I agree in theory with just about everything that Tim Geithner said over the past two hours. The trouble is, his solutions-- a systemic risk regulator, giving regulators more powers -- won't be enough to fix the system. You need hard rules in place that force regulators to do their jobs, and you need smaller institutions that won't wreck the economy when they fail, so that market and regulatory errors won't leave us stuck with massive bailouts.
Wallison is really being bizarre here. He keeps saying over and over again that the real problem was not insufficient regulation, but trillions of dollars in complex, illiquid mortgage securities. There is no reason to believe that these things are separate issues.
Brooksley Born on too big to fail. She points out that Geithner had authority over the largest banks in the country when he was at the New York Fed, and that those banks would have failed without massive taxpayer bailouts. Given that record, Born wants to know whether these companies can
Geithner says that they didn't have anybody looking across the system for broad risks-- instead they were focused on individual firms. That's a dumb excuse. All of these institutions were taking huge risks individually. They didn't get hit by some Tsunami outside their own operations-- they were woefully undercapitalized and gambling on a single asset class-- housing.
So then Geithner makes an interesting acknowledgement:
"I do not believe you can depend on a community of regulators always being wise and having foresight."
And yet Geithner opposes breaking up the big banks, and even opposes allowing Congress to set hard caps on leverage.
"When things are going well and people are making money they tend to think it's because they're smart, not lucky."
True. And these people also have lobbyists and are not afraid to use them. That makes it very difficult for regulators to crack down when things are on the up-and-up. Good regulators who actually believe in regulation don't succumb to this pressure, but if you structure a market such that every bank can fail safely, you establish a second layer of protection. The only way to do that is to break up the banks, since regulators themselves will have the choice of whether to invoke the mechanisms to shut down a failing bank or to bail it out.
Bill Thomas spent a very long time asking Geithner why he didn't do anything to deal with the housing bubble, increased leverage, and general insanity that reined on Wall Street between 2003 and 2008, when Geithner was President of the New York Fed.
"We were deeply focused on exactly this risk," Geithner said, referring to the shadow banking market. Geithner also said the New York Fed realized the problem, tried to do something about it, but misunderstood "vulnerability to runs."
That's a rather glaring hole, but at least Geithner acknowledges it.
Geithner does point out that the regulations on commercial banks are generally pretty good, and they should be applied to investment banks, particularly now that investment banks have access to Federal Reserve loans.
"It sure looked to me like some kind of coordinated action." That's Paulson on the short-seller attacks on Bear Stearns in mid-March 2008.
"The discipline of marking securities to market."
Paulson is talking about accounting rules. But wait! I promise this is actually interesting. If you abuse accounting, you can create totally fake profits out of thin air, and pay huge bonuses based on them.
When commercial banks extend a loan, they get to use their own internal metrics to figure out what it's worth. Same thing if they buy a security that they plan to own for a long time. But investment banks have to value their securities holdings at the current market value-- what that security would fetch if they sold it. Marking-to-market makes sense, particularly with complex instruments that are nearly impossible to accurately value based on intrinsic characteristics. Capitalism is about markets.
Congress pushed accounting regulators to relax these mark-to-market rules during the crisis, because once everybody figured out mortgage-backed securities were worthless, they didn't want to buy them, and the market prices plunged. This was a huge under-the-table bailout that has not been reversed. Banks are still using their own secret models to assign value to their holdings, and
This has real implications for ordinary people. Accounting gimmicks are fueling foreclosures. Banks continue to insist that home equity loans are quite valuable based on their internal models, even though home equity loans issued between 2004 and 2007 are worthless. When the value of the house declines, the home equity loan is immediately wiped out.
But if a borrower gets a loan modification on her first mortgage, that modification will wipe out the home equity loan. Now, everybody knows that the home equity loan is actually worthless. But since the bank can book fake profits on that loan by invoking internal models, the bank that owns the home equity loan refuses to let the borrower get help on her first mortgage. Ultimately, this game blows up for everybody. The borrower loses her home, the primary mortgage takes a huge loss on foreclosure and the home equity loan is totally wrecked. But in the short-term, the bank gets to keep saying it's making money on its worthless loans. That's better for the bank than getting wiped out now with no short-term payments.
