The Financial Crisis Inquiry Commission Report: Downplaying derivatives

Matías Vernengo

The Financial Crisis Inquiry Commission (FCIC) released its report last week, and concluded that the crisis was foreseeable and avoidable.  The FCIC argues that authorities were permissive and that: “the prime example [of permissiveness] is the Federal Reserve’s pivotal failure to stem the flow of toxic mortgages, which it could have done by setting prudent mortgage-lending standards.”  The report is right to emphasize that failures of regulation and supervision were crucial to the eventual collapse, which by the way is a fitting indictment of Geithner, Bernanke and several other policy-makers still in key positions.

The thrust of the FCIC report concludes that excessive leverage and lack of transparency were at the heart of the crisis.  It also argues that over the counter (OTC) derivatives contributed to the crisis, and that the decision not to regulate derivative markets was a mistake.  Finally, the report suggests that “one type of derivative—credit default swaps (CDS)—fueled the mortgage securitization pipeline.”  When the housing prices collapsed, derivatives then were central to the crisis.  The main conclusions in the report are not new or particularly controversial.

As Yogi Berra put it: “you can observe a lot just by watching.”  The problem with the report is not so much that it states the obvious, but that it actually misses the point of why derivatives were central for the crisis.  The FCIC argues that “capital availability and excess liquidity, the role of Fannie Mae and Freddie Mac (the GSEs), and government housing policy” were the three main causes of the crisis.  In this view, derivatives are relevant only because they allow the excessive expansion of credit.

In fact, the slim set of recommendations in the concluding section of the report suggests that regulation is needed to avoid excessive credit creation, and that governmental housing policies should be changed.  This obviously will please those who support the current set of limited regulations and who prefer to avoid looking for culprits.  As noted by Frank Partnoy, this is no Pecora Commission.

The problem is that derivatives were central to the crisis not just because they allowed excessive borrowing in the run up to the housing bubble collapse.  It was excessive speculation in the financial sector, not excessive borrowing by families to buy houses, that led to the crisis.  In fact, the vast majority of OTC derivatives in June of 2008, on the verge of the crisis, were (and still are) interest-rate swaps, not directly connected to subprime lending, according to the Bank of International Settlements (BIS).  Supposedly trading in those instruments reduces risk exposure, but it is hard to defend this idea after the Lehman collapse.

It is important to note that the huge notional value of derivatives contracts outstanding of more than US$580 trillion as of June 2010 reflects the fact that banks are still fundamentally in the business of proprietary trading, that is, speculative investment.  This incredible figure, more than 10 times world GDP, represents what in previous crises was referred to as debt overhang.  As noted by Jane D’Arista, Jerry Epstein, and other economists at Experts for Stable, Accountable, Fair and Efficient Financial Reform (SAFER), proprietary investments made a much bigger contribution to bank revenues (and losses) than bankers and the press have suggested, and their ability to do so should be severely restricted.

The European crisis is not disconnected from the fact that a great amount of collateralized debt obligations (CDO) had been sold to European institutions, and that the holders of these bonds in many instances became insolvent.  In Europe, of course, there are other problems associated with the structure of the common currency, but debt overhang (a typical problem in all debt crises) is certainly important.  And debt overhang implies that the mechanisms that led to the previous crisis are still in place.  The fact that the prices of commodities are still influenced by the strong presence of speculators, as noted in the United Nations Conference on Trade and Development’s (UNCTAD) Trade and Development Report, implies that the recovery in the periphery is also at risk.

The report misses the opportunity to promote a more comprehensive reform of the financial sector.  Keynes believed, correctly, that those who disagreed with him would “fluctuate … between a belief that [he was] quite wrong and a belief that [he was] saying nothing new.”  And so it will be with those who read this report.

