I wanted to address a glaring error in a David Leonhardt NYT Sunday Magazine article, titled Heading Off the Next Financial Crisis,

In the column, Leonhardt wrote:

“But there was a fatal flaw in the new system. The banks’ new competitors received scant oversight. They were not directly bound by Roosevelt’s restrictions. “We had this entire system of outside banks that had no meaningful constraints on capital and leverage,” Geithner says. Investment banks like Lehman Brothers were able to make big profits in part by leveraging themselves more than traditional banks. To use the down-payment analogy again, it was as if Lehman were allowed to put down only 3 percent of a house’s purchase price while traditional banks were still making larger down payments. When the house’s value then rose by just 3 percent, Lehman doubled its investment. A.I.G., similarly, created a highly leveraged derivatives business that regulators essentially ignored…

The deregulation of the last few decades has come in for a lot of blame for the current financial crisis. It deserves some blame, too. If Citigroup and Bank of America were still operating under the New Deal rules, they might not have flirted with bankruptcy. But take a minute to think about which firms had the biggest problems. They were the shadow banks: stand-alone investment banks like Lehman, Bear Stearns and Merrill Lynch; and other firms, like A.I.G., that were not banks at all. They were never fully covered by the New Deal regulation, and they were not the ones most affected by the deregulation.” (emphasis added).

This is not precisely right.

And as applied to AIG, it is absolutely, totally wrong.

Thanks to the The Commodity Futures Modernization Act of 2000 (CFMA), the universe of structured derivatives were completely exempt from ALL regulation. Whether it was Collateralized Debt Obligations (CDOs) or Credit Default Swaps (CDSs), the CFMA put them into the world of shadow banking.

How? The CFMA mandated it.  No supervision was allowed, no reserve requirements for potential future payouts were mandated, no exchange listing requirements were put into effect, all capital minimums were legally ignored, there was no required disclosures of counter-parties. Derivatives were treated differently from every other financial asset — stocks, bonds, options, futures. They were uniquely unregulated.

Indeed, even state insurance regulators were prevented from oversight — including normal  reserve requirements. That was how AIG Financial Products was able to ramp up their derivative exposure to more than three trillion dollars.  This was directly due to radical deregulation.

Even the most basic reserves would have kept their derivative exposure to much more modest numbers. With absolutely zero capital requirements, AIG FP went wild. Tom Savage, the president of FP, summed up what the lack of reserve requirements meant to the firm: “The models suggested that the risk was so remote that the fees were almost free money. Just put it on your books and enjoy.”

To the tune of $3 trillion dollars.

All in all, this wasn’t so much a case of Washington DC failing to keep up with Wall Street, rather, it was a case of DC actively granting what Wall Street (Enron, AIG and other derivative traders) wanted — precisely zero oversight.

Hence, it was deregulation that made the AIG disaster possible.

As to the investment houses (Bear, LEH, MER, etc.), all you need to do is look one step upstream in the securitized mortgage process. There, you see the impact of the radical deregulation mindset.

Consider the mass of subprime loans that the investment houses were securitizing. The majority of these came from non-bank lenders. These were the firms that Fed Chair Alan Greenspan described as innovators.

He elected not to regulate them. I called this “Nonfeasance” in Bailout Nation. No lending standards: Zero income checks, ignore the debt load, eliminate LTV, even fail to do a simple simple FICO credit check. Just a lend-to-anyone-then-sell-to-securitizers business model.

Securitization wasn’t the problem, it was simply Garbage in, Garbage out. Had Greenspan required nonbank lenders to maintain normal lending standards (As was his official duty), much of the crisis could have been avoided. At the very least, all of the subprime related loans, derivatives, and default swaps built on top of these garbage mortgages would have been dramatically reduced.


Bottom line: Radical Deregulation is what allowed most of the worst actions to take place. This wasn’t a case of DC failing to keep up with Wall Street — its more accurate to observe that DC rolled over for Wall Street, and gave the Street precisely what it asked for.


Heading Off the Next Financial Crisis
NYT, March 22, 2010

Category: Bailouts, Derivatives, Financial Press, Really, really bad calls, Regulation

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

26 Responses to “Misunderstanding the Last Financial Crisis”

  1. We cannot possibly fix Wall Street and finance if we fail to understand what is wrong. The magazine article failed to recognize key elements of the crisis.

