Santa Clara University

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After Words

Sins of commission and sins of omission

Staving off the next economic crisis

Alexander J. Field

The current financial crisis is likely to be the most severe the country has seen since the Great Depression. Students graduating from college face a tough labor market. Family members may have lost their job. Retirement savings have dwindled. Many households find themselves with negative equity in their homes, and some have lost them. We all face the prospect of higher taxes or inflation to discharge the obligations associated with rising government debt incurred to bail out banks and insurance companies.

So who is responsible? The search for that answer can easily become counterproductive but, as Santayana put it, if we fail to understand our history we will almost certainly be condemned to repeat it.

The ultimate origin of our financial and economic crisis is to be found in private behavior and privatesector financial innovation. Collateralized debt obligations (CDOs) and credit default swaps are new. But the housing boom they facilitated reflected proclivities in human behavior whose consequences have been evident repeatedly during the last several centuries.

That said, the need to contain these proclivities was predictable; actions by our leaders could have been different. We can and should hold government accountable for not maintaining a regulatory system that restrained leverage and the growth of systemic risk.

A toxic symbiosis

CDOs emerged when financial institutions took a pool of mortgages and issued securities derived from them. Originally, mortgage-backed securities simply sold a right to a share of interest and principal payments from the underlying pool. Securitization reduced variance of the bond’s return, but the expected payout couldn’t really be different from that of the underlying mortgages. CDO engineers, however, figured out how to perform the financial alchemy of turning junk into gold: Starting with a pool of risky mortgages, they created different grades, or tranches, of derivative securities. Senior tranches paid lower interest rates but were safer. More junior tranches paid higher interest but took the first hit if underlying mortgages went bad. Ratings agencies like Moody’s or Standard and Poor’s stamped senior tranches AAA. Still, some holders of these bonds worried about how safe they were.

Enter credit default swaps. For a small “premium,” institutions could insure themselves against the risk that the bonds might default. Since swaps were not technically insurance, they were beyond the reach of state regulators. American International Group (AIG) and other issuers did not maintain adequate reserves to meet collateral calls when mortgage defaults rose. In a sense, they simply pocketed the premiums without providing the insurance.

Stories like this help explain how, until relatively recently, the financial sector (finance, insurance, and real estate), which employs 8 million fulltime equivalent workers—out of a U.S. total of about 130 million—was booking more than 40 percent of all domestic corporate profits. A high percentage came from transactions in CDOs and credit default swaps.

A few economists, such as Nouriel Roubini and Robert Shiller, raised red flags. So did some policy makers, including Brooksley Born, who in 1998 was head of the Commodity Futures Trading Commission. Concerned by the explosive growth of credit default swaps, she called for requiring them to be traded and cleared in the way that futures contracts are—on a centralized exchange—rather than in an unregulated over-the-counter market.

She was essentially shouted down by Alan Greenspan (then head of the Federal Reserve), Arthur Levitt (then head of the Securities and Exchange Commission), Robert Rubin (then treasury secretary), and Larry Summers (Rubin’s successor as treasury secretary, subsequently president of Harvard, and now senior economic advisor to President Obama). The result of their victory was legislation in December 2000 explicitly prohibiting any government regulation of swaps.

Greenspan justified his position on ideological grounds. Others argued this was just a regulatory turf battle, or that regulation would drive trading overseas. None of these arguments stands up well in the light of what subsequently happened.

To a greater or lesser degree, Greenspan, Levitt, and Rubin have admitted they were wrong and apologized. Unfortunately, this was too late to stop financial sector managers from collectively creating a system that, when it faltered, presented taxpayers with the choice between bailouts or a collapse of the real economy. In the future, laissezfaire ideology must not go so unchecked as to prevent needed reforms. This is particularly so if government is ultimately to be blamed for sins of both commission and omission.

Alexander J. Field is the Michel and Mary Orradre Professor of Economics at SCU and Executive Director of the Economic History Association.

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