The Most Astonishing Thing About the Financial Crisis

Of all the fascinating accounts of the financial crisis that have come out in recent years, Sheila Bair's Bull by the Horns has to be one of the most astonishing.

Bair headed the Federal Deposit Insurance Corporation from 2006 to 2011, during which time she played a leading role in coping with the unfolding disaster as well as reforming the system. The FDIC is responsible for preventing bank runs in the United States by insuring bank deposits, supervising risk-taking, and cleaning up failing banks.

Bair's known for taking a no-nonsense approach to dealing with Wall Street. She currently chairs the Systemic Risk Council, an independent, nonpartisan group that includes Paul Volcker, Simon Johnson, Jeremy Grantham, Jack Reed, and reform-minded financial experts.

Bull by the Horns ruthlessly explores the crisis and its aftermath. Nearly every page reveals something astonishing about our financial and political systems.

Here are just a few of the intriguing bits:

"Bailing out the boneheads"
A big chunk of the book covers what Bair describes as incompetence by many of the people running our largest banks, and the largesse policymakers lavished on them during bailouts.

Bair characterizes Citigroup's (NYSE: C  ) management as "bungling", its then-CEO Vikram Pandit an inexperienced banker, a "poor choice ... a hedge fund manager by occupation and one with a mixed record." Bank of America (NYSE: BAC  ) then-CEO Ken Lewis exhibited poor deal-making skills, overpaying for Countrywide and Merrill Lynch. And Merrill Lynch then-CEO John Thain? He drops the first question in the bailout briefing: Will there be limits on executive bonuses?

But Bair reserves her harshest criticism for fellow (de)regulatory heads -- John Dugan, John Reich, and especially Timothy Geithner -- for going too easy on the banks. During the go-go days, they were eager to let banks ratchet up risky behavior. During the bailout, Bair portrays Geithner as eager to extend generous bailouts with few strings attached. In Bull by the Horns, he pushes for the teetering Citigroup to acquire Wachovia instead of the much stronger Wells Fargo (NYSE: WFC  ) so as to get the FDIC to ensure Citigroup's loans. He tries to water down key financial reforms such as the Volcker Rule and tougher capital cushion standards with mixed success.

Bair takes pains to point out that these examples of deregulation and bank-coddling aren't due to corruption per se, but stem from a common worldview: banking "self-regulation" works better than correct incentives and real regulatory oversight, and the preservation and profitability of our megainstitutions trump other concerns.

Forestalling disaster
One of the key reasons the American financial system is in so much better shape than Europe's today is that European banks, if it can be believed, took on even more debt than ours did. While we tend to think of the 30 times leverage U.S. investment banks like Lehman Brothers took on as Exhibit A in a bygone age of stupidity, it was common for European banks to use as much as 50 times leverage. (Barclays (NYSE: BCS  ) , Credit Suisse (NYSE: CS  ) , and Deutsche Bank (NYSE: DB  ) still carry more than 25 times leverage.)

In 2004, during a period of prevailing deregulatory fervor, bank regulators came to the "Basel II" international framework that said banks should be allowed to use their own models to figure out how much capital they would need to set aside in case things went bad. Because more leverage means higher profits for banks but more risk, banks obviously decided to use too much leverage.

Bair describes how, with a little help from Ben Bernanke, the FDIC was able to continue slow-walking the implementation of Basel II. Looking back, it's astonishing that even in 2006, on the doorstep of the largest financial crisis in generations, banks like Washington Mutual (which two years later would become the largest bank failure in U.S. history) were aggressively trying to increase risk-taking. FDIC figures showed that big banks might have released a whopping quarter of their safety cushion if Basel II had gone into effect.

Bair's account adds new color to then-Citigroup CEO Charles Prince's infamous 2007 comment, "As long as the music is playing you've got to get up and dance. We're still dancing."

Turning around the FDIC
Pretty much every FDIC employee I've spoken with agrees that Bair turned the place around. How she managed to do so provides an important lesson in management for managers and investors alike.

