Sheila Bair, Former FDIC Chairman, Discusses the Financial Crisis

Wednesday, Apr 20, 2016
by restrada

Eight years after the financial crisis, competing narratives continue to clash over the causes of the great recession.  Sheila Bair, who served as the Chairperson of the U.S. Federal Deposit Insurance Corporation (FDIC) and is currently President of Washington College, offered her own perspectives—on which narratives ring true, and whether responses to the crisis have made the system safer—over an informal lunch with a group of Princeton University students on March 30, 2016.  As Chairperson of the FDIC from 2006 to 2011, Bair was a key player in the response to the U.S. subprime mortgage crisis, taking measures to quickly restore confidence in the banking system.

Watch Sheila Bair give her public talk, "The Bullies of Wall Street: This Is How Greed Messed Up Our Economy" >

Bair places blame for the crisis largely on Wall Street; this perspective stands in sharp contrast to those who place it on the government’s misguided attempts to promote home ownership, or on macroeconomic factors (savings glut), with Wall Street playing a passive role by meeting the world’s demand for “safe” assets.

Bair’s view tails the narrative expressed in Michael Lewis’ book (recently adapted for the silver screen), “The Big Short.” Wall Street’s embrace of the whole mortgage-back securities (MBS) industry and especially of synthetic MBS and other derivatives, was at the center of the leverage explosion that resulted in the system’s implosion.  The seeds of the crisis were sown by the mortgage originators. The borrowers were not the main culprits, nor were they largely flippers and scammers, as portrayed in “The Big Short” (the one strong misgiving that Bair has with the movie). In fact, around two-thirds of the houses were owned by legitimate homeowners who had taken cash-out refinancing and who were desperately trying to hold on to their homes—only one-third of the houses belonged to flippers and scammers.  Compounding factors were interest rates, kept too low for too long, and the search for yield encouraged investment in mortgage-backed securities.  As accurately shown in “The Big Short,” mortgage brokers had very strong incentives to originate high-risk mortgages. They stood to reap much greater profits from these securities as compared with safer assets.

She discounted the narrative that government programs to expand home ownership access to low income communities were to blame. Wall Street was earning large profits from issuing cash-out refinancing, and expanding access to home ownership was the cover, not the motivation. The maligned Community Reinvestment Act (CRA), which required banks to lend to low income communities, did not play a big role. CRA-lending constituted only a small percentage of mortgage-backed lending.  Furthermore, CRA credit was confined to mortgage origination, an activity shunned by most commercial and regional banks, as well as by the big banks who concentrated on providing warehouse financing and securitization.

Bair also discounted the narrative that Fannie Mae and Freddie Mac were the main drivers of the crisis. They contributed to the crisis, she said, but not through origination. The mortgages Fannie Mae and Freddie Mac bought and packaged into securitization performed much better than the private label securitizations provided by Wall Street.  Instead, Fannie Mae and Freddie Mac fueled the MBS market and the subsequent crisis by investing heavily in private label securitizations, which earned high interest, and they funded these purchases with cheap borrowing made possible by their implied government backing. These brought easy profits for the two mortgage giants. 

Finally, Bair discounted the narrative that the crisis was created by macroeconomic factors, in particular the increase in savings coming from China.  Many banks did not participate in subprime mortgage lending: Wells Fargo, JP Morgan (starting in 2006), and many regional banks. Blaming macroeconomic factors and market demand is not consistent with the fact that many banks did stay out of it. 

Bair then offered her views on the bailout process and regulation. She questioned whether the bailout was necessary in all cases. While she agreed that a bailout was necessary in the case of Citigroup, she stressed the importance of imposing more accountability—for example, by imposing losses on subordinated debt holders. She doesn’t agree, however, that throwing trillions of subsidy dollars at the problem was the only way to save the system. She argued that imposing accountability could have been a more effective means to stabilize the system, and that the right amount of accountability is yet to be achieved.

Bair does believe that the financial system is now safer. She pointed to several measures that are aimed at imposing accountability. For example, under Dodd-Frank a large financial conglomerate is required to go into a controlled resolution process, whereby the government is able to continue to provide funds to keep essential operations going, but shareholders and secured creditors have to take losses.  Other new regulations include: mortgage lending standards from the Consumer Bureau, a three-year deferral pay period on variable pay, regulation from the Federal Reserve that requires big banks to issue long-term debt that would be converted to equity to recapitalize, and limits to credit exposure that banks can have to each other. Despite these improvements, she still sees a lot to be done, especially on the issue of compensation structure. She is dismayed that there hasn’t been significant changes to Wall Street culture.

Following her remarks, Bair responded to students’ questions.  She delved into the details of how collateralized debt obligations (CDOs) and synthetic CDOs were constructed—and clearly exposed their flaws.  One student remarked: “We know who the losers were, but who were the winners?”  To this, Bair explained that we still don’t really know;  many transactions were not carried out in a centralized clearing house, but were private bilateral deals. There was also discussion on the international dimension of financial regulation, and particularly about global systemically important banks (GSIBs) and the new long-term debt holding requirement known as “total loss-absorbing capacity” (TLAC). 

On the subject of how to best help homeowners affected by the crisis, Bair’s view is that the government could have required principal write-downs, even if this would have affected the banks’ bottom lines.  This was a point of contention with then Secretary of the Treasury, Tim Geithner, who wanted to make the banks strong to revive the economy.  Bair thought that excessive debt was holding back consumer spending, and that this continues to be a drag on the economy.  She cited a recent study, which estimates that there are about 8 million underwater homeowners in minority neighborhoods, paying interest rates of 7, 8, and 9 percent, who have not gotten any relief.

Regulatory failure also shares blame for the crisis.  One factor that contributed to excessive leverage was the loosening of capital standards in 2004—the consolidated supervised entity (CSE) capital framework allowed banks to use their own models to define how risky their holdings were, and therefore how much capital they should hold. (The program was abolished in 2008.) While investment banks had capital ratios of 12 to 1 prior to 2004, the ratios shot up, reaching up to 50 to 1 in some cases.  The market accepted these high leverage ratios, perhaps in part because they were in compliance with prevailing regulations. Bair cautioned: “Regulators must be careful because they give their seal of approval—investors rely on that.”

Bair also worries about problems in the regulatory process, in particular with “cognitive capture”—regulators start seeing the world through the eyes of the entities that they regulate. In her view, the lawyers and other experts that represent the banks have too much influence on the regulators when it comes rule-making; many regulators become advocates for the industry.

Bair returned repeatedly to the need for accountability.  She saw the current practice of imposing corporate fines as having no impact on changing behavior.  Fines are paid by shareholders, sometimes without affecting compensation.  Individuals need to be held accountable, and that has not happened.  

The discussion ended with Bair’s view on what constitutes effective regulation.  The key issue, she said, is to make sure incentives align with good behavior.Leading up to the crisis, the incentive for mortgages brokers was to originate mortgages with the highest risks possible—they would get a lot of money, and there was no risk of loss if the deals went sour.  Bair concluded: “Regulation that leaves the same incentives in place will fail, because greed will always trump playing by the rules; that is why the best rules are the ones that are simple, align economic incentives, and impose losses when people take risks that they should not have taken. That is not the philosophical underpinning of the current environment. We are doing a lot of micro-management—‘you can do this, you can’t do that’—and if you leave the economic incentives in place, it is not going to work.” 

News category: