Below is my wish list for lines of inquiry for the Financial Crisis Inquiry Commission that was created in May 2009. What lines of inquiry would you like to see from this "independent" commission? We must understand the extent of the problems that precipitated this crisis in order to make policy decisions that will prevent this from happening again. BTW, as of July 10, 2009, the Financial Crisis Inquiry Commission has not been formed.
The Act that created the Financial Crisis Inquiry Commission enumerated various issues that the Commission should and has the authority to address:
(1) to examine the causes of the current financial and economic crisis in the United States, specifically the role of--
(A) fraud and abuse in the financial sector, including fraud and abuse towards consumers in the mortgage sector;
(B) Federal and State financial regulators, including the extent to which they enforced, or failed to enforce statutory, regulatory, or supervisory requirements;
(C) the global imbalance of savings, international capital flows, and fiscal imbalances of various governments;
(D) monetary policy and the availability and terms of credit;
(E) accounting practices, including, mark-to-market and fair value rules, and treatment of off-balance sheet vehicles;
(F) tax treatment of financial products and investments;
(G) capital requirements and regulations on leverage and liquidity, including the capital structures of regulated and non-regulated financial entities;
(H) credit rating agencies in the financial system, including, reliance on credit ratings by financial institutions and Federal financial regulators, the use of credit ratings in financial regulation, and the use of credit ratings in the securitization markets;
(I) lending practices and securitization, including the originate-to-distribute model for extending credit and transferring risk;
(J) affiliations between insured depository institutions and securities, insurance, and other types of nonbanking companies;
(K) the concept that certain institutions are ‘too-big-to-fail’ and its impact on market expectations;
(L) corporate governance, including the impact of company conversions from partnerships to corporations;
(M) compensation structures;
(N) changes in compensation for employees of financial companies, as compared to compensation for others with similar skill sets in the labor market;
(O) the legal and regulatory structure of the United States housing market;
(P) derivatives and unregulated financial products and practices, including credit default swaps;
(R) financial institution reliance on numerical models, including risk models and credit ratings;
(S) the legal and regulatory structure governing financial institutions, including the extent to which the structure creates the opportunity for financial institutions to engage in regulatory arbitrage;
(T) the legal and regulatory structure governing investor and mortgagor protection;
(U) financial institutions and government-sponsored enterprises; and
(V) the quality of due diligence undertaken by financial institutions;
(2) to examine the causes of the collapse of each major financial institution that failed (including institutions that were acquired to prevent their failure) or was likely to have failed if not for the receipt of exceptional Government assistance from the Secretary of the Treasury during the period beginning in August 2007 through April 2009;
This list is pretty thorough. However, I would like to add very specific incidents and policy decisions involved in this crisis and should be thoroughly investigated:
- Gramm Leach Bliley Act of 1999 (AKA Financial Services Modernization Act) - GLBA repealed several key provisions of the Glass-Steagall Act of 1933. The most important Glass-Steagall provision that was repealed was the one that mandated that commercial banking be separate from investment banking and other financial services functions. This law shielded depositors from the hazards of risky investments and speculations. The essentially keep commercial banking boring and conservative. The banking industry had been lobbying for the repeal of key provisions of Glass-Steagall during the 1980's. They argued it would be beneficial to consumers because it would provide a "one stop shop" for financial services at lower costs. What they didn't say was that it did wonders for their bottom line and opened the flood gates to grow into financial conglomerates. Citigroup was the first to truly benefit from GLBA.
- Commodities Futures Modernization Act of 2000 - This act was essential in the proliferation of Credit Default Swaps. It basically said that the federal and state governments will not regulate the "Over the Counter" market for financial derivatives. The Wall Street Casinos were open for business and AIG found a great money maker - writing almost limitless CDS contracts with no margin or capital requirements.
- Fannie/Freddie Gets a Free Ride and What to do With them - Fannie Mae and Freddie Mac are (or were) government sponsored enterprises (GSE). The Federal government created both organizations but they were publicly traded companies with shareholders. A strange and turns out troubling hybrid. The original intent of both organizations (BTW there is a government owned enterprise that is not publicly traded called Ginnie Mae - Government National Mortgage Association) was to provide liquidity to the mortgage market through securitization. The original intent was admirable but the problem was in the execution. Fannie/Freddie operated like a public company in the pursuit of profit and shareholder returns but at the same time had to answer to politicians in Washington (both political parties). Its executives were beneficiaries of generous compensation plans.
Fannie/Freddie (particularly Fannie) employed a very powerful lobbying organization that it used very effectively to kill any legislative proposals that limited or tried to regulate its securitization activity. Fannie had a very good and profitable relationship with Countrywide Financial (before it was bought by Bank of America). Countrywide would originate the mortgage loans in huge quantities and Fannie would purchase them from Countrywide - practically no questions asked.
- SEC's net capital ruling of 2004 - Here is how a very good article from the New York Times describes this SEC decision:
On that bright spring afternoon, the five members of the Securities and Exchange Commission met in a basement hearing room to consider an urgent plea by the big investment banks.
They wanted an exemption for their brokerage units from an old regulation that limited the amount of debt they could take on. The exemption would unshackle billions of dollars held in reserve as a cushion against losses on their investments. Those funds could then flow up to the parent company, enabling it to invest in the fast-growing but opaque world of mortgage-backed securities; credit derivatives, a form of insurance for bond holders; and other exotic instruments.
Five investment banks led the charge to loosen the net capital requirements including Bear Stearns (failed) and Lehman Brothers (bigger failed). This opened the door for these financial conglomerates to go hog wild in their risk taking. The SEC did another very interesting thing with this ruling. It also decided to rely on the firms’ own computer models for determining the riskiness of investments. That is right self-regulation and what did self-regulation lead to:
Over the following months and years, each of the firms would take advantage of the looser rules. At Bear Stearns, the leverage ratio — a measurement of how much the firm was borrowing compared to its total assets — rose sharply, to 33 to 1. In other words, for every dollar in equity, it had $33 of debt. The ratios at the other firms also rose significantly.
- AIG bailout - We need to know the decision making process for providing $70 billion to AIG and effectively owning this insurance conglomerate. Was Goldman Sachs involved in the discussions to bailout AIG? If so, why? Did the Fed pay market value or more for the securities that were enhanced by CDS contracts written by AIG?
- IndyMac/WaMu fiascos - In the case of IndyMac, why did federal regulators ignore the problems? Did the same thing happen to Washington Mutual?
The truth about this financial crisis will be painful for both political parties. Can Washington handle the truth? We anxiously wait to see.