The key, as she told me and described in her book, was restoring a sense of purpose. People at the FDIC needed to know that management supported them, and they needed objective incentivized goals such as bonuses for making sure that every failing bank would be open for business the next day after the FDIC took over.

"Stepping over a dollar to pick up a nickel"
In 2010, the "robo-signing" scandal shined a public spotlight on some of the damaging conflicts of interest in today's banking world. Under the old model whereby lenders held onto mortgages, banks might save quite a bit of money by modifying troubled mortgages rather than foreclosing on homeowners. But today, the banks that service mortgages don't always have skin in the game for loans that have been pooled, sliced up, and sold to investors. Unfortunately, that means it's sometimes more cost-effective for banks to needlessly foreclose on struggling homeowners rather than modify their loans, even in cases where both homeowners and investors would be better off.

Bair describes efforts to fix the problem dating as far back as 2007, which suggests that such conflicts of interest may have been a massively underappreciated cause of the financial crisis. She also describes how the conflicts of interest run even deeper than the servicing level, with some investors actually threatening to sue servicers for trying to save them money by rehabilitating bad loans. Why? Investors who had bought the top slice of pools of loans were protected under a mass foreclosure scenario because they'd only lose money if more than 20% or 30% of mortgages defaulted.

It's an underappreciated example of how poor market incentives, conflicts of interest, and shortsightedness helped to undermine the financial system.

The most astonishing thing
I asked Bair what she thought was the most surprising thing about her time at the FDIC. She gave an interesting two-part response:

How bad it got. We didn't have the information that we needed. That's why it's good the Dodd-Frank financial reform law gave the FDIC backup regulatory authority for large banks.

Also the response was so ad-hoc. Policymakers were too reluctant to let the banks take any pain.... I never saw any good analysis on who Bear Stearns' counterparties were and why they needed to be bailed out in that way. [JPMorgan (NYSE: JPM  ) received federal assistance to acquire Bear Stearns.] Why couldn't AIG's (NYSE: AIG  ) counterparties take a 10% haircut? Why did we have to pay those AIG derivatives employees their $165 million retention bonuses -- did we really want to keep those guys?

To this I think it's fair to add the astonishing lack of thoughtfulness and introspection on the part of the crowd which thinks that what's best in the short term for Wall Street is what's best for America, a sentiment that -- believe it or not -- is still all-too-common in New York and Washington. You'd think the financial crisis would have laid bare that Wall Street needs a fundamental transformation of incentives and meaningful, clear rules banning socially dubious practices that put our entire economy at risk.

But learning from the crisis is still a work in progress. Exhibit A: Only about one-third of the 2010 Dodd-Frank Wall Street Reform Act has actually been implemented by regulators more than two years after the law's passage. That's because Wall Street and its allies are fighting tooth and nail to carve out exemptions from any rule that could possibly impinge on the profitability of the largest banks.

The result is a series of unnecessarily complex, difficult to navigate rules that may or may not get the job done, whereas in many cases, simple, straightforward rules could be effective. For example, if it's very difficult to craft a perfect ban on speculation that still permits hedging risk, then in addition to a ban, as Bair puts it, "don't let banks pay derivatives managers who are supposed to be only making hedges bonuses for their trading profits."

The American pragmatist philosopher William James noted that in certain cases where we're forced to make a timely judgment, endless nitpicking itself "is attended with the same risk of losing truth." Regulators and investors alike have to form judgments about complex phenomena based on imperfect evidence. The trick to making good choices is to also consider what happens when you're wrong, because that's going to happen sometimes.

In the case of financial reform, regulators, bankers, politicians, and society should be asking themselves, is the monumental complexity of our largest banks so socially valuable that we really need to gamble another financial crisis over hair-splitting the perfect rule? Maybe it's better -- as Bair thinks it is -- to cut the financial system's Gordian knot with clean, simple rules that are easy to enforce.

