By Richard Roth, J.D., Editor, the CCH Federal Banking Law Reporter, CCH Bank Compliance Guide, Bank Digest; co-author, Dodd-Frank Wall Street Reform and Consumer Protection Act—Law, Explanation and Analysis.
There were enough warning signs before the financial crisis struck that it could have been prevented, according to the final report of the Financial Crisis Inquiry Commission. Commission Chairman Phil Angelides said that "The greatest tragedy would be to accept the refrain that no one could have seen this coming and thus nothing could have been done. If we accept this notion, it will happen again."
"The captains of finance and the public stewards of our financial system ignored warnings and failed to question, understand, and manage evolving risks within a system essential to the well-being of the American public. Theirs was a big miss, not a stumble," the report asserts.
The FCIC report spreads blame for the crisis broadly, covering banks and bankers, regulators and consumers. It traces the crisis to five main causes:
- regulatory failures, which specifically include the Federal Reserve Board’s failure to act against "toxic mortgages";
- corporate governance failures, including recklessness and excessive risk-taking;
- excessive borrowing and risk-taking by both consumers and Wall Street;
- policymakers’ failure to understand fully the financial system they were supposed to regulate (with the Fed, Treasury Department and Federal Reserve Bank of New York receiving special notice); and
- systemic breaches in accountability and ethics at all levels.
Contrary to some assertions, the FCIC determined that while the government-sponsored housing enterprises contributed to the crisis, they were not a primary cause. The GSEs participated in the expansion of subprime and other risky mortgages, but they followed rather than led Wall Street and other lenders in the rush for fool’s gold, the report concludes. However, a dissenting report by Commissioner Peter J. Wallison principally places the blame for the crisis on the federal government’s housing policies.
The FCIC report specifically describes a number of signs that should have warned of an impending crisis, such as:
- an explosion in risky subprime lending and securitization;
- an excessive rise in housing prices;
- egregious and predatory lending practices;
- large increases in consumers’ mortgage indebtedness;
- rapid growth in financial firm trading activities, in derivatives and in short-term "repo" lending markets.
The FCIC attributes the failure to heed these warning signs to pervasive permissiveness and deems the Fed’s failure to act against toxic mortgages as the "prime example."
Financial System Component Failures
The report goes on to describe how problems in specific components of the financial system contributed to the crisis. According to the FCIC:
- The decline in mortgage lending standards combined with the mortgage securitization process to both start and spread the crisis.
- Over-the-counter derivatives contributed to the crisis by encouraging mortgage securitization, permitting the creation of synthetic collateralized debt obligations, and being "in the center of the storm" when the housing bubble popped. The FCIC specifically notes the effects of legislation in 2000 that prohibited the regulation of OTC derivatives, calling it "a key turning point in the march toward the financial crisis."
- Credit rating agency failures were essential to the crisis. "Their ratings helped the market soar and their downgrades through 2007 and 2008 wreaked havoc across markets and firms," according to the report.
Three commissioners, including the vice-chairman, filed a dissenting report. The dissenters identify 10 causes of the financial crisis:
- a credit bubble with its roots in the 1990s when China, some developing nations and the oil producing nations accumulated large capital surpluses that they loaned to the United States;
- a housing bubble that began in the 1990s and grew in the following decade;
- the use of nontraditional mortgages that often were deceptive, confusing and beyond consumers’ ability to repay;
- failures in credit rating and securitization that "transformed bad mortgages into toxic financial assets";
- financial institutions that concentrated risk in housing, mortgages and related investments;
- excess leverage and liquidity and inadequate capital;
- risk of contagion—the fear that the failure of one large firm would bring others down as well;
- "common shock"—many financial institutions failing because they made the same investments;
- financial shock and a resulting loss of confidence in the financial system; and
- the financial crisis spreading to a crisis in the broader economy.
The complete reports are available on the FCIC’s website at www.fcic.gov.