"Those of us who have looked to the self-interest of lending institutions to protect shareholders' equity, myself included, are in a state of shocked disbelief." — Alan Greenspan, testimony before the House Committee on Oversight & Government Reform, Oct. 23, 2008
The crash of 2008 put to rest the intellectual model that inspired, and to a large degree facilitated, the bubble. It spelled the end of the immodest faith in Wall Street's ability to forecast. No better testimony exists than the extraordinary recanting of former Federal Reserve Board Chairman Alan Greenspan, the public official most associated with the thesis that markets are ever to be trusted.
In October 2008, 10 days after the first round of Troubled Asset Relief Program (TARP) investments, Greenspan appeared in the House of Representatives in effect to repeal the credo by which he had managed the nation's economy for 17 years: "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 derivative markets....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."
This remarkable proclamation, close to a confession, was the intellectual counterpart to the red ink flowing on Wall Street. Just as Fannie Mae (FNM), Freddie Mac (FRE), and Merrill Lynch (BAC) had undone the labors of a generation—had lost, that is, all the profits and more that they had earned during the previous decade—Greenspan undermined its ideological footing. And even if he later partly retracted his apologia (in the palliative that it wasn't the models per se that failed but the humans who applied them), he was understood to say that the new finance had failed. The boom had not just ended; it had been unmasked.
Why did it end so badly? Greenspan's faith in the new finance was itself a culprit. The late economist Hyman P. Minsky observed that "success breeds a disregard of the possibility of failure." Greenspan's persistent efforts to rescue the system lulled the country into believing that serious failure was behind it. His successor, Ben Bernanke, was too quick to believe that Greenspan had succeeded—that central bankers had truly muted the economic cycle. Each put inordinate faith in the market and disregarded its oft-shown potential for speculative excess. Excessive optimism naturally led to excessive risk.
The Fed greatly abetted speculation in mortgages by keeping interest rates too low. Meanwhile, the willingness of government to abide teaser mortgages, "liar loans," and home mortgages with zero down payments, amounted to a staggering case of regulatory neglect.
The government's backstopping of Fannie and Freddie, along with the federal agenda of promoting homeownership, was yet another cause of the bust. Yet for all of Washington's miscues, the direct agents of the bubble were private ones. It was the market that financed unsound mortgages and collateralized debt obligations (CDOs) that spread their contagion globally; the Fed permitted, but the market acted. The banks that failed were private; the investors who financed them were doing the glorious work of Adam Smith.
Rampant speculation in mortgages was surely the primary cause of the bubble, which was greatly inflated by leverage in the banking system, in particular on Wall Street. High leverage and risk taking in general was fueled by the Street's indulgent compensation practices.
The system of securitizing mortgages lay at the heart of Wall Street's unholy alliance with Main Street, and several links in the chain made the process especially risky. Mortgage issuers, the parties most able to scrutinize borrowers, had no continuing stake in the outcome; the ultimate investors, dispersed around the globe, were too remote to be of any use in evaluating loans. These investors (as well as various government agencies) relied on the credit agencies to serve as a watchdog, and the agencies, being cozy with Wall Street, were abysmally lax.
Wall Street's penchant for complexity was itself a risk. Abstruse securities were more difficult to value, and multitiered pyramids of debts were far more susceptible to collapse. Individual malfunctions were indicative of a larger failure: The market system came undone. What truly failed was the postindustrial model of capitalism. The market's tools for measuring risk simply did not work. The most sophisticated minds on Wall Street proved no wiser than country loan officers. All in, the big Wall Street banks were stuck with an estimated 30% of subprime losses....
Counter to the view of its apostles, the market system of the late 20th and early 21st centuries did not evolve in a state of nature. It evolved with its own peculiar prejudices and rites. The institution of government was nearly absent. In its place had arisen a system of market-driven models, steeped in the mathematics of the new finance.
The rating agency models were typical, and they were blessed by the Securities & Exchange Commission. The new finance was flawed because its conception of risk was flawed. The banks modeled future default rates as though history could provide the odds with scientific certainty—as precisely as the odds in dice or cards.
But markets are different from games of chance. The cards in history's deck keep changing. Prior to 2007 and '08, the odds of a nationwide mortgage collapse would have been seen as very low, because during the previous 70 years it had never happened.
What the bust proved, or reaffirmed, was that Wall Street is (at unpredictable moments) irregular; it is subject to uncertainty. Greenspan faulted the modelers for inputting the wrong slice of history. But the future being uncertain, there is no perfect slice, or none so reliable as to warrant the suave assurance of banks that leveraged 30 to 1.
In particular, the notion that derivatives (in the hands of American International Group (AIG) and such) eradicated risk, or attained a kind of ideal in apportioning risk to appropriate parties, was sorrowfully exposed. When mortgage securities were introduced, they were applauded because they enabled lenders to issue loans without retaining risk. And this they did. They also created new vulnerabilities. The ability of Countrywide Savings & Loan and Washington Mutual to parcel out loans to Wall Street encouraged them to issue more and riskier loans than had no securitization channel existed. The perception of decreased risk to the individual firm thus increased risk for society at large.
