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Is It Too Big to Save?

Saturday, May 8, 2010

If you’re only going to read one book on the financial crisis, this should be the one.

One of the most striking features of the debate about the financial crisis is that there’s still little agreement about the underlying causes. The legislation creating the Financial Crisis Inquiry Commission called on commission members to explore the causes of the crisis—and then listed 22 different possible causes. A Congressional Research Service report on the financial crisis, issued last year, listed 26 different possible causes.

It’s all a bit overwhelming, and many of the highly publicized books that have already been written about the financial crisis have been long on drama and narrative but more abbreviated on explanation and elaboration.

Stepping into this breach is Robert Pozen with his book Too Big to Save? How to Fix the U.S. Financial System. If you’re only going to read one book on the financial crisis, this should be the one. Think of Pozen as the financial sector’s Dragnet (minus the badge and the square suit)—“just the facts” is his approach, and his insights are informed by his extensive experience.

The legislation creating the Financial Crisis Inquiry Commission called on commission members to explore the causes of the crisis—and then listed 22 different possible causes.

He’s had high-level positions in the financial sector (he was a vice chairman at Fidelity, and is currently chairman of MFS Investment Management), he’s served in a regulatory role (associate general counsel at the Securities and Exchange Commission), and he’s toiled in academia (he’s currently a senior lecturer at Harvard Business School). His prescriptions for how to fix the financial system don’t fit into any neat ideological boxes, and one doesn’t have to agree with all of them (or any of them) to find Too Big to Save? a worthwhile read.

At the heart of the book is a dispassionate look at three fundamental issues: what triggered the financial crisis, what the U.S. government did right and wrong in responding to the crisis, and what should be done to prevent a crisis from happening again.

Pozen’s thoughts about the fundamental cause of the crisis are pretty standard, saying that it “resulted from the bursting of the U.S. housing bubble, which was financed through excessive debt spread around the world by mortgage securitization.” Over the next few chapters, he takes the reader on a very accessible tour of some topics that are often inaccessible even to those in the financial sector (securitization, credit default swaps, interest rates, Fannie Mae and Freddie Mac, credit rating agencies, and bank capital standards, to name just a few). Along the way, Pozen knocks down some wrongheaded ideas that have crept into the policy debate.

Pozen points out that had Glass-Steagall still been law in 2008, investment banks Merrill Lynch and Bear Stearns would have been unable to merge with universal banks Bank of America and JPMorgan, respectively.

For example, a number of policy makers and financial pundits have suggested that a key contributor to the financial crisis was the law passed in 1999 that repealed Glass-Steagall, the 1933 law that separated commercial banks from investment banks. Paul Volcker and some others have proposed measures that would effectively reinstate Glass-Steagall. Pozen strongly disagrees with this approach. He points out that had Glass-Steagall still been law in 2008, investment banks Merrill Lynch and Bear Stearns would have been unable to merge with universal banks Bank of America and JPMorgan, respectively. But more fundamentally, he points out that universal banks are more diversified than pure investment banks—they have more sources of funding (commercial paper and repos, insured deposits, and loans from the Federal Reserve)—and are thus better equipped to absorb volatility. Indeed, Citigroup notwithstanding, he points to a number of studies showing that universal banks have been more stable, and more disciplined in their risk taking, than their investment banking counterparts. The largest losses incurred by universal banks were connected to their traditional lending activity—not their underwriting of securities.

In dissecting the federal government’s response to the financial crisis, Pozen expresses a number of concerns. For example, he’s very critical of the assistance to Citigroup and Bank of America. His criticism is not that the assistance was given, but rather that the government negotiated poor terms. He labels this “one-way capitalism” in which “taxpayers own most of the downside . . . [and] a very small percentage of the upside if these banks turn around and become profitable.”

Underpinning many of his concerns with Washington’s response is that it will contribute to moral hazard. For example, he says that the Federal Deposit Insurance Corporation’s decision to guarantee 100 percent of the debt issued by depository institutions and their holding companies until mid-2012 will disincentivize large investors to perform any due diligence on the issuing institution, since they’ll know that if the bank becomes insolvent the FDIC will bail them out.

Pozen has a number of sensible suggestions for fixing regulation, and for overhauling the financial architecture (such as merging the Securities and Exchange Commission and the Commodity Futures Trading Commission).