Interesting discussion of what went wrong at Fannie and Freddie. Basically, Paulson is saying these firms weren't appropriately or effectively regulated.
For all the Republican bluster on Fannie and Freddie, the actual problem is that they weren't regulated. They were allowed to operate like the largest hedge funds in the world, and hedge funds are inherently unstable.
"Complexity, in general, is our enemy."
Paulson is talking to Brooksley Born about derivatives, and backing up my prior point. Paulson says we need to standardize as much of the derivatives market as possible, trade the standardized stuff on exchanges, and penalize the non-standardized stuff with onerous capital requirements, effectively making banks pay a lot of money for trading off exchanges.
This is a beautiful moment. Brooksley Born's career was crushed by Alan Greenspan, Robert Rubin and Larry Summers in the late 1990s because she had the audacity to suggest that we regulate the derivatives market. Now one of the most powerful CEOs in history and a Republican Treasury Secretary is saying that Brooksley Born was exactly right about derivatives reform, and endorsing a thorough overhaul of the market.
But why does it take 12 years and the worst financial crisis in history to get people to believe in regulation? Mike Konczal has a great post up about regulation in the 1970s , in which the SEC defends itself by saying tough regulations and enforcement helped ensure the post-World War II American prosperity. Why isn't that the default view anymore? Why do people believe that letting Wall Street run wild is going to be good for the economy?
And now Bill Thomas comes to his point: rating agency reform. Thomas is pointing out that the Wall Street overhaul is pretty much ignoring rating agencies, and that's a problem. Paulson says we need to defang rating agencies by just removing all references to rating agencies in securities laws.
There's a sense in which Paulson's position is perfect, and a sense in which it's just reckless insanity.
If Wall Street securities were simple, straightforward and easily decipherable, we really wouldn't need rating agencies. But the last crisis showed very clearly that investors of all stripes-- from banking behemoths to pension fund managers to individuals-- couldn't figure out what crazy complex securities were worth, or assess the risks of such securities. Ex-Merrill Lynch CEO John Thain has acknowledged that there is no way to accurately value some of the most complicated securities out there.
So if we dramatically simplify the securities business with very strict regulations, I don't think we'd need rating agencies. But if we don't do that, we still have a very complicated business in need of simplification. That's what rating agencies are supposed to do, take some investment and explain in easily understood terms how risky it is. That can be a legitimate public service. But it has to be restructured, because the current model, in which securities issues pay the rating agency for ratings, is totally corrupt.
Bill Thomas is completely useless. He's long-winded, boring, and prone to lengthy analogies that just don't make sense. He's been going on about crows for a few minutes, and how crows are like Bear Stearns and rating agencies. I can't tell if he's trying to sabotage the hearing, or if he's just a clueless ex-politician.
Angelides is asking Paulson on the alleged fraud with Goldman and Abacus. Paulson is explaining how the business of market-making works and how underwriting securities works. Paulson's explanations are neither here nor there. Nobody wants to end market-making, and nobody wants to ban securities.
Angelides should have pressed Paulson harder here. It's not okay to lead your client to believe you are long on an investment when you are shorting it. Paulson points out that securities underwriting often involves investment bankers taking a short position to hedge their risk. That's not what Goldman is accused of doing in Abacus. They're accused of taking a massive short in order to profit from the security's failure. The accusation is not that they were hedging their risk, but making a bet that this security would fail, not telling their clients about it, and profiting in the process
Paulson is giving a pretty standard history of the crisis, in which everybody screws up and large economic forces are at work. I don't think many people dispute the broad outline of his narrative, but the policy implications of this story are very much in dispute.
Paulson is also harping on one of my pet peeves by talking about our "archaic and outmoded" regulatory system that was "built at a different time for a different system and it has not kept pace" with financial innovation. The repeal of Glass-Steagall and the passage of the Commodities Futures Modernization Act made our regulatory system outmoded. They were an intentional effort to defang regulators, because people really believed regulation hurt the system.
The good news is that even Goldmanite freemarketeers like Henry Paulson actually believe in regulation now. The bad news? In March of 2008, Paulson published a book-length paper on reforming our regulatory system. This was prior to the financial collapse. And Paulson's preferred reforms from that time form the core of the reforms currently in the Senate . . . except the Senate bill has been shot through with loopholes that make even Henry Paulson's preferences weaker.