Then-Treasury Secretary Henry M. "Hank" Paulson gave voice (on Sept. 15, 2008, the day Lehman Brothers failed) to the need for reform, and President Barack Obama, as well as Congress, avidly pursued it. In general, there was greater agreement that reform was necessary than there was over what it should entail. Legislative attention focused on four areas: protecting consumers of financial products such as mortgages and credit cards; regulating complex instruments such as derivatives; obviating the need for future government bailouts, either by keeping banks from becoming too big to fail or ensuring that big banks did not assume too much risk; and limiting Wall Street bonuses.
The public embraced only the last of these. Early in 2009, after revelations of continued outsize bonus payments at AIG and Merrill Lynch, an uproar ensued. Astonishingly, Merrill had paid million-dollar bonuses to approximately 700 employees in 2008, a year in which the firm lost $27 billion and in which both it and its acquirer were rescued with federal TARP monies. And Merrill was far from alone. Goldman Sachs' (GS) bonus machine barely paused for breath.
Popular outrage was manifest; briefly, a vigilante spirit obtained. A bus tour organized by the Connecticut Working Families Party carried tourists through local suburbs to see the homes of bonus recipients, as if in hopes of dragging the bonus takers to the guillotine.
A few of those judged complicit were actually sacked. John A. Thain, the Merrill chief, was denied in his quest for a $30 million bonus; his mere asking sealed his end. Kenneth D. Lewis, the Bank of America CEO with whom Thain had previously hit it off, fired him. When it emerged later that the bonuses paid by Merrill had been approved by Bank of America (BAC), Lewis resigned as well.
The problem of executive pay did not admit to an easy fix. Well into the crisis period, when banks such as Citigroup (C) were operating on federal investment and when Citi's stock was in single digits, Vikram Pandit, the CEO, was observed with a lunch guest at Le Bernardin, one of the top-rated restaurants in New York. Pandit looked discerningly at the wine list, saw nothing by the glass that appealed, and ordered a $350 bottle so that, as he explained, he could savor "a glass of wine worth drinking." Pandit drank just one glass; his friend had none.
Bankers vigorously sought to defend their pay, and their perks. Setting wages is a function of labor markets; the best reform would have aimed at making the market work better. (For instance, forcing companies to seek shareholder approval of their executive pay arrangements would have restored proper control over wages and countered the executives' sense of entitlement.)
The government chose instead to supervise compensation, in various but limited ways. Congress banned cash bonuses for TARP recipients, and a "pay czar," appointed by Treasury Secretary Timothy F. Geithner, restricted executive salaries at government-controlled companies such as General Motors and Citi....
The issue of "too big to fail," which Bernanke had called "a top priority" for reform, hung over Washington like a dark cloud. The crisis had bequeathed precisely the moral hazard that Paulson had feared. Post-crash, markets presumed that the government would, if necessary, bail out important banks.
Being among the circle of the protected was considered such a boon that both the Administration and Representative Barney Frank (D-Mass.), who managed the bill in the House, initially proposed keeping the list of "too big to fail" institutions secret. Experts consulted by Congress sensibly advised an opposite tack—that the government discourage banks from becoming (or being) too big by making it undesirable.
They proposed that stricter capital requirements and hefty insurance premiums be imposed as a price for bigness. Greenspan reckoned that regardless of official policy, the market would conclude that every big bank enjoyed a federal safety net. Therefore, the surest way to prevent moral hazard was to break up Big Banking à la Standard Oil. But pending final passage of the legislation, Wall Street institutions emerged from the crisis more protected than ever....
The Fed also elevated the role of regulation. At the Greenspan Fed, only monetary policy mattered. After the crash, the agency returned to the job of assessing bank loans and balance sheets, and with a more skeptical eye toward risk models. Daniel K. Tarullo, the first Fed governor appointed by Obama, tartly informed a Senate panel in October 2009 that "things [for banks] are going to change. That means business models. That means the way of assessing risk. That means how you run your institution."
The central bank emerged from the crash sorely humbled. Bernanke conceded publicly that the crisis had caught him off guard. The Fed has a huge stake in ensuring that it is not embarrassed by a bubble again. Presumably, after the economy does recover, the Fed is unlikely to flirt with ultralow interest rates as it did in the '00s....
Finance was reborn when the panic subsided, but in many respects it was a changed industry—more sheltered, more regulated, more concentrated, and less competitive. The scrappier, smaller firms that previously challenged Goldman Sachs were licking their wounds or had disappeared altogether. Goldman's only true rival was JPMorgan Chase (JPM), now the king of Wall Street. (Goldman and Morgan were among the first to repay their TARP monies.)
Commercial banking was exceptionally concentrated, with the four biggest banks claiming almost 40% of deposits and two-thirds of credit cards. Effectively, the Wild West model was supplanted by a more European-seeming arrangement, in which a few elite players thrived within the government's embrace. Goldman still took big risks, but now with the backing (if needed) of the taxpayers. The banks were like Fannie and Freddie before the crash: for-profit institutions with a presumptive lifeline to the Treasury.
