Must See T.V.! Frontline: Inside the Meltdown

On Tuesday, PBS aired Inside the Meltdown, Frontline‘s investigation of major events in 2008 that resulted in the near-total collapse of the financial markets in late September. The hour-long documentary is mesmerizing not only for its detailing of the speed with which the market seized but its look at (former) Treasury Secretary Paulson’s perceived philosophical struggle between the theoretical ideal of the free market and the regulatory and interventionist imperatives of the modern, post-industrial, global economy. If anything, it is clear House Republicans’ galvanizing mantra of “no intervention” is grossly irrelevant. As Barney Frank (D-MA) notes:

Paulson and Bernanke say, “Hey, you know, reality counts.” The House Republicans say: “Who cares about reality? I’m sticking with my view.” …

Everyone wants to know what caused the crisis. What was the trigger, the fuse, the actual atom that split? I can only say there is plenty of blame to go around. Some activites had more direct influence than others. For instance, predatory lending and the actual drafting of bad loans (and the institutionalized tricks for doing so) to people who had no business taking on such debt can be considered a direct cause: Mortgage defaults were the first dominoes to fall. Also direct was the bundling of mortgages into CDOs (collateralized debt obligations) and their sale to other entities, which meant loan originators had no interest in whether the debt was settled. The slicing of CDOs into graded risks, where the riskiest components paid the most and last, while the safest parts paid least and first is problematic, too, because rating agencies, who — at best — were asleep at the wheel, apparently rated CDOs based on their least risky contents, as if the riskiest, highest-yield parts didn’t exist. Thus, the CDOs were a way to get a cake (high rating) and eat it, too (high yield).

We had an entire market based on an innovative investment product that, theoretically, is fine if it were constructed with sound loans and rated accurately, but since CDOs were not entirely sound, all of the products deriving from them were likewise unsound. Notwithstanding this, er, small detail, as long as the housing market was growing, why not create entire product lines that could not fail? Hence, we have the development of complex derivatives like, dangerously, credit default swaps (CDS). If the CDOs, theoretically, are the closest representation of the lender-borrower relationship (at least to the last entity holding the CDO), derivatives and CDSs represent bets against the failure of the CDOs. A CDS is an insurance purchased by a CDO owner. (AIG failed because it sold CDSs all over the market. When the CDOs stopped paying, the insured came-a-knockin’.) I consider the derivatives market a mid-level contributor to the crash. There is nothing inherently wrong with CDSs and other derivatives, except when parties inaccurately assess risk, out of greed or laziness or ignorance … It doesn’t matter.

More “blame” and Frontline interview excerpts after the jump.

Probably the least direct, but still important, “cause” of the crash was the environment established in the second Clinton term and cultivated through both Bush administrations. The repeal of the Glass-Steagall Act in 1999 removed the wall separating investment banks and commercial banks, which, for instance, allowed commercial banks to take on massive risk (think Citigroup). The refusal of Alan Greenspan either to cool the housing market (with interest rate hikes that threatened to quash economic growth) or (with the support of Robert Rubin) to regulate the mortgage-backed securities (MBS) and deriviatives markets also contributed. On the one hand, the Fed walks a tightrope balancing sound monetary policy against economic growth. On the other hand, when ideology stifles pragmatism (like addressing regulatory holes in the lightning-fast development of the MBS market), the actions by the Fed must be questioned, even (or especially) during booms. Finally, there were the changes the Clinton Administration made to the Community Reinvestment Act. “Someone’s Daddy,” a commenter on another thread put it quite well:

Clinton’s action was very well intentioned and was designed to allow more people to become first time homebuyer’s. The primary roadblock to home purchasing was the down payment. So [losing] the [loan-to-value ratio] standards (and deregulation as a whole) was a way around that.

I was surprised to learn that Paulson really did want to focus on the purchase of toxic assets. He was opposed to nationalizing institutions on ideological grounds. I don’t mind using TARP for capitalization, but there were problems with the way in which the program was “sold,” leaving many with the impression the housing market was no longer important. I also don’t agree with capitalization without conditions or strict oversight, which is how Paulson “administered” TARP. Frankly, I want to see changes in leadership beyond reduced compensation packages, but as Simon Johnson recently pointed out on Bill Moyers Journal:

[T]he policy that we seem to be [pursuing], of being nice to the banks, is a mistake. The powerful people are the insiders. They’re the CEOs of these banks. They’re the people who run these banks. … Now, those bonuses are not the essence of the problem, but they are a symptom of an arrogance, and a feeling of invincibility, that tells you a lot about the … attitudes of the people who lead them.

******************************************************************

******************************************************************

Here are some excerpts from the multiple illuminating interviews that accompany the Frontline documentary. (Note: Producer Michael Kirk said, “We offered many [R]epublican senators and congressmen equal opportunities to talk …. They chose not to participate.”):

Sheila Bair (Chairman, FDIC): [I]t was pretty frightening what we saw, especially with the subprime market, these very, very steep payment [resets]. You had starter rates that were very high already, 8 or 9 percent. Then they would go up to 11, 12, 13 percent after two or three years. And they really weren’t designed to be affordable after that reset. They were designed to prompt another refinancing, so you get another whole round of fees and, in some instances, prepayment penalties. They weren’t designed to be a long-term sustainable product. Of course, you can only refinance if the housing market is going up, right? If you don’t have any equity in your home, you can’t refinance. … as the housing market started to … go down. These folks were locked into these mortgages.

Adam Davidson (Journalist): We are brand new in this world of structured finance, and we had a regulatory apparatus, we had a Federal Reserve system, we had an entire financial oversight system built on a different model. … I think Alan Greenspan, a lot of people were taking the logic of the old model and trying to apply it to this new world, and it didn’t make sense. …

Martin Feldstein (Economist): [A] lot of people were saying, “Well, we’ve got to slow this economy down; we can’t continue to grow at this rate,” Greenspan said, “No, what’s really going on now is not excessive demand, but a more rapid productivity growth than we’ve been accustomed to in the past, and therefore the old speed limits don’t count. We can grow at this faster rate and still have low inflation.” … He may have kept it going too long. He certainly kept it going longer than most of us, including myself, would have wanted, and yet he was right for most of that time.

Mark Gertler (Economist): [T]he best response to an asset bubble was regulatory; that is, set up a regulatory system where the financial institutions would be protected against the fallout. What we found is that if the central bank tries to directly attack the bubble by raising interest rates, that could have a destabilizing effect. So the best thing the Fed could do with interest rate policy would be to stabilize the economy, and it should use regulatory policy ahead of time to try and insulate the economy against the effects of asset bubbles.

….

The great difficulty is, it’s hard to know when you’re in the midst of a bubble whether they’re justified by fundamentals or not, because they depend upon investors’ expectations of future dividends flow, their beliefs about how they should discount asset prices. So in the midst of a bubble it’s very, very difficult to identify one. Even ex post, there can be some debate, because it’s possible that investors had some reasonable expectations at the time, and then had good reason to change their minds.

Alan “Ace” Greenberg (Former CEO, Bear Stearns): I knew this: I knew that it was crazy to see people flipping houses for profit. The vigorish in buying and selling a house is so big that it’s ridiculous. I mean, the house has to go up 5 to 10 percent in value before you’re even by the expenses and maintenance and so forth. So I thought that was crazy, and the speculation was crazy. I thought it was crazy to see ads where people would lend you 140 percent of the assessed value of your house. I thought that was nuts. Did I know that grassroots brokers were getting people financing that had no business [buying], that they were falsifying their wages, they were falsifying their ability to carry the mortgage? Did I know it was that bad? No, I did not.