    The lack of oversight was by design. It wasn’t that Washington failed to keep up, as Leonhardt states incorrectly. It was that they were designed out of the way, in some cases like derivatives, completely.

    Let’s hope policy makers get their bailout facts and analysis from other sources . . .

  2. Marcus Aurelius says:

    Why do we allow our banking system — specifically the Fed and it’s member banks – to operate for profit and outside the public trust? If fiduciary duty is at question (and demonstrably, it is), clear regulations, in the form of laws, as well as strict enforcement, are required in order to protect the public trust and treasure.

    P.S: rootless cosmopolitan: “we” in this context includes the citizenry of the United States of America. Just in case you don’t understand the context in which I (as in me – a specific organism) used the word.

  3. tagyoureit says:

    Innovative, free markets, gotta love em! Anyone for tea?


  4. anewc2 says:

    It wasn’t so much DC giving Wall Street what it wanted, they were simply delivering on what had been bought and paid for.

  5. Peter G. says:

    Thanks Phil Gramm!
    …and who said one man can’t make a difference.

    The man simply never saw a radical deregulation he didn’t like.

  6. don’t We have a more basic, systemic, problem of utilizing a Debt-based Currency Schema?

    circulating Currency, at interest, is designed to Fail, no?

    see QOTD: “The monstrous credit and debt bubble in the United States, through years of overaccommodation by the Federal Reserve, has created an economy with an array of horrible and massive dislocations and imbalances that make a sustained recovery impossible.” —Kurt Richebacher

    and http://economicedge.blogspot.com/2010/03/most-important-chart-of-century.html

  7. no, that’s an entirely different issue than this one.

    (Damn gold bugs!)

  8. BR,

    I can appreciate that it’s a different issue, though, We’ve a problem, created by the existence of the FedRes, along the lines of: “Why do we allow our banking system — specifically the Fed and it’s member banks – to operate for profit and outside the public trust?”–MA, above.

    The USTreas, as our History shows, is equally capable of circulating Fiat Currency. We should cut out the middle-man, the FedRes. At the very minimum, we could keep the vig in our own Pockets, not those of some Stranger(s)..

    but, to be clear, I’m more of a “Free Banking” advocate, complete with competitive Currencies, than a Gold Standard ‘hard-liner’..

    LSS: Monopolies, anywhere found, are sub-optimal. They reduce innovation and, thereby, cripple those who are under them..

  9. flipspiceland says:

    Thanks for doing that.

    When I read about a third of the way thru it yesterday, I threw the paper across the room, ran out of the house and cut down some trees with a Recip saw, that required more energy than I had theretofore been able to muster.

  10. JSchmid says:

    Marcus Aurelius – the answer to your question can be found in Freddie Mac and Fannie Mae. Both are public organizations that are out of control and the fact that they are government run makes them worse because they have less accountability than private banks.

    The answer to the problem is not bigger and more government but rather smaller and more banks… if we limited the max size of any one bank. the bank would become more accountable to the community it serves and less likely to have any significant effect on the overall market in the event the bank goes belly up.

  11. I’m down with more banks, more competition, and removing the absurd competitive advanattges the bailouts gganted to the 10 largest banks.

  12. willid3 says:

    i wonder how the supporters of the TBTF keep coming up with ways to misdirect blame? we have them blaming the CRA, Freddie and Fannie, etc, all seemingly just escape the fact that the TBTF created todays debacle. and created a mirage of an economy that appeared to be working fine, but in reality wasn’t much more than hoax

  13. BILLCNY says:

    Barry: You are correct that the federal government gave Wall Street carte blanche on derivatives. However it is important to understand how bipartisan that effort really was. I have done a little noodling around and found the following.

    Sen. Phil Gramm is often associated with this legislation but in the Senate he was one of several co-sponsors. Interestingly, both Tim Johnson and Tom Harkin, currently sitting Democratic members of the Senate were among the Senate co-sponsors of the legislation.

