A very confident Timothy Geithner, the 75th Treasury Secretary of the United States, on the Obama-backed Dodd-Frank financial reform law:
These reforms are not perfect, and they will not prevent all future financial crises. But if these reforms had been in place a decade ago, then the rise in debt and leverage would have been less dangerous, consumers would not have been nearly as vulnerable to predation and abuse, and the government would have been able to limit the damage that a financial crisis could have on the broader economy. President Obama, along with Sen. Chris Dodd and Rep. Barney Frank, deserves enormous credit for pushing for tough reforms quickly.
My wife occasionally looks up from the newspaper with bewilderment while reading another story about people in the financial world or their lobbyists complaining about Wall Street reform or claiming they didn’t need the Troubled Asset Relief Program. She reminds me of the panicked calls she answered for me at home late at night or early in the morning in 2008 from the then-giants of our financial system.
We cannot afford to forget the lessons of the crisis and the damage it caused to millions of Americans. Amnesia is what causes financial crises. These reforms are worth fighting to preserve.
1. Dodd-Frank has not ended Too Big To Fail. The biggest banks, those with assets over $10 billion, are still able to borrow more cheaply than smaller institutions. Why? Because lenders assumes Uncle Sam will again ride to the rescue if they get in trouble. Indeed, the biggest banks are bigger today than before the crisis. If Dodd-Frank doesn’t end TBTF, then it is a failure. An epic failure.
2. Geithner doesn’t know the lessons of the financial crisis. MIT economist Andrew Lo sat down and read 21 books about the financial crisis. Here is what he found:
There are several observations to be made from the number and variety of narratives that the authors in this review have proffered. The most obvious is that there is still significant disagreement as to what the underlying causes of the crisis were, and even less agreement as to what to do about it. But what may be more disconcerting for most economists is the fact that we can’t even agree on all the facts.
Did CEOs take too much risk, or were they acting as they were incentivized to act?
Was there too much leverage in the system?
Did regulators do their jobs or was forbearance a significant factor?
Was the Fed’s low interest-rate policy responsible for the housing bubble, or did other factors cause housing prices to skyrocket?
Was liquidity the issue with respect to the run on the repo market, or was it more of a solvency issue among a handful of “problem” banks?
And yet Geithner and the Obama White House decided to rush through a ginormous and consequential piece of legislation. The president signed Dodd-Frank just 18 months after he took office. Glass-Steagall didn’t pass Congress until four years after the 1929 stock market crash.
Lo highlights three supposed facts about the financial crisis that don’t turn out to be so factual:
Supposed Fact #1: “The devotion to the Efficient Markets Hypothesis led investors astray, causing them to ignore the possibility that securitized debt2 was mispriced and that the real-estate bubble could burst.” | Reality Check: Yet before the crisis, mortgage-backed CDOs were offering higher yields than regular corporate bonds with the same ratings. As Lo puts it,”Disciples of efficient markets were less likely to have been misled than those investors who flocked to these instruments because they thought they had identified an undervalued security.”
Supposed Fact #2: “Wall Street compensation contracts were too focused on short-term trading profits rather than longer-term incentives. Also, there was excessive risk-taking because these CEOs were betting with other people’s money, not their own.” | Reality Check: A recent study of executive compensation contracts, Lo points out, concluded that CEOs’ aggregate stock and option holdings were more than eight times the value of their annual compensation, and the amount of their personal wealth at risk prior to the financial crisis, which “makes it improbable that a rational CEO knew in advance of an impending financial crash, or knowingly engaged in excessively risky behavior (excessive from the shareholders’ perspective, that is).
Supposed Fact #3: “Investment banks greatly increased their leverage in the years leading up to the crisis, thanks to a rule change by the U.S. Securities and Exchange Commission.” | Reality Check: Turns out that investment banks Goldman Sachs, Merrill Lynch, and Lehman Brothers had much higher levels of leverage in 1998 than 2006. (See chart below.) Moreover, Lo says, it turns out that the SEC rule change had no effect on leverage restrictions.
Geithner seems confident that Washington has gone a long way toward preventing another major financial crisis. He may be the only one.