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.
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.
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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.