On the Various Causes of the Financial Crisis of 2008: Have We Learned Anything?

In January, 2011, the Financial Crisis Commission announced its findings. The usual suspects were not much of a surprise; what is particularly notable is how little had changed on Wall Street since the crisis in September of 2008. According to The New York Times, "The report examined the risky mortgage loans that helped build the housing bubble; the packaging of those loans into exotic securities that were sold to investors; and the heedless placement of giant bets on those investments." In spite of the Dodd-Frank Financial Reform Act of 2010 and the panel's report, The New York Times reported that "little on Wall Street has changed." One commissioner, Byron S. Georgiou, a Nevada lawyer, said the financial system was “not really very different” in 2010 from before the crisis. “In fact," he went on, "the concentration of financial assets in the largest commercial and investment banks is really significantly higher today than it was in the run-up to the crisis, as a result of the evisceration of some of the institutions, and the consolidation and merger of others into larger institutions.” Richard Baker, the president of the Managed Funds Association, told The Financial Times, "The most recent financial crisis was caused by institutions that didn't know how to adequately manage risk and were over-leveraged. And I worry that if there is another crisis, it will be because the same institutions have failed to learn from the mistakes of the past." From the testimonies of managers of some of those institutions, one might surmise that the lack of learning in the two years after the crisis was due to a refusal to admit to even a partial role in crisis.  In other words, there appears to have been a crisis of mentality, which, as it contains intractable assumptions and ideological beliefs, as well as stubborn defensiveness, is not easy to dislodge such that legislation past Dodd-Frank could ever be passed.
It is admittedly tempting to go with the status quo than be responsible for reforms. If the reformers are also the former perpetrators, their defensiveness and ineptitude mesh well with the continuance of the status quo even if an entire economy the size of an empire is left vulnerable to a future crisis. To comprehend the inherent danger in the sheer continuance of the status quo, it is helpful to digest the panel's findings. 
The crisis commission found "a bias toward deregulation by government officials, and mismanagement by financiers who failed to perceive the risks." The commission concluded, for example, that "Fannie and Freddie had loosened underwriting standards, bought and guaranteed riskier loans and increased their purchases of mortgage-backed securities because they were fearful of losing more market share to Wall Street competitors." These two organizations were not really market participants, as they were guaranteed by the U.S. Government. That government-backed corporations would act so much like private competitive firms undercuts the assumed civic mission that premises government-underwriting. All this ought to have raised a red flag for everyone--not just the panel which stressed the need for a pro-regulation verdict. 

Lehman was a particularly inept player leading up to the crisis.     Zambio

In terms of the private sector, The New York Times reported that the panel "offered new evidence that officials at Citigroup and Merrill Lynch had portrayed mortgage-related investments to investors as being safer than they really were. It noted — Goldman’s denials to the contrary — that 'Goldman has been criticized — and sued — for selling its subprime mortgage securities to clients while simultaneously betting against those securities.'”  The bank's proprietary net-short position could not be justified by simply market-making as a counter-party to its clients, Blankfein's congressional testimony notwithstanding. 
Relatedly, the panel also pointed to problems in executive compensation at the banks. For example, Stanley O’Neal, chief executive of Merrill Lynch, a bank which failed in the crisis, told the commission about a “dawning awareness” through September 2007 that mortgage securities had been causing disastrous losses at the firm; in spite of his incompetence, he walked away weeks later with a severance package worth $161.5 million. The panel might have gone on to point to the historically relatively huge difference between CEO and lower-level manager compensation and questioned the relative merit, but such a conclusion would go beyond the commission's mission to explain the financial crisis.

With regard to the government, The New York Times reported that the panel "showed that the Fed and the Treasury Department had been plunged into uncertainty and hesitation after Bear Stearns was sold to JPMorgan Chase in March 2008, which contributed to a series of “inconsistent” bailout-related decisions later that year." The Federal Reserve was clearly the steward of lending standards in this country,” said one commissioner, John W. Thompson, a technology executive. “They chose not to act.” Furthermore, Sabeth Siddique, a top Fed regulator, described how his 2005 warnings about the surge in “irresponsible loans” had prompted an “ideological turf war” within the Fed — and resistance from bankers who had accused him of “denying the American dream” to potential home borrowers. That is to say, the Federal Reserve, a corporation wholly owned by the U.S. Government, is too beholden to bankers instead of the common good. So we are back to the issue of a government-guaranteed corporation acting like or on behalf of private companies (and badly at that).
We can conclude generally that governmental, governmental-supported, and private institutions, all acting in their self interests, contributed to a "perfect storm" that knocked down Bear Stearns, Lehman Brothers, Countrywide, AIG, and Freddy and Fannie Mae. Systemically, the commercial paper market--lending between banks--seized up and many of the housing markets in the U.S. took a severe fall such that home borrowers awoke to find their homes under water. The Federal Reserve was caught off-guard, as its chairman, Ben Bernanke, had been claiming that the housing markets could be relied on to stay afloat. Relatedly, AIG insured holders of mortgage-based bonds without bothering to hold enough cash in reserves in case of a major decline in the housing markets all at once. Neither the insurer nor the investment banks that had packaged the subprime mortgages into bonds though to investigate whether Countrywide's mortgage producers had pushed through very risky mortgages before selling them to the banks to package. In short, people who were inept believed nonetheless that they could not be wrong. Dick Fuld, Lehman's CEO, had the firm take on too much debt to buy real estate so that eventually his firm would be as big as Goldman Sachs. That such recklessness would be on the behest of a childish desire to be as big as the other banks testifies as to the need for financial regulation that goes beyond the "comfort zone" of Wall Street's bankers and their political campaign "donations."

