The Wall Street Journal

  • DECEMBER 12, 2011

In the U.S. mortgage crisis and the European sovereign debt crisis, bad policies subsidized bad investments.


EXCERPT FROM THIS ARTICLE:  The reason prosecutors can’t prove criminal intent is that in many cases the bankers were simply trading in compliance with the regulations governing them.

  • Art imitates life, even on Wall Street. Consider the recent thriller “Margin Call,” depicting the frantic response at an investment bank during the mortgage-backed securities crisis of 2008:

A young risk analyst trained as a rocket scientist has just run numbers showing the firm has taken on much more risk investing in mortgages than its financial models had assumed was possible. His boss needs the numbers explained, saying, “I don’t even know what you do.” When the head of trading is shown the spreadsheet, he says, “I can’t read those things.” The fictional chief executive (“John Tuld,” a play on Dick Fuld of Lehman Brothers) asks the analyst to explain what he had discovered: “Speak to me in plain English, as you would to a young child or golden retriever.”

It wasn’t just senior executives at Wall Street firms who failed to understand the numbers and how bundling subprime mortgages would undermine value-at-risk measures. The same was true for the lawmakers and regulators who created the problem. Rep. Barney Frank, who last week announced his intention to retire from Congress, will be remembered for his comment in 2003: “I want to roll the dice a little bit more in this situation towards subsidized housing.” He got what he wanted: By 2008, half of the 54 million mortgages in the U.S. were subprime and other low-quality loans.

The instant spread of information in financial markets means that policy mistakes are reflected quickly, globally and sometimes signaling trillions of dollars in regulatory mistakes. But our system is so complex that it now takes actual rocket scientists to measure the risks.

Another example: The chief risk officer at MF Global spent a decade in aerospace and engineering before switching to Wall Street. Michael Roseman warned CEO Jon Corzine and the MF Global board about the risks of too much exposure to the bonds of European countries, to no avail. The firm went bankrupt as it became clear that sovereign debt was riskier than financial models assumed. Mr. Corzine, a Democratic former senator and governor of New Jersey, last week told a House committee: “I simply do not know where the money is.”

What the U.S. mortgage crisis and the European sovereign debt crisis have in common is policies that subsidized certain investments—bad mortgages in the U.S. and the bonds of European countries like Greece—and then compounded the mistake with regulations that forced all the biggest banks into the same undiversified bad investments.

The “Basel rules” governing big banks call for a significant amount of bank capital to be held in supposedly low-risk investments such as mortgages and mortgage-backed securities. When these blew up, it took down many banks.

Likewise, the losses at MF Global were facilitated by Basel rules based on the assumption that sovereign debt has no risk. But the debt of Greece is not as sound as the debt of Switzerland. Mr. Corzine and his colleagues should have done better homework, but the Basel regulators made their investments seem reasonable.

As banking expert Peter Wallison recently wrote in the Journal, “In the U.S. and Europe, governments and bank supervisors are reluctant to acknowledge that their political decisions—such as mandating a zero risk-weight for all sovereign debt, or favoring mortgages and mortgage-backed securities over corporate debt—have created the conditions for common shocks.”

Regulators try to micromanage complex markets when the better course would be to simplify the rules to avoid unintended consequences. They could start by taking politics out of markets by ending market-distorting subsidies for causes such as mortgages and sovereign debt.

Instead, the political culture in the U.S. still focuses on crime as the cause of the mortgage crisis. Federal prosecutors tried and failed to bring criminal cases relating to mortgage-backed securities against AIG, Countrywide Financial, Washington Mutual and Goldman Sachs. In an interview with this newspaper last week, former top FBI investigator for financial crimes David Cardona said: “There’s been a realization and a more deliberate targeting by the Department of Justice before we launch criminality on some of these cases.” The reason prosecutors can’t prove criminal intent is that in many cases the bankers were simply trading in compliance with the regulations governing them.

The New Yorker’s David Denby says “Margin Call” is “easily the best Wall Street movie ever made.” It portrays a real Wall Street of people trying to make a killing, or at least a living. They operate in a highly complex, highly regulated environment that can spin out of anyone’s control.

Thanks to technology and instant flows of information, markets quickly reflect wrong-headed regulations. This is true whether politicians are demanding riskier mortgages, pretending that all government debt is risk-free or requiring big banks all to hold the same risky capital. Regulations that lead markets to blunder are legal, but worse than a crime.


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