Financial Crisis Was Avoidable, Inquiry Finds

http://www.nytimes.com/2011/01/26/business/economy/26inquiry.html?_r=1

Financial Crisis Was Avoidable, Inquiry Finds

By SEWELL CHANPublished: January 25, 2011

WASHINGTON — The 2008 financial crisis was an “avoidable” disaster  
caused by widespread failures in government regulation, corporate  
mismanagement and heedless risk-taking by Wall Street, according to  
the conclusions of a federal inquiry.

The commission that investigated the crisis casts a wide net of blame,  
faulting two administrations, theFederal Reserve and other regulators  
for permitting a calamitous concoction: shoddy mortgage lending, the  
excessive packaging and sale of loans to investors and risky bets on  
securities backed by the loans.
“The greatest tragedy would be to accept the refrain that no one could  
have seen this coming and thus nothing could have been done,” the  
panel wrote in the report’s conclusions, which were read by The New  
York Times. “If we accept this notion, it will happen again.”

While the panel, the Financial Crisis Inquiry Commission, accuses  
several financial institutions of greed, ineptitude or both, some of  
its gravest conclusions concern government failings, with embarrassing  
implications for both parties. But the panel was itself divided along  
partisan lines, which could blunt the impact of its findings.

Many of the conclusions have been widely described, but the synthesis  
of interviews, documents and testimony, along with its government  
imprimatur, give the report — to be released on Thursday as a 576-page  
book — a conclusive sweep and authority.

The commission held 19 days of hearings and interviews with more than  
700 witnesses; it has pledged to release a trove of transcripts and  
other raw material online.

Of the 10 commission members, the six appointed by Democrats endorsed  
the final report. Three Republican members have prepared a dissent  
focusing on a narrower set of causes; a fourth Republican, Peter J.  
Wallison, has his own dissent, calling policies to promote  
homeownership the major culprit. The panel was hobbled repeatedly by  
internal divisions and staff turnover.

The majority report finds fault with two Fed chairmen: Alan Greenspan,  
who led the central bank as the housing bubble expanded, and his  
successor, Ben S. Bernanke, who did not foresee the crisis but played  
a crucial role in the response. It criticizes Mr. Greenspan for  
advocating deregulation and cites a “pivotal failure to stem the flow  
of toxic mortgages” under his leadership as a “prime example” of  
negligence.

It also criticizes the Bush administration’s “inconsistent response”  
to the crisis — allowingLehman Brothers to collapse in September 2008  
after earlier bailing out another bank,Bear Stearns, with Fed help —  
as having “added to the uncertainty and panic in the financial markets.”

Like Mr. Bernanke, Mr. Bush’s Treasury secretary, Henry M. Paulson  
Jr., predicted in 2007 — wrongly, it turned out — that the subprime  
collapse would be contained, the report notes.

Democrats also come under fire. The decision in 2000 to shield the  
exotic financial instruments known as over-the-counter derivatives  
from regulation, made during the last year of President Bill Clinton’s  
term, is called “a key turning point in the march toward the financial  
crisis.”

Timothy F. Geithner, who was president of the Federal Reserve Bank of  
New York during the crisis and is now the Treasury secretary, was not  
unscathed; the report finds that the New York Fed missed signs of  
trouble at Citigroup and Lehman, though it did not have the main  
responsibility for overseeing them.

Former and current officials named in the report, as well as financial  
institutions, declined Tuesday to comment before the report was  
released.

The report could reignite debate over the influence of Wall Street; it  
says regulators “lacked the political will” to scrutinize and hold  
accountable the institutions they were supposed to oversee. The  
financial industry spent $2.7 billion on lobbying from 1999 to 2008,  
while individuals and committees affiliated with it made more than $1  
billion in campaign contributions.

The report does knock down — at least partly — several early theories  
for the financial crisis. It says the low interest rates brought about  
by the Fed after the 2001 recession;Fannie Mae and Freddie Mac, the  
mortgage finance giants; and the “aggressive homeownership goals” set  
by the government as part of a “philosophy of opportunity” were not  
major culprits.

On the other hand, the report is harsh on regulators. It finds that  
the Securities and Exchange Commission failed to require big banks to  
hold more capital to cushion potential losses and halt risky  
practices, and that the Fed “neglected its mission.”

It says the Office of the Comptroller of the Currency, which regulates  
some banks, and the Office of Thrift Supervision, which oversees  
savings and loans, blocked states from curbing abuses because they  
were “caught up in turf wars.”

“The crisis was the result of human action and inaction, not of Mother  
Nature or computer models gone haywire,” the report states. “The  
captains of finance and the public stewards of our financial system  
ignored warnings and failed to question, understand and manage  
evolving risks within a system essential to the well-being of the  
American public. Theirs was a big miss, not a stumble.”

The report’s implications may be felt more in the political realm than  
in public policy. The Dodd-Frank law overhauling the regulation of  
Wall Street, signed in July, took as its premise the same regulatory  
deficiencies cited by the commission. But the report is sure to be a  
factor in the debate over the future of Fannie and Freddie, which have  
been run by the government since 2008.

Though the report documents questionable practices by mortgage lenders  
and careless betting by banks, one striking finding is its portrayal  
of incompetence.

It quotes Citigroup executives conceding that they paid little  
attention to mortgage-related risks. Executives at the American  
International Group were found to have been blind to its $79 billion  
exposure to credit-default swaps, a kind of insurance that was sold to  
investors seeking protection against a drop in the value of securities  
backed by home loans. AtMerrill Lynch, managers were surprised when  
seemingly secure mortgage investments suddenly suffered huge losses.

By one measure, for about every $40 in assets, the nation’s five  
largest investment banks had only $1 in capital to cover losses,  
meaning that a 3 percent drop in asset values could have wiped out the  
firm. The banks hid their excessive leverage using derivatives, off- 
balance-sheet entities and other devices, the report found. The  
speculative binge was abetted by a giant “shadow banking system” in  
which the banks relied heavily on short-term debt.

“When the housing and mortgage markets cratered, the lack of  
transparency, the extraordinary debt loads, the short-term loans and  
the risky assets all came home to roost,” the report found. “What  
resulted was panic. We had reaped what we had sown.”

The report, which was heavily shaped by the commission’s chairman,  
Phil Angelides, is dotted with literary flourishes. It calls credit- 
rating agencies “cogs in the wheel of financial destruction.”  
Paraphrasing Shakespeare’s “Julius Caesar,” it states, “The fault lies  
not in the stars, but in us.”

Of the banks that bought, created, packaged and sold trillions of  
dollars in mortgage-related securities, it says: “Like Icarus, they  
never feared flying ever closer to the sun.”
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