The Five Villains of the Current Financial Crisis

Last night we were invited to small gathering by a friend to hear from a retired Chief Executive of a major US financial institution. Our friend thought it would be interesting to hear from this guy with long experience in the financial industry. He argued that the current crisis was precipitated by five villains - two members of congress and three organizations.

He first described the Community Reinvestment Act. Surprisingly to me he thought the intent of the Act was pretty noble. The idea, when the Act was first adopted, was to reduce the possibility for lenders to "red-line" areas - exclude lending in an area. He described lending practices by some lenders before the CRA as "reprehensible." But he also expressed skepticism about the underlying assumption by at least some who supported the Act that everyone should be able to own a home.

His first two villains were Senator Christopher Dodd and Congressman Barney Frank - who have served as either the ranking member or chair of the financial institutions committee in the Senate and the House. He described their absolute defense of increasing the leverage of the two agencies dealing with housing finance. His next two villains were the two Government Sponsored Enterprises - Fannie Mae and Freddie Mac that Dodd and Frank defended. His description is a perfect example of what some political scientists call an "iron triangle" where elected officials and industry and bureaucrats work in common purpose. The organizational structure of Fannie and Freddie put them as neither fish nor fowl in the financial world. Their congressional protectors were perfectly willing to allow them to continuously expand their leverage well beyond what a private financial institution could. The ultimate result was predicted well before it happened by a number of observers including the Bush administration - privatizing gain and socializing risk. As leverage for the two institutions increased the executives of Fannie and Freddie made huge bonuses. The politicians got the credit for expanding housing opportunities and the taxpayers were stuck with paying the bill for this largesse. The final villains were the ratings agencies. He argued that the incentives for the ratings agencies were all wrong. Ratings agencies, much like the role of bond attorneys, were supposed to be working for future investors, but in this crisis they figured out that the fees they received were actually from the debt issuers who wanted favorable ratings to sell their securities. Much of what he argued was not surprising - from my perspective, while he suggested at the beginning that there was plenty of blame beyond the five villains, I think he captured the most important five.

He also had comments about FASB 157 or "mark to market." FASB 157 requires financial institutions to establish a current "market value" for assets held on the balance sheet. He suggested that in many cases there may not be a market for the asset and in others the valuation is not based on current value. Thus, when a lender offers a mortgage to a borrower, the expectation is that the value of the mortgage will be realized over the term of the mortgage. While there should be a reliable underlying ratio to value, there can be times during the period of the mortgage where that value will fluctuate. The problem with 157 is that by requiring current valuations, when markets fluctuate financial institutions see significant hits to their capital. Financial institutions are required to maintain a ratio of hard assets to lending which might be 1:10. When an asset gets marked down the financial institution has less to loan. The essence of his argument was that transparency here was more apparent than real and that a competent financial executive should have some level of professional judgment about valuation of assets.