Post-crash, consumer habits shifted abruptly. Households had heavy debts to work through, a process expected to take years. Americans relied more on income, less on Wall Street financings. For regulatory and also societal reasons (such as high unemployment), expectations downshifted. Wall Street's impression on American culture seemed to have eroded, its glossy optimism worn to a thrifty nub.
Higher saving was itself a rejection of the Wall Street credo; it signaled Americans' unease about the future. For almost their entire adulthood, baby boomers had assumed that even small accounts (or their homes) would build into appreciable savings and provide for retirements. Now they were mere squirrels, storing acorns for winter.
The drop in spending revived an essential puzzle, prevalent in the Depression years and also in Japan in the '90s: How to create sufficient demand for goods and labor? As compared with Wall Street's golden age, government seemed destined to supply more of the answer, bankers less. After all, the recovery had been purchased with massive public-sector spending and loans, and the federal pipeline showed no sign of shutting down. The Administration was anointing preferred industries (energy, the environment) for investment, a throwback to the fad for industrial planning of the '70s.
Unemployment was higher, the government's role as a social guarantor larger. Obama, though only with a bruising fight, muscled through a new health-care law, a goal pursued by liberals since the New Deal. Indeed, John Maynard Keynes, the 20th century British economist and statesman famous for his skepticism of the market, was reinstated to his previous perch in the canon. A trio of timely books argued that the way out of the recession was to heed Lord Keynes, who emphasized the uncertainty of economic life, and prescribed government fine-tuning as a permanent feature of industrial societies, necessary to balance the ups and downs of the economic cycle. The Obama stimulus itself was pure Keynesian economics, a standard tool of American policymakers through the 1970s that had been shelved during the bubble years.
Spending policies had a dark side—they shredded government finances. Among the Group of 20 nations, deficits soared from an average of 1% of total gross domestic product to 8%. The U.S. was among the worst offenders, with a deficit equal to 10% of GDP. In the year after Lehman's collapse, America's debt rose by $1.9 trillion.
"In our opinion," wrote Robert L. Rodriguez, CEO of First Pacific Advisors who had issued early warnings of the bubble, "this is a very dangerous road we have chosen."
It is arguable that the U.S. government resolved the crisis simply by appropriating Wall Street's debts, transferring a private-sector problem to the public. In any case, its "solution" further depreciated its international account.
The failure of America's model stirred a geopolitical realignment. Europe no longer slobbered to imitate the U.S.; Asian economies were ascendant. Americans at the 2009 economic summit in Davos, accustomed to preaching the wonders of the market, were subjected to lectures by the potentates of command economies....
The legacy of the bust—what Wall Streeters called the "new normal"—entailed, prospectively, a weaker dollar, a greater government presence, more joblessness, and higher taxes. It was a world of pinched horizons. From roughly the 1980s on, no horizon had been deemed necessary. Ronald Reagan had decreed that government was the problem, not the cure. Markets were viewed as self-regulating ecosystems.
The province of regulation shrank, the volume of market innovations commensurately expanded. By the 2000s, the market's innovations were no longer even questioned: Anything invented on Wall Street was, perforce, good. Complex creations such as securitized assets basked in the presumption of safety. Greenspan's 1998 testimony, recall, was that "regulation of derivatives transactions that are privately negotiated by professionals is unnecessary." The notion that the Street should run a casino, taking bets on which companies will live and which will die, did not strike observers as even mildly objectionable.
A generation invested a higher proportion in stocks, fed on the nostrum that risk was outmoded. Just as the fall of the Iron Curtain supposedly ended history, Wall Street's smooth rise through most of the '90s and the '00s was to have ended market history. (No more earthquakes—just steady gains.) The crash of 2008 spelled the end of that end....
Previous to the crash, it was assumed that no statutes or rules were needed to prevent banks from making foolish loans; after all, the theory went, why would institutions ever jeopardize their own capital? This cornerstone of efficient market theory—the view of economic man as always rationally self-interested—was rather embarrassingly upended. Similarly, the faith that bankers know best, that they could be counted on to preserve their firms, was shattered.
It may be too much to expect that, in the future, economists take forecasting models with a grain of salt, or that executives refrain from relying on "liquidity" to bail them out of a jam. But the worst recession in 70 years—unsuspected by most economists even when it had been under way for more than six months—should inspire a modicum of humility. Speculation will return, of course, and so will bubbles. The question is whether Americans will treat them so lightly.
Overseas, the notion that central banks should restrain speculation is hardly controversial. In the U.S., it was. Both Greenspan and Bernanke devoted many words to rebutting the idea that bubbles should be "pricked."
Instead, they endorsed a policy of cleaning the mess up afterward. This reflected their doubts that mere humans, even Fed governors, could detect whether an elevated market was irrational—whether any market was irrational. Even after the crash, Bernanke could barely bring himself to utter the word "bubble."
The formative lesson that Bernanke drew on in 2008 had been sketched prior to and during the Great Depression, when, he believed, the Fed had erred in clamping down on credit formation, including the credit used to speculate in stocks. In other words, the Fed had been too restrictive. Future central bankers may draw an opposite lesson from 2008: The Fed let speculation go on far too long.