Her book is a fascinating read. You can buy Bull by the Horns here.

And if you want us to keep you up-to-speed on financial reform and investor protection, just shoot a blank email to financialreform@fool.com.

Ilan Moscovitz has no positions in the stocks mentioned above. The Motley Fool owns shares of American International Group, Bank of America, Citigroup, JPMorgan Chase, and Wells Fargo and has the following options: long JAN 2014 $25.00 calls on American International Group. Motley Fool newsletter services recommend American International Group and Wells Fargo. Try any of our Foolish newsletter services free for 30 days.

We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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Read/Post Comments (5) | Recommend This Article (45)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 07, 2012, at 7:39 PM, TMFBane wrote:

    Great review, Ilan! I'll definitely get a copy of the book. It sounds interesting.

  • Report this Comment On December 10, 2012, at 11:12 PM, DBrown7 wrote:

    Excellent article! If there were any justice in Washington, Sheila Bair would be nominated for Secretary of the Treasury when Geithner steps down. Unfortunatly, there is probably little chance of this happening, since she is not friend of Wall Street.

    I saw her interviewed recently and she seemed to indicate she would accept the nomination. I think she also recognized that the nomination was unlikely to come her way. What a shame! She would be a breath of fresh air in our nation's capital and a more than capable Treasury Secretary. Maybe there should be a grassroots movement to promote her nomination. TMF could lead the effort. It would be a great service to our country.

  • Report this Comment On December 11, 2012, at 2:29 AM, erikinthered100 wrote:

    It might be interesting to hear her take on Dodd-Frank which has been harshly criticized for not only failing to address "too big to fail" but increasing the likelihood of further bailouts. "Bailing out boneheads" only rewards incompetence and/or corruption. Instead of prosecuting the Wall Street criminals who bungled and pillaged, the current party in power has rewarded them with billions in bailouts.

    Dodd-Frank also failed to address government meddling in the market in the form of the GSE's and Community Reinvestment Act which inflated the housing bubble by pushing irresponsible lending.

    It would seem that Bair would find Dodd-Frank, the opposite of "clean and simple," to be an abomination.

  • Report this Comment On December 11, 2012, at 4:11 PM, TooTall100 wrote:

    This review is a shill job. Having not read the book I won't comment on it. The notion that stupidity is the primary cause of the financial meltdown is hors**t. The calamity was the largest ponzi scheme in the history of mankind. I get it. The idea is to paint the picture of incompetence, forgive the criminals, and queue up for the next party. I prefer the punitive approach. Lets realign the Department of Jokestice and go after the ratings companies who clearly committed fraud. That would be Moody's and Standard and Poors to name a few. For S and P to say 'oh its just our opinion' is truly an insult. Here is a company built on trust. Where do you look for good numbers and high quality ratings? Why, S and P of course. These people ARE PROFESSIONALS. They rate debt instruments for a living. For them to say 'we didn't know' is inexcusable, and its a lie. For them to go from being trusted for generations to being con artists in a flash is criminal. The crime is called fraud. Please.

  • Report this Comment On December 14, 2012, at 5:35 PM, SkepikI wrote:

    There are generally interesting things to be learned from bubble failures. BUT the most interesting thing is to apply them to the NEXT bubble. Very few are calling the financial crisis in Investment Banking/Banking a bubble, and I am no banking expert, but it sure has the look to me. SO, where might the next one be? hmmmm excessive valuations, out of historic proportion returns, under average risk adjusted "earnings" lots of claims that its a new age and historical precedents don't apply anymore. Official tolerance or policy of looking the other way when new and unusual practices are employed, AND pleas that the experts know what they are about. Sounds like the Bond Market today. I sincerely hope I am wrong. Between the circular game of 3 card Monte on equities, real estate, banking and now maybe bonds, I fail to see how the movement of a bubble in peoples assets followed by a bailout that moves the bubble elsewhere can end well.

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