Wednesday, March 5, 2008

They Were Warned and Didn't Listen

From the WSJ:

A top Federal Reserve official said the central bank failed to fully appreciate risks that financial institutions were taking before the recent credit problems, and it is reviewing its regulations.

During a sometimes-contentious Senate hearing, Fed Vice Chairman Donald Kohn said the central bank is likely to become "more forceful" with the financial institutions it supervises. Mr. Kohn didn't explain what new actions the Fed might take, but he did warn banks to rely less on the assessments of credit-rating agencies.

After years of watching the banking industry make record profits, regulators are now scrambling to deal with turmoil stemming from problems in the U.S. housing market. Large U.S. banks have had to write down the value of assets by billions of dollars, including slivers of mortgage-backed debt that many believed were almost risk-free.

Mr. Kohn's comments mark one of the few times that a top Fed official has acknowledged shortcomings in regulation as a cause of the mess.

"I don't know that we fully appreciated all the risks out there," he told the Senate Banking Committee. "I'm not sure anybody did, to be perfectly honest." Later, he said the Fed "did not perform flawlessly -- I absolutely agree with that."

Now they admit things got out of hand. Well -- they have been warned. While I've been writing about the negative implications of the massive debt build-up in the US economy, I doubt Fed officials read my stuff on a daily basis -- if at all. But I'm not the only one whose been warning about this stuff by a long shot:

Edward M. Gramlich, a Federal Reserve governor who died in September, warned nearly seven years ago that a fast-growing new breed of lenders was luring many people into risky mortgages they could not afford.

But when Mr. Gramlich privately urged Fed examiners to investigate mortgage lenders affiliated with national banks, he was rebuffed by Alan Greenspan, the Fed chairman.

In 2001, a senior Treasury official, Sheila C. Bair, tried to persuade subprime lenders to adopt a code of “best practices” and to let outside monitors verify their compliance. None of the lenders would agree to the monitors, and many rejected the code itself. Even those who did adopt those practices, Ms. Bair recalled recently, soon let them slip.

And leaders of a housing advocacy group in California, meeting with Mr. Greenspan in 2004, warned that deception was increasing and unscrupulous practices were spreading.

John C. Gamboa and Robert L. Gnaizda of the Greenlining Institute implored Mr. Greenspan to use his bully pulpit and press for a voluntary code of conduct.

“He never gave us a good reason, but he didn’t want to do it,” Mr. Gnaizda said last week. “He just wasn’t interested.”

And here's the money quote:

An examination of regulatory decisions shows that the Federal Reserve and other agencies waited until it was too late before trying to tame the industry’s excesses. Both the Fed and the Bush administration placed a higher priority on promoting “financial innovation” and what President Bush has called the “ownership society.”

On top of that, many Fed officials counted on the housing boom to prop up the economy after the stock market collapsed in 2000.

Mr. Greenspan, in an interview, vigorously defended his actions, saying the Fed was poorly equipped to investigate deceptive lending and that it was not to blame for the housing bubble and bust.

First, I'm pretty sure the standard response was, "you're being a worry wort. Everything will be fine. Self regulation will work out." Seven years later we know that's just not true.

Here's the bottom line: you have to have rules. Left to their own devices, people in powerful positions have a tendency to become greedy which in turn compromises their ethics.

A story from law school comes to mind. One day I was in the student lounge watching the news when a story came across the wire that an executive at a corporation had lied about financial figures. He overstated earnings, which would have boosted the stock price. This in turn would have made his options more valuable.

A person behind me commented, " just lose your ethics when you become an executive?"

Here's my response: excessive virtue is the result of insufficient temptation. Think about this. You're an executive with a large corporation. One day your CFO comes in and says, "we could game the numbers and make the company more profitable on paper. This should increase share value which could increase your net worth by $100 million dollars." What would you do? Anyone who says they wouldn't at least think about it is lying. Figures that large tend to do that. And when you know a whole system is gamed like that (for example, mortgage brokers who don't perform credit checks, banks and ratings agencies barely perform collateral checks) your ethics get squishier. And then you realize that $100 million buys a lot of lawyering to keep you out of jail.

While I am all for capitalism, I also realized that capitalism unleashes greed. Greed must be controlled or it will feed on itself and eventually destroy the system completely. Think I'm wrong? This chart says I'm right: