Was the financial crisis just an economic act of God which could not have been prevented? This is what Alan Greenspan and other economic policy makers claim. U.S. economist Ross Levine now strongly challenges this view. Levine has conducted a meticulous autopsy of the financial system which leads to a rather unsettling conclusion.
He does not have a first name, lives on a houseboat in dry dock and is a notorious bullhead: Quincy. The diligent medical examiner, constantly chasing ruthless poisoners and similar vicious characters, was the main character of NBC television series “Quincy M.E.” aired from 1976 to 1983. Even today, Quincy is cult. On Youtube, old trailers of the series are watched by hundreds of thousands of people.
Ross Levine, finance professor with Brown University on the American east coast could become something like a Quincy of the economics profession. Levine has done a thorough autopsy of the American financial system. “Accident, Suicide, or Negligent Homicide?” is the leitmotif of his recently published work entitled “An Autopsy of the U.S. Financial System”.
The starting point of his economic necropsy is an argument frequently put forward by central bankers and politicians. Ben Bernanke, Alan Greenspan, Hank Paulson and others like to state that the financial crisis just happened by accident and that there was no way that this mess could have been prevented. There was a deluge of foreign capital flocking to the United States, so the common gospel goes. This “savings glut” is supposed to have lowered long term interest rates in the U.S. and fuelled the speculation bubble in the US housing market. According to this line of thought, the crisis just was an economic act of God.
But the truth is different, shows Levine in his Quincy-style analysis. His meticulously compiled post-mortem comes to the conclusion that the financial system in no way died of natural causes. In fact, the Fed and the U.S. administration bear the blame for its demise. “The evidence indicates that the senior policymakers repeatedly designed, implemented and maintained policies that destabilized the global financial system in the decade before the crisis,” summarises Levine in his galling verdict.
And things are even worse. Levine presents a lot of evidence showing that the Fed as well as the US administrations were aware of the malicious consequences of their policies but deliberately decided not to change them. According to Levine, the policymakers knowingly pushed the financial system towards perdition.
That is quite an accusation. However, Levine manages to support it with a bunch of convincing evidence. For example, 14 years ago the Federal Reserve Bank made a momentous decision on Credit Default Swaps (CDSes). These financial products enable a lender to insure himself against the bankruptcy of his borrower. If the borrower defaults, the seller of the CDS will meet his payment obligations. Unlike traditional insurances, CDSes themselves are traded on financial markets.
In theory, financial institutions are able to reduce their credit risks buying CDSes. In 1996 the Fed decreed that a bank which buys a CDS for an outstanding loan is allowed to put aside less regulatory equity. This decision drastically reduced the costs of loan provision for the financial institutions. “A bank with a typical portfolio of $10 billion of commercial loans could reduce its capital reserves against these assets from $800 million to under $200 million by purchasing CDSes for a small fee,” Levine points out. Hence the new regulatory framework facilitated risk taking within the financial sector. It allowed “banks to reallocate capital to higher expected return, higher-risk assets.”
However, the sellers of CDSes, like AIG, increasingly made pledges they were unable to keep in in times of emergency. Additionally, the market for CDSes was highly opaque so that nobody really knew who bore the credit risks at the end of the day. Levine argues that the Fed was aware of these problems as early as 2004. The only catch was that the central bank did not draw the conclusions from their knowledge and consequently heavily violated their duties. Making sure that banks have enough equity and can therefore survive credit defaults is part of the core business of banking regulators, Levine points out. He accuses the Fed of knowingly sticking to a rule which enabled banks to operate with an inadequate cushion of safety. “The Fed´s decision to maintain its regulatory stance toward CDSes was neither a failure of information,nor a shortage of regulatory power,” he concludes. “It was a choice.”
Another, rather unedifying example is how the economic policymakers dealt with the over-the-counter market (OTC) for credit derivatives. Plenty of complex financial products like CDSes are being traded outside the orderly world of regulated stock exchanges. Since the 1990s the OTC markets have been infamous for being extremely muddy. In 1998, for instance, the collapse of the hedge fund Long Term Capital Management (LTCM) caught everyone by surprise. Since LTCM was primarily dealing in the opaque OTC market, nobody was aware how many risky positions the fund had accumulated.
LTCM crisis threatened the stability of the entire financial system and the Fed had to orchestrate a bailout. Afterwards, however, the American central bank nonetheless fiercely fought against making the OTC markets more transparent. Jointly with the U.S. treasury and the Security and Exchange Commission (SEC), the Fed thwarted a reform initiative by the Commodity Future Trading Commission (CFTC). This agency, which regulates the commodity future and option markets in the United States, had sketched a plan aiming for greater information disclosure in the OTC market, as well as improved record keeping and containment of fraud. The Fed, U.S. Treasury and SEC, however, argued heavily against tougher regulation of these activities. In 2000 they finally succeeded: US congress made a law that explicitly exempted the OTC derivatives markets from government regulation. In Levine’s words: “Senior regulators and policymakers lobbied hard to keep CDSes and other derivatives in opaque markets.”
He also makes the point that SEC is at least partially responsible for the crisis of all major U.S. investment banks in the autumn of 2008. Several interlinked decisions by the SEC enabled Lehman and their competitors to engage in much riskier and short-sighted business. “The SEC’s fingerprints are indelibly imprinted on this debacle,” asserts Levine.
Since 2004 the investment banks have been allowed to calculate their appropriate level of capital using their own mathematical models. They used this as an opportunity to buy more risky assets with borrowed money. “Leverage ratios soared from their 2004 levels, as the bank’s models indicated that they had sufficient capital cushion,” writes Levine. Adding insult to injury, the SEC had way too few competent staff for the supervision of the investment banks. Only seven SEC employees were responsible for keeping a sharp eye on an industry which moved $4 trillion.
All in all, the verdict of Levine – aka economics Quincy – is clear: With regard to the demise of the financial system between 2007 and 2009, the policymakers committed negligent homicide.
(c) Olaf Storbeck 2010
A German version of this text is available on Handelsblatt.com.