would be dedicated to the European investors demanding high-yielding, high rated securities. And, in the last wedge, we’d see the image of former Fed governor, Ed Gramlich, the person who indeed sounded an alarm about subprime origination, but who just didn’t ring it loudly enough.

The problem with the Greenspan Game is that it precludes one obvious solution. Namely, “It was Greenspan at the Fed, in the subprime market with the credit default swaps.” And, indeed, the problem with the game in general is this crisis was more like Agatha Christie’s, Murder on the Orient Express, where all of the suspects are guilty.

The refusal to see his role as central to the housing bubble and to the proliferation of the dangerous instruments he condemned, made for fascinating television. However, it will not help us get to the truth or to the roadmap for regulatory reform.  He made some useful recommendations (such as substantially increasing capital and liquidity at the banks and shadow banks) and that we need to end “privatizing profit and socializing losses.” However, the lack of candor about the failure of regulators to intervene and the “unintended consequences” of deregulation made his testimony incomplete.  While Greenspan admitted at one point that he was wrong “30 percent of the time,” he did not admit with any kind of particularity that his inaction (and action) were primary contributors to the crisis.

Fortunately, there were many Commissioners on the panel who refused to play the Greenpan Blame Game. They included Phil Angelides, Byron Georgiou, John Thompson and Brooksley Born. Taken together, the panel of Commissioners attempted to demonstrate that the Fed had the ability but not the will to prevent the catastrophe. One problem was that the Fed failed to use its authority under Home Ownership and Equity Protection Act (HOEPA) in a timely and comprehensive manner. HOEPA gave the Fed the authority to make rules governing all practices in the mortgage market. Another was that Greenspan championed the deregulation of the over-the-counter (OTC) derivatives market.

Worth watching in particular was the segment during which Brooksley Born questioned Greenspan about the CFMA. She said that it had “eliminated all federal government regulation of OTC derivatives markets” which meant there was virtually no regulation of the derivatives market. By the summer of 2008, the notional value of the market was $680 trillion. She asked Greenspan whether credit default swaps caused or exacerbated the crisis.  She mentioned that Greenspan had personally recommended their deregulation.

Greenspan replied that only in 2004 did the BIS count CDS. He said the bulk of market is in foreign exchange and interest rate derivatives. He defended them saying how resilient they were in the crisis.  Born countered that that CDS “certainly existed at the time.” She mentioned a 1997 memo. She also referenced Financial Times reporter Gillian Tett’s book, Fool’s Gold, which traced the origins of credit insurance back to the 1990s. She asked him if he believed the $180 billion bailout of AIG was caused by CDS.

Greenspan responded that CDS was just 1% of the total notional value back in 1997. And, while he admitted that AIG “offering and selling vast amounts of CDS was the proximate cause of problem,” he said they could have done the same thing with insurance products.

Born disagreed. She noted that CDS “insure the principal as well as interest,” whereas interest rate swaps only insure interest.  Born also said that $60 trillion (equal to the GDP of all countries of the world) is a “big number.” She also said that with insurance the buyer needs and insurable interest and the seller needs to maintain capital reserves.

For sound-bite seekers, some other highlights included when Greenspan assured Born that notwithstanding the views he expressed in his writing, that he followed the law “unbiased by ideology.” In addition, in the understatement of the day, he remarked that there was “a bit of dubious book keeping going on” at some of the banks.