Yardeni on the Financial Crisis of 2008 Part VI: FLAW IN THE MODEL

This seven-part series is excerpted from Chapter 8 of my book, Predicting the Markets: A Professional Autobiography.

Part I: In the Beginning, Part II: Rounding Up the Suspects, Part III: Weapons of Mass Financial Destruction, Part IV: The Great Recession, Part V: Faulty Insurance Policies, Part VI: Flaw in the Model, Part VII: Feddie.

IN THE MOVIE Casablanca (1942), police Captain Louis Renault walks into the back room of Rick’s Café and asserts, “I’m shocked, shocked to find that gambling is going on in here!” As he shuts the place down, the casino manager hands him his recent winnings. Likewise, Alan Greenspan repeatedly professed his shock at what had gone on in the credit casino under his watch, and he certainly lost some of his public admiration when he did so—though Greenspan’s shock was a good deal more genuine than Renault’s.

In the prepared remarks for his October 23, 2008 testimony before the House Committee on Oversight and Government Reform, at a hearing on the role of federal regulators in the financial crisis, the former Fed chairman noted that subprime mortgages were the root of the problem but indicated that the real crisis stemmed from the uncontrolled securitization of those mortgages: “The evidence strongly suggests that without the excess demand from securitizers, subprime mortgage originations (undeniably the original source of crisis) would have been far smaller and defaults accordingly far fewer.” He went on: “[S]ubprime mortgages pooled and sold as securities became subject to explosive demand from investors around the world.” Greenspan noted that there had been a surge in global demand for US subprime securities by banks, hedge funds, and pension funds that were supported by “unrealistically positive rating designations by credit agencies.”[1]

Greenspan continued, “As I wrote last March: those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity (myself especially) are in a state of shocked disbelief. Such counterparty surveillance is a central pillar of our financial markets’ state of balance. If it fails, as occurred this year, market stability is undermined.” During his Q&A exchange, he said:

“I made a mistake in presuming that the self-interest of organizations, specifically banks and others, [was] such [that] they were best capable of protecting their own shareholders and their equity in the firms. . . . So the problem here is something which looked to be a very solid edifice and, indeed, a critical pillar to market competition and free markets did break down. And I think that, as I said, shocked me. I still do not fully understand why it happened and, obviously, to the extent that I figure out where it happened and why, I will change my views. And if the facts change, I will change.”

Then he admitted, “I found a flaw in the model that I perceived is the critical functioning structure that defines how the world works, so to speak.” He added, “That’s precisely the reason I was shocked, because I had been going for 40 years or more with very considerable evidence that it was working exceptionally well.”[2]

In his prepared remarks, Mr. Greenspan said that the models used by Wall Street’s financial engineers were also flawed:

“In recent decades, a vast risk management and pricing system has evolved, combining the best insights of mathematicians and finance experts supported by major advances in computer and communications technology. A Nobel Prize was awarded for the discovery of the pricing model that underpins much of the advance in derivatives markets. This modern risk management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year because the data inputted into the risk management models generally covered only the past two decades, a period of euphoria. Had instead the models been fitted more appropriately to historic periods of stress, capital requirements would have been much higher and the financial world would be in far better shape today, in my judgment.”

Apparently, he was in so much shock that he offered the committee only one specific recommendation: “As much as I would prefer it otherwise, in this financial environment I see no choice but to require that all securitizers retain a meaningful part of the securities they issue. This will offset in part market deficiencies stemming from the failures of counterparty surveillance.” Greenspan’s reluctance to force securitizers to have skin in their own game is just plain odd. 

Committee Chairman Henry Waxman (D, CA) blamed regulators and Congress alike. “Congress is not exempt from responsibility,” he acknowledged. “We passed legislation in 2000 that exempted financial derivatives from regulation. And we took too long—until earlier this year—to pass legislation strengthening oversight of Fannie Mae and Freddie Mac. Over and over again, ideology trumped governance.” Politics, greed, and outright corruption trumped governance as well.