8 Responses to “The Financial Crisis Inquiry Commission Report: Downplaying derivatives”

  1. Kevin P. Gallagher says:

    Glad someone commented on this. I’m now through only about a third of it and am about to give up. Shocking to me how poorly this is put together. This is a much bigger story than deregulation and greed. The piece that is most missing is the “story.” This report is some trees, no forest. The crisis was a Kindleberger/Minsky-like mania, panic, and crash. There is no acknowledgement of that, nor an alternative narrative. The second problem, which surprisingly the Republicans discuss a tad but wholly inadequately, is the global dimension. There is little understanding of the interlocking nature of the shadow banking system, and how global it is. The amount of European exposure to toxic assets was extreme and was a key transmitter of making this a global crisis (you wouldn’t know it was a global crisis from reading the report). The report also hardly weighs in on the controversy regarding whether the underlying problems were due to a savings glut or ballooning deficits in the US. Oh yeah, then there is the fact that the report comes to us AFTER the regulatory debate happened. So much for informed debate.

  2. I agree particularly on your last point. This report seems like they are whitewashing the whole crisis.

  3. Ilene Grabel says:

    I agree with Kevin and Matias regarding the multiple “sins” of this report.

    I do have to admit, however, that I was pleased to see that Greenspan comes in for a real drubbing. I was also pleased that the report does at least highlight the contribution of free market ideology and the sheer corruption of the policy making process by financial interests as important contributors to the crisis. Moreover, at least the report takes on the new conventional wisdom that the crisis was just an inexplicable perfect storm that “we” never could have imagined, a view that seems to have been pushed by representatives of the private financial community at the World Economic Forum in Davos last week (along with the view that regulators should just stop giving financiers a hard time-they have feelings, too!).

    BUT the report nevertheless is a stunning and disappointing document.

  4. Kevin P. Gallagher says:

    Yes, perhaps I was too harsh. Another key aspect of the report is the in depth story of exactly how exposed an ingrained Citi was–which has largely unknown. Of course, Rubin’s hands are filthy throughout. I also agree with Ilene that Greenspan gets hit. He takes the blame for the short-term rates. And Bush gets some blame for further deregulation and the lack of regulation in terms of the shadow banking system. But less so on over-expansionary fiscal policy during a boom (which relates to the lack of a “story” point I made earlier). I think the long-term rate liquidity was largely due to the US budget deficit–two wars that no one else would pay for plus a tax cut. We wouldn’t be in the midst of this budget hysteria and looking at a limp recovery if…

  5. Jane D'Arista says:

    All the above are points with which I agree – that the report missed much but, as Ilene notes, it does lay blame directly where it should. I think one other thing missing is what happened to the structure of the system. My SAFER colleague, Jennifer Taub, sent me a speech by Paul McCully (which I had not seen) in which he notes that the critical structural issue in the development of the “shadow banking system” (which he takes credit for naming) was the growth of non-deposit liabilities in the system – a point Tom Schlesinger and I made in our 1993 EPI paper, “The Parallel Banking System”. The explosion in derivatives and the debt overhang were made possible because the regulators allowed the mega-institutions to use their own balance sheets to create liquidity by monetizing debt through repo and cp markets.

  6. Ramanan says:

    I agree with commentators that the report makes absolutely no mention of people who saw this crisis.

    The report can be categorized as “just another report” with the exception that this one has more gossip.

    It is surprising that there is dearth of any talk in the mainstream about conventional remedies not being enough to resolve the crisis. Maybe not surprising.

    Matias: Have dropped you a comment and an article in the “Who Killed The Euro” post.

  7. Pressie Shane Presga says:

    The Financial Crisis Inquiry Commission report increasingly looks like a whitewash. Even though the commission has made referrals for criminal prosecution, you’d never know that reading its end product. The references to “fraud” and “crime” are sparing, and ex mention of the SEC’s fraud investigation of Goldman, consist almost entirely of mortgage fraud, which is the FBI’s notion of “fraud for profit” or “fraud for housing”, meaning borrower fraud.