    In the House the first g0-round, HR 4541, passed the House on a vote of 377-4. Two Democrats and two Republicans voted against the measure. Among the Democrats voting for that bill were Nancy Pelosi, Steny Hoyer, Barney Frank, Jim Clyburn, Henry Waxman, David Obey and John Dingell. A conference committee report caused the introduction of HR 5660 which passed 292-60. On this vote Hoyer, Clyburn, Obey and Dingell voted “aye”. Barney Frank voted “nay” and Pelosi and Waxman did not vote.

    This House bill then went to the Senate where it was passed by unanimous consent, although Senators Inhofe and Wellstone apparently objected to the proposed legislation. I guess in Washington the word “unanimous” means something different from my understanding of that word. Be that as it may, the bill was signed into law in December 2000 by President Bill Clinton.

    Why do I bring this up? I fear that too many people do not understand what really caused the passage of this bill. It passed because the securities industry owns Congress, including both political parties. The companies in that industry are our generation’s Robber Barons. Anyone who thinks one political party bears more responsibility for the derivatives mess than the other party is deceiving himself and is likely to put his hope in the “other” political party stepping in to fix things. That approach is nothing short of foolish. For example, good luck to anyone thinking that derivatives will be subjected to any effective regulatory scheme.

  14. Moss says:

    Brings new meaning to the Intelligence Design theory.

  15. Niskyboy says:

    What happened to the blog, News from 1930, today?

  16. burnstony says:

    “No haircut Capital Management” -John Merriweather – When Genius Failed

  17. [...] Ritholtz lays out the case that AIG is the result of specific deregulation carried out in 2000. Two things about [...]

  18. rootless_cosmopolitan says:

    @Marcus Aurelius:

    “Why do we allow our banking system — specifically the Fed and it’s member banks – to operate for profit and outside the public trust?”

    As for “operate for profit”. It’s a capitalist society. The main purpose of any economic activity in a capitalist society is to generate profit for the investors/owners of the means of production. Banks or any other private companies aren’t founded to “serve the public”. The question of the degree of regulation as a framework for operating for a profit is another one then, though.

    “P.S: rootless cosmopolitan: “we” in this context includes the citizenry of the United States of America. Just in case you don’t understand the context in which I (as in me – a specific organism) used the word.”

    Many of the ones who have gained from the losses of the others in this society are also part of the citizenry of the USA.


  19. rootless_cosmopolitan says:

    Marcus Aurelius,

    The illusion behind the collective “we” is that everyone was sitting in the same boat, but that’s not true. There are very different boats going to very different directions. There are very different, divergent special interests in a society, in parts even centrifugal, antagonistic interests.


  20. ToNYC says:

    Has Marcus yet again failed to notice that as the Earth on which he stands, rotates toward the East on a very stable axis; and every 24 hours at least, this giant ball of thermonuclear fire appears and allows us ALL a Free Lunch?

  21. BILLCNY says:

    Drewbie: Why attempt to blame one person for this mess? I do not know much about John Dugan, but he did not pass any of the legislation which you fault. Indeed he did not even have a vote on any such legislation. Those votes were cast by the members of Congress, and it was a bipartisan effort. I refuse to believe these members of Congress were just by the nose by folks like Dugan or Phil Gramm to cast votes in favor of particular pieces of legislation. This calamity occurred because the Democratic and Republican members of Congress failed in their duties. Do not let these elected officials off the hook.

  22. Amos Satterlee says:

    I agree with Barry’s assessment of the history. What is beginning to bother me is this: if this kind of behavior happened anywhere else in society, wouldn’t we call either anarchy or mob rule or vigilante economics?

    I appreciate the care with language, but Radical Deregulation and Nonfeasance just sound too polite to my ear.

  23. [...] Ritholtz at The Big Picture critiques David Leonhardt on heading off the next financial [...]

  24. [...] Look at Barry Ritholtz’s book, Bailout Nation. Barry sets forth some of policy errors that led up to the crisis. Recently he criticized and corrected the New York Times. Barry is right on the mark. Here is the link. [...]

  25. [...] Reinvestment Coalition’s call to strengthen the Senate bill. Meteor Blades also notes Barry Ritholtz’s critique of one aspect of Leonhardt’s article: Thanks to the The Commodity Futures Modernization Act [...]