Many lay blame for the subprime crisis on the GSEs’ embrace of the low-end lending market—or, rather, their forced embrace. Former Senator Phil Gramm, the same fellow who had pushed for the law that outlawed regulating credit derivatives, drew such a linkage in a Wall Street Journal editorial on February 20, 2009. He observed that when the housing market collapsed, Fannie Mae and Freddie Mac had to deal with three quotas: 56% of their mortgage holdings had to be loans to people with below-average incomes, 27% had to be loans to families with incomes at or below 60% of the area median income, and 35% had to target underserved geographic areas. Consequently, the subprime portion of the mortgage market shot up from 5% (with 31% of that securitized) in 1994 to 20% (81% securitized) in 2006.[3]

Needless to say, Gramm was doing his best to absolve himself and his two signature pieces of legislation in 1999 and 2000 from any responsibility for the financial disaster that seemed to ensue from them. Instead, he blamed it all on the “politicization of the mortgage market.” He quoted from Greenspan’s October 23, 2008 testimony that “the subprime market . . . essentially emerged out of CRA.” In other words, the government made the lenders take on these riskier mortgages. 

The GSEs initially resisted purchasing these risky mortgages. But they ended up going along for the ride. It was a win-win for everyone. Poor communities and their community organizers benefited from the surge in homeownership. Wall Street profited from increased sales of Fannie Mae, Freddie Mac, and guaranteed MBSs and derivatives. And the GSE heads were very richly rewarded, so they showered their political friends in Washington with campaign contributions.

In 2009, the renowned economist Henry Kaufman put the financial crisis into perspective in a book titled The Road to Financial Reformation: Warnings, Consequences, Reforms. A review of it in The Economist was titled “He Told Us So.”[4] The reviewer wrote that he felt “shortchanged” because Kaufman didn’t mention his role at Lehman and didn’t “shed light on the failings of corporate governance that contributed to the humbling of high finance.” Martin Feldstein, who had chaired the Council of Economic Advisers in the Reagan administration and was another paragon of financial conservatism, sat on AIG’s board when it collapsed.

On April 18, 2010, former President Bill Clinton squarely blamed two of Time’s “Three Marketeers,” Rubin and Summers, for their bad advice on the credit derivatives market, in an interview on ABC’s This Week program: “On derivatives, yeah I think they were wrong and I think I was wrong to take [their advice] because the argument on derivatives was that these things are expensive and sophisticated and only a handful of investors will buy them and they don’t need any extra protection, and any extra transparency. The money they’re putting up guarantees them transparency,” Clinton said. “And the flaw in that argument,” he added, “was that first of all sometimes people with a lot of money make stupid decisions and make [them] without transparency.”[5] 

In response to the financial crisis of 2008, Congress passed the Dodd–Frank Wall Street Reform and Consumer Protection Act in 2010. Ironically, the sponsors were none other than US Senator Chris Dodd and US Representative Barney Frank, whom some believed should have been included in the list of people to blame for the crisis. The Act increases the amount of liquid assets and capital that banks must have to back up their activities. Large banks must pass an annual stress test administered by the Fed. The Act’s so-called “Volcker Rule” bans the big banks’ trading desks from proprietary trading, limiting them to making markets for their clients. The Trump administration is committed to easing some of the regulatory constraints imposed by the Act.

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[1] See “Testimony of Dr. Alan Greenspan,” October 23, 2008, before the US House of Representatives’ Committee of Government Oversight and Reform. The Q&A portion is available in an October 24, 2008 Washington Times article titled “He Found the Flaw?”

[2] Again, see Greenspan’s October 23, 2008 testimony and the October 24, 2008 Washington Times article for the Q&A.

[3] “Deregulation and the Financial Panic,” Gramm’s op-ed in The Wall Street Journal, February 20, 2009.

[4] “Henry Kaufman on Financial Reform: He Told Us So,” The Economist, August 27, 2009. Kaufman did have more to say about Lehman in Tectonic Shifts in Financial Markets (2016). However, rather than recounting his experiences at Lehman as board director, he blamed US Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke for letting the firm fail. See Appendix 3, Bernanke’s Fed and the Lehman Bankruptcy.

[5] “Clinton: I Was Wrong to Listen to Wrong Advice Against Regulating Derivatives,” ABCNews.com, April 18, 2010.