Has Wall Street Learned its Lesson?

A new book argues that that the blame for the financial crisis lies not with greedy bankers or foolish homeowners. The real culprit is Wall Street replacing human judgment with financial models.

Andrew Redleaf and Richard Vigilante’s new book, em>Panic:  The Betrayal of Capitalism by Wall Street and Washington< is the perfect antidote to the political and mainstream media sensationalism that have drown out rational explanations of what actually transpired to take us to the edge of the abyss.  To the Left, deregulation, greedy Wall Street bankers and predatory lenders were the main culprits; to Main Street and the Tea Party movement, greedy bankers and corrupt public policies combined forces to lend mortgages to Americans who just didn’t deserve to own a home; and, to the casual but rational observer, there was just too much leverage in the system, particularly mortgage debt carried by American homeowners.  All of these observations may be valid, but true accountability lies deeper within the American financial culture.

In language that is clever and accessible, the authors lay out a longer view of the roots of the crisis, striking at the heart of “modern finance ideology” – the acceptance of “efficient markets” as a replacement for human judgment that has characterized the American financial system over the past several decades. Once the engines and operators of the global financial system delegated risk management to statistically-driven algorithmic models, they abandoned the human curiosity and self-doubt that are required to monitor and challenge the very assumptions that feed the models.  Remember the 1983 movie War Games with Matthew Broderick?  If no human being periodically challenges and provokes the system, we end up with the financial equivalent of global thermonuclear war.

If only the investors – Wall Street firms, pension funds, foreign central banks – were the only ones who embraced the notion of efficient markets then perhaps some of the damage could have been contained. But what made this latest crisis catastrophic and inevitable, the authors argue, is that the regulators (and ratings agencies) all believed the same assumptions.  Innovation of financial instruments and corresponding accounting practices outpaced the regulatory frameworks in place to monitor and prevent systemic failure.  The result was that regulators (and most Wall Street analysts) reached the same conclusion as the banks themselves – that risk was sufficiently spread around to accommodate any major shocks.  We know that to be true because the models said so.

In the wake of behind-the-scenes accounts of the events leading up to crisis such as Andrew Ross Sorkin’s Too Big to Fail and former Treasury Secretary Henry Paulson’s On the Brink, which focused largely on the powerful personalities at the center of the storm, it is refreshing to read a straight-forward, pragmatic assessment of how and why the system experienced such utter failure.  To their credit, the authors and some well known investors like John Paulson identified systemic risks early on, made huge bets and reaped enormous rewards shorting the housing and mortgage markets.  This early contrarian position provides Panic with market credibility that is lacking in more academically-oriented competing views.

But if there is a broad weakness in Panic, it is the authors’ failure to address where we go from here.  Don’t we have the very embodiment of an anti-capitalist, “inefficient market” when there is only one real participant in housing finance (the U.S. government)?  Through trillions of dollars of TARP, RMBS purchase programs and FDIC/FHA/GSE guarantees, banks have been deleveraged and risk shifted to the taxpayer.  FHA-insured loans have become the new subprime and Fannie/Freddie have choked off credit to all but the best borrowers while implementing appraisal rules that perpetuate downward pressure on home prices.   The financial crisis of 2008 was created by cheap credit beginning with Fed rate cuts in 2001, faulty model assumptions, poor regulation, a cognitive belief that risk was permanently contained and by widespread fraud.

Today, we are in more or less the same place.  Rates are at all-time lows, Wall Street models assume housing prices fall, financial regulatory reform bills are stuck in Congress and banks are still holding mortgages at artificially high values, paying bonuses on profits that are at best exaggerated and at worst outright lies.  Instead of a housing bubble, we have a housing crater.  Default risk?  What default risk?  U.S. government guarantees are considered to be “risk-free.” In the authors’ words, “U.S. home mortgages remained the foundation of the U.S. banking system and thus of the American economy and the dollar itself.”  This statement has never more true than today – just insert “government-insured” before mortgages.  What has changed?  Only the model assumptions, and now they all point downward.