See also Essays on the Financial Crisis: Systemic Greed and Arrogant Stupidity, available at Amazon.

Source:

Sam Jones, "Hedge Funds Rebuke Goldman," Financial Times, January 28, 2011, p. 18.

Decreasing Bank Size by Increasing Capital-Reserve Requirements: Plutocracy in Action?

Although the Dodd-Frank Financial Reform Act was passed in 2010 with some reforms, such as liquidity standards, stress tests, a consumer-protection bureau, and resolution plans, the emphasis on additional capital requirements (i.e., the SIFI surcharges) could be considered as weak because they may not be sufficient should another financial crisis trigger a shutdown in the commercial paperr market (i.e., banks lending to each other). A study by the Federal Reserve Bank of Boston found that even the additional capital requirements in Dodd-Frank would not have been enough for eight of the 26 banks with the largest capital loss during the financial crisis of 2008. As overvalued assets, such as subprime mortgage-backed derivatives, plummet in value, banks can burn through their capital reserves very quickly. A frenzy of short-sellers can quicken the downward cycle even more. This raises the question of whether additional capital resources would quickly be "burnt through" rather than being able to stand for long as a bulwark. The financial crisis showed the cascading effect that can quickly run through a banking sector as fear even between banks widens as one damaged bank impacts another, and another. 
With the $6.2 billion trading loss at JPMorgan Chase in the hindsight, Sen. Sherrod Brown (D-Ohio) and Sen. David Vitter (R-La) in the U.S. Senate proposed a bill that would require banks with more than $400 billion in assets to hold at least 15 percent of those assets in hard capital. The two senators meant this requirement to encourage the multi-trillion-dollar banks to split up into smaller banks. Although it had been argued that gigantic banks are necessary given the size of the loans wanted by the largest corporations, banks had of course been able to form syndicates to finance such mammoth deals. 
The Senate had recently voted 99-0 on a nonbinding resolution to end taxpayer subsidies to too-big-to-fail banks, so the U.S. Senate had Wall Street’s attention. Considering that the U.S. House of Representatives was working on legislation to deregulate derivatives, the chances that the U.S. Government would stand up to Wall Street even to the too-big-to-fail systemic risk were slim to nil. Indeed, the U.S. Department of Justice’s criminal division had been going easy in prosecuting the big banks for fraud out of fear that a conviction would cause a bank collapse (or because President Obama had received very large donations from Wall Street banks including notably Goldman Sachs).
The two senators’ strategy of going about breaking up the biggest banks indirectly by increasing their reserve requirements disproportionately didn't work, at least as of 2019. Advantages of size, including the human desire to empire-build (witness Dick Fuld at Lehman Brothers), could have been expected to outweigh the economic preference for a lower, more proportionate, reserve requirement. With anti-trust laws having been used to break up giants such as Standard Oil and ATT, the thought of breaking up the banks too big to fail even in the wake of the financial crisis was strangely viewed as radical and thus at odds with American incrementalism. The question was simply whether systemic risk should be added to monopoly (i.e., restraint of trade) as an additional rationale for breaking up huge concentrations of private property. This question could have been made explicit, rather than trying to manipulate the big banks to lose some weight.  
The approach of using disproportionately reserves can be critiqued on at least two grounds. First, should one or more of those banks decide to go with the 15% requirement rather than break up into smaller firms, even the additional capital might not be enough to protect a bank during a financial crisis. The study discussed above suggested as much. Second, even if the additional requirements would turn out to be sufficient in a crisis, the approach would obviate a decision by the government on whether systemic risk justifies a cap on how large banks can get. 
I suspect that the U.S. Congress and president backed off in really reforming Wall Street because of its money in campaign finance. In short, the big banks in Wall Street didn't want to shrink. In a system of political economy wherein the economy is regulated by government, rather than vice versa, backing off just because large concentrations of wealth (and thus power--even political) don't like the plans is unacceptable. Moreover, it is a sign of encroaching plutocracy wherein the regulated dictate behind closed doors to the regulators and politicians. Meanwhile, the public, including the economy itself, remains vulnerable. 

See Essays on the Financial Crisis: Systemic Greed and Arrogant Stupidity, available at Amazon.

Sources:

Eric Rosengren, “Bank Capital: Lessons from the U.S. Financial Crisis,” Federal Reserve Bank of Boston, February 25, 2013.
Zach Carter and Ryan Grim, “’Break Up the Banks’ Bill Gains Steam in Senate As Wall Street Lobbyists Cry Foul,” The Huffington Post, April 8, 2013.

