Government panel report is more sizzle than steak

The final report from the Financial Crisis Inquiry Commission is a disappointment. It fails to reach a firm conclusion about what actually caused the financial crisis and, worse, it provides little guidance on how to

identify and prevent future crises.The report also falls short in that the panel split along partisan lines and didn’t unite behind its findings. Because of those divisions, the report published by the majority was accompanied by two dissents.

In its report, the FCIC identifies a range of perpetrators, including banks that obviously made reckless bets, credit-rating agencies that endorsed risky mortgage bonds, and various government regulators that overlooked danger signs until those weaknesses threatened the global financial system.

But the 633-page report, which was crafted by a 10-member commission appointed by Congress, doesn’t identify how the housing bubble that led to the mortgage collapse and the financial crisis was inflated in the first place. It also doesn’t suggest how to identify and prick emerging bubbles.

Its vision is too narrow.

The majority report argues that though excessive capital availability was an essential ingredient in the bubble, the crisis still could have been averted if the Federal Reserve and regulatory agencies had acted to rein in the excesses in the mortgage-lending industry.

‘WIDESPREAD FAILURES’

The first cause of the crisis listed in the report is “widespread failures in financial regulation and supervision.”

Other causes identified include “widespread failures of corporate governance and risk management at systemically important institutions,” “a combination of excessive borrowing, risky investments and lack of transparency,” “a systemic breakdown in accountability and ethics,” and “collapsing mortgage-lending standards and the mortgage securitization pipeline.”

It also noted that “over-the-counter derivatives contributed significantly” and that “the failures of credit-rating agencies were essential cogs.”

The majority report argues that while the actions of Fannie Mae and Freddie Mac contributed to the crisis, they weren’t a primary cause. However, the agencies suffered from the same failures of corporate governance and risk management as other financial firms.

Meanwhile, the minority report states that while Fannie and Freddie didn’t cause the crisis, they were major contributors.

The more important of the dissents, joined by three of four Republican appointees, it argues that the thesis that too little regulation and lax enforcement of regulation is too simplistic an explanation for the crisis.

UNANSWERED QUESTIONS

It asks important questions not addressed by the majority report: Why did housing bubbles occur at the same time in many countries, which all have different regulatory frameworks and different mortgage finance systems? Why did large financial institutions in other countries collapse, even though they weren’t significantly exposed to U.S. mortgage assets and operated in different regulatory environments?

The dissent argues that there were 10 essential causes of the crisis, starting with the capital surpluses built up by China and other emerging countries. These surpluses produced credit bubbles in Europe and the United States, which in turn produced the housing bubbles.

Although many of the other causes identified by the dissent agree with those identified in the majority report, the emphasis is different. For example, the dissent puts more emphasis on the highly correlated bets major institutions placed on mortgage-related investments, and on the leverage that magnified those bets.

The second dissent blames the crisis almost exclusively on Fannie Mae and Freddie Mac.

There were several major problems with the commission.

First, it was given a time limit for its investigations — it had to report to the president and Congress by Dec. 15. This no doubt hampered the development of its analyses of the causes.

Second, the Dodd-Frank financial reform law was passed before the commission finished its investigations, making the outcome almost irrelevant. Third, perhaps because the reform law likely would be passed before the commission reported, it wasn’t asked to present proposals for changes in law or regulation.

In essence, Congress decided to treat the illness without waiting for a diagnosis. Nevertheless, though not asked to do so, the commission should have examined Dodd-Frank in the light of its investigations and commented on whether the law’s provisions were likely to prevent another such crisis.

This would have made the report more relevant and it might have prompted amendments to improve the financial reform law, or at least provided guidance to those developing the regulatory changes called for by the law.

NO DEFENSE FOR FUTURE

However, while better regulation might prevent a repeat of the mortgage bubble and the subsequent financial crisis, it is unlikely to prevent future bubbles, which are easier to identify in hindsight. The mortgage bubble began less than five years after the bursting of the technology bubble, and yet few recognized the warning signs.

Investors can’t rely on government regulation to protect them from financial manias and the damage that occurs when manias end. With the help of their financial advisers, investors must develop their own warning systems and their own emergency plans so as to avoid or minimize their losses in such situations.