So how to prevent future crises? Pozen has a number of sensible suggestions for fixing regulation, and for overhauling the financial architecture (such as merging the Securities and Exchange Commission and the Commodity Futures Trading Commission). And he cuts through the clichés. One of the standard tropes in discussions of financial regulation is the need for global standards and greater global coordination. Pozen is not opposed to a more global approach, but he rightly acknowledges that it’s difficult (if not impossible) to implement because it depends on countries settling on common standards while also agreeing to an enforcement mechanism. “No country will cede control of its financial regulation to any global organization because, at the end of the day, the costs of bank failures must be absorbed by each national government.” And he points out that there was a global standard for financial regulation—Basel I—but that its terms contributed to the excesses in the mortgage securitization market that were a catalyst for the financial crisis.

While lacking the drama of Too Big to Fail by New York Times reporter Andrew Ross Sorkin, or the insider perspective of On the Brink by former Treasury Secretary Henry Paulson, Too Big to Save? will be of greater interest to policy wonks and economic historians. Pozen appears to have plowed through just about everything written about the financial crisis, and pulled out the most compelling material (the footnotes go on for 41 pages). If you’re the type who highlights material while you read (thus not a Kindle reader), have your pens at the ready.

This book contains a number of “gee whiz” factoids that help to illuminate key issues in the crisis. Here are a few:

• Before 2008, no housing slump in any country had ever triggered a global financial crisis.

• Until mid-2008, the Federal Housing Administration offered loans that only required a 3 percent down payment, and even this modest sum was often covered by nonprofits groups tied to developers or builders.

• AIG’s predictive models for defaults on credit default swaps never considered that counterparties had a right to demand cash collateral from AIG.

• The decline of the Dow Jones Industrial Average accelerated after Congress authorized the Treasury to spend billions of dollars resolving the financial crisis.

Too Big to Save? is a comprehensive book. Is anything missing? One of the regulatory decisions Pozen points to as important to understanding the financial crisis was a Securities and Exchange Commission vote in 2004 that enabled investment banks to use a different method of calculating their capital requirements. After this measure was approved, says Pozen, the investment banks dramatically increased their leverage levels (Bear Stearns reached about 33:1 shortly before its demise), which made them highly vulnerable when the slowdown arrived. But what’s an acceptable leverage level? Pozen touches on this, though in no great detail. Some historical comparisons of leverage levels would have been welcome.

Regulation can provide a false sense of security—and regulators must remember that good regulation is going to be trumped by bad behavior.

There is one other fundamental issue I would have liked Pozen to grapple with: the effectiveness of regulation. In all of the commentary about how to address the financial crisis, it’s striking how little anyone focuses on the fact that there was a landmark corporate reform bill, Sarbanes-Oxley, signed into law just a few years before the market started to go haywire. Did it do anything to mitigate (or perhaps even contribute to) the financial crisis?

This question gets at the issue of whether regulation is always going to be a step (or many steps) behind the market innovations that make the financial sector so dynamic. It’s well established that soon after cracking down on one set of practices, other practices come into existence that threaten the stability of the financial system. So regulation can provide a false sense of security—and regulators must remember that good regulation is going to be trumped by bad behavior.

That calls for a strict enforcement regime that punishes wrongdoers. It’s also a reminder that regulation is, ultimately, a second-best measure. The long-term health of the marketplace depends on market participants who are imbued with a deep commitment to ethics, integrity, and professional responsibility, as that builds the trust that leads investors to allocate capital with the belief that they are playing a game that is fair. It’s not government’s job to inject a greater commitment to ethics and integrity into the marketplace, but the issue merits more attention from a range of institutions—from financial to educational—since it is a cornerstone of prosperity, and a determinant of market returns and economic growth.

Matthew Rees is the founder of Geonomica, a speechwriting firm focused on financial markets.

FURTHER READING: Jeffrey Friedman discussed causes for the financial crisis in “Capitalism without Romance,” Alex Pollock considers a world after the crisis in “TARP and Leviathan,” and Arnold Kling explains “Regulation and the Financial Crisis: Myths and Realities.” AEI scholars outline “The Cascading Financial Crisis,” while Peter Wallison explains “What’s Missing in the Financial Rules Bill?”

Image by Darren Wamboldt/Bergman Group.

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