Johnson’s “Reinvention” of JC Penney: Too Much and Too Little

In April 2013, JC Penney’s board wished the CEO, Ron Johnson, “the best in his future endeavors.” His effort to “reinvent” the company had been “very close to a disaster,” according to the largest shareholder, William Ackman. During Johnson’s time at the company as its CEO, shares fell more than fifty percent. In February 2013, Johnson admitted to having made “big mistakes” in the turnaround. For one thing, he did not test-market the changes in product-line and pricing-points. The latter in particular drove away enough customers for the company’s sales to decline by 25 percent. Why did Johnson fail so miserably?

Ron Johnson's short tenure as CEO of JC Penney was disastrous, according to Altman.   Source: Reuters

Some commentators on CNBC claimed that JC Penney’s board directors should have known better than hire someone from Apple to have so much responsibility right off the bat in a department store. However, Johnson had been V.P. for merchandising at Target before going over to Apple. Therefore, Penney’s board cannot be accused of ignoring the substantive differences between sectors. Even so, Target and Walmart are oriented to one market-segment, whereas JC Penney, Kohls and Macys are oriented to another. Perhaps had he taken the time to have market tests done at JC Penney, any error in applying what he had learned at Target could have been made transparent.
Although as the former CEO Ullman who would be replacing Johnson pointed out, customer tastes are always changing so you can’t go back to worked in the past, to “reinvent” a company goes too far in the other direction. For one thing, it is risky for a retail company to shift from one market-segment to another, given the company's image. Additionally, to “reinvent” something is to start from scratch to come up with something totally new. Even if that were possible for a retail chain, the “new front” would likely seem fake to existing customers. “They are trying to be something they are not,” such customers might say. Put another way, Ron Johnson might have gotten carried away.
In an interview just after Johnson’s hiring at JC Penney had been announced in June 2011, he said, “In the U.S., the department store has a chance to regain its status as the leader in style, the leader in excitement. It will be a period of true innovation for this company.” A department store is exciting? Was he serious? Perhaps his excitement got the better of him in his zeal for change. Were the changes really of “true innovation?” Adding Martha Stewart kitchen product-lines was hardly innovative—nor was getting rid of clearance sales and renovating store designs and the company logo.
Renovation generally-speaking is rather superficial, designed perhaps to give customers an impression of more change than s actually the case. Is a given renovation an offshoot of marketing or strategy? Ron Johnson may have been prone to exaggeration, as evinced by his appropriation of faddish jargon, while coming up short in terms of substantive change. In an old company trying to be something it's not (i.e., going from a promotional to a specialty pricing strategy), too much superficial change can easily outweigh too little real change. Sometimes even upper-level managers can get carried away with their own jargon in trying to make their respective companies something they are not. It is like a person trying to be someone he or she is not. In "reinventing" JC Penney, Ron Johnson was trying to make an old woman come off as young by applying make-up and new clothes.

Sources:

Stephanie Clifford, “J.C. Penney Ousts Chief of 17 Months,” The New York Times, April 9, 2013.

Joann Lublin and Dana Mattioli, “Penney CEO Out, Old Boss Back In,” The Wall Street Journal, April 8, 2013.

Is Modest Growth vs. Full Employment a False Dichotomy?

As Summer slid into Autumn in 2012, the Chinese government was giving no hint of any ensuing economic stimulus program. This was more than slightly unnerving for some, as a recent manufacturing survey had slumped more than expected, to 49.2 in August. A score of 50 separated expansion from contraction. A similar survey, by HSBC, came in at 47.6, down from 49.3 the previous month. Bloomberg suggested that China might face a recession in the third quarter. So why no stimulus announcement?  Was the Chinese government really just one giant tease? I submit that the false dichotomy of moderate economic growth and full employment was in play. In short, the Chinese government did not want to over-heat even a stagnant economy even though the assumption was that full employment would thus not be realizable.

Wang Tao, an economist at UBS, explained the “very reactionary, cautious approach” as being motivated by the desire to avoid repeating the “excesses of last time.”[1] The stimulus policy in the wake of the 2008 global downturn had sparked inflation and caused a housing bubble in China. According to The New York Times, China was avoiding “measures that could reignite another investment binge of the sort that sent prices for property and other assets soaring in 2009 and 2010.”[2] A repeat of any such binge could not be good, for it can spark the sort of irrational excitement that have a life of its own.
In short, too much stimulus in an economy can cause inflation and put people’s homes at risk of foreclosure once the housing bubble bursts, whereas a lack of stimulus means that a moderate growth rate is likely, rather one that could give rise to full employment. Is there no way out of this trade-off? 
Keeping fiscal or monetary stimulus within projections of a moderate growth can occur with more government spending targeted to a combination of giving private employers a financial incentive to hire more people and increasing the number of people hired by state enterprises. In principle with the Full Employment Act of the U.S. in 1946, a government can see that anyone who wants a job has one, while still maintaining a moderate stimulus. A modest growth-rate can co-exist with full employment. 

1, Bettina Wassener, “As Growth Flags, China Shies From Stimulus,” The New York Times, September 3, 2012. 
2. Ibid.