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.