Figuring out what led to today\u27s economic mess could hold the best clues for moving forward - and averting the world\u27s next financial crisis

McGuire, Patrick

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Anatomy of a Meltdown

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JD 2009 I 24 IAnatomy'ofa e townFiguring out what led to today's economic messcould hold the best clues for moving forward-andaverting the world's next financial crisis.By PatrickA. McGuireSOME CALL IT A BLACK HOLE. OTHERS USE THE MORE SINISTER METAPHOR of "a darkmarket." Robert Rhee, an associate professor at the University of Maryland School of Lawwho teaches corporate finance and corporate ethics says flatly "so much of the financialuniverse out there is unknown territory."His colleague, Law School Professor Michael Greenberger, the former federal regulatorand now oft-quoted explainer of the economic meltdown for NPR and "60 Minutes,"speaks of "a shadow market." This is a market, he says, that is understood by few, includingtop Wall Street insiders. Many of them, he says, had such little appreciation for the detailsof their risky practices that they not only caused unprecedented losses in the national andworld economies, but wiped out tens of millions-in some cases hundreds of millions-of dollars from their own personal wealth."It's crystal clear," says Greenberger, who has testified on Capitol Hill about the financialmeltdown almost a dozen times this year, "that except for some of the people doing thetrading, at the highest levels the CEOs, the top officers absolutely did not understand whatwas happening."25 JD 2009Exactly what was happening?As policy makers in Washington sift through the debris of de-railed derivatives and default swaps for answers to that question,Maryland School of Law faculty such as Greenberger and Rheesee a common cause for the meltdown."The biggest legal aspect to what's happening now is thelack of regulation and the ineffectiveness of regulations,"says Rhee. "Aside from that, the larger causal mechanisms ofthis crisis remain outside of the law."An inciting incident that most financial experts now pointto as an immediate cause of the current economic chaos wasthe passage in December 2000 of the Commodity FuturesModernization Act. The bill's passage was principallyarranged by Senator Phil Gramm, then chair of the SenateBanking Committee; it was sent to the floor of bothHouses of Congress as a 262 page rider to an 11,000page omnibus appropriations bill on the last day of alame duck session of Congress on December 15,2000.The bill was embraced by both sides of the aisle, passedby wide margins and was signed into law just before Christmas byPresident Bill Clinton.In effect it deregulated the trading of derivatives and defaultswaps by telling the Securities and Exchange Commission (SEC) andthe Commodities Futures Trading Commission (CFTC) that theyhad virtually no authority at all over them. And yet, according toGreenberger, there is more investment money today tied up in deriva-tives than in stocks and bonds."Nobody's complaining that stock trading put us in this meltdown,or that regulated futures trading put us here," says Greenberger, whoserved on the CFTC from 1997 to 1999. "It's this dark-market deriv-ative product, these private, bilateral transactions. Over the counterderivatives are today a $600 trillion notional value market. We [theCFTC] thought when it was $27 trillion in 1998 it ought to be regu-lated. We lost that battle."Derivatives are not new. Rhee says that derivatives have a Jekyll-Hyde duality. They can be used to hedge (mitigate) risk, but they can"There has to be arelationship betweenrisk and return. Butproper risk takingis where Wall Streetfell down."- Robert RheeJD 2009 26also be used to magnify risk-taking. As opposed to an investment in acommodity itself, a derivative is a bet on the future price of some otherasset or index, such as stock or interest rates. The plainest instrumentsare futures and options. While investing in the standard commodityfuture remains mostly regulated, newer non-traditional forms such ascredit default swaps are private transactions that are legally traded"off the books" and subject to almost no official scrutiny.That the risk-hedging derivative suddenly became an economy-busting risk of its own derives from its use as a hedge against the failureof investments in sub-prime mortgage securities. Adding to the problem,according to a Maryland Law graduate who is now a prominent con-sultant to the financial industry in regulatory and governance services,were government policies that overinflated the sub-prime mortgagemarket and set the stage for its subsequent collapse."The rampage in derivatives was an outgrowth of the Fed's 'easymoney' policies," says Ellyn Brown '80, a current member of theboard of directors of NYSE-Euronext, Inc., the publicly traded entitythat owns and operates the New York Stock Exchange and the pan-European stock exchange. "The federal legislative and executivebranches' promotion of home ownership as an absolute good was illthought-out and mostly uncoordinated," she says. That, and whatshe sees as Congressional resistance to adequate oversight of FannieMae and Freddie Mac.Brown, the Securities Commissioner for the State of Marylandfrom 1987 to 1992, cites economist Robert Samuelson, who "givesperhaps the most organic explanation of the genesis of today's crisis:'Taking financial stability for granted, money managers, bankers,traders, government officials and ordinary investors did things thatdestroyed financial stability."As sub-prime mortgage loans were bundled together and sold assecurities and collateralized debt obligations they, like most loans,were classified as senior, mezzanine and junior debt. As such theyreceived credit ratings from organizations such as Moody's andStandard and Poor's."They got Triple A ratings for the most secure senior debt," saysGreenberger, "but that's senior debt of sub-prime mortgages, givento people who have a high probability of not being able to pay theloans back. But many of the 'brilliant minds' ignored the underly-ing risk, and believed they got Triple A and Double A paper andthey believed these were therefore conservative, solid investmentsand they sold them as that. People who bought them thought theywere conservative, solid investments, not understanding it was aTriple A rating of junk."The frosting on this devil's food cake was the credit default swaps.Those who granted the sub-prime mortgages, and those whobought them, took out what was essentially an insurance policy-sothat if the mortgage holder defaulted, the insurance paid back theirinvestment. Though these policies were often issued by insurancecompanies, such as AIG, they were not called insurance because thenthey would fall under state insurance regulations, which would haverequired capital reserves to support the guarantees. Labeled "creditdefault swaps," they were deemed not subject to regulation and therewere no capital requirements. The delusion of safety moved from themortgagers to the insurers."They thought, 'We're getting premiums for this insurance forwhich we will never have to pay anything because there are norisks," says Greenberger. "It wasn't just AIG. Everyone was issuinginsurance, calling it swaps and not setting aside reserves and itblew a multi-trillion dollar hole in the economy. They never thoughthousing prices would go down. When housing prices went downthe 'insurance' or swap got triggered. But unlike regulated insurance,they never had to set aside reserves to pay those policies. Andyou're talking about a minimum of $25 trillion in insurance withno capital reserve."The insurance became the ultimate factor in self-delusion, saysRhee. "I think the insurance fed into the psychology and affected ex-ecutive opinions as to how much risk they'd exposed themselves to."Once the supposed fail-safe factor of sub-prime mortgages-thathousing prices will never fall-actually failed, no one was monitoringthe domino effect of thousands of sub-prime mortgage foreclosureson other aspects of the economy. Investments thought to have beenwithout risk now, in hindsight, seem obviously reckless.27 JD 2009"There has to be a relationship between risk and return," notesRhee, a former New York and London investment banker with aWharton MBA. "But proper risk taking is where Wall Street fell down."Rhee worked as a vice president in the investment banking armof Swiss Re in New York, as well as an investment banker with UBSWarburg and Deutchebanc Alex. Brown in Baltimore. He cites thereorganization of Wall Street firms as a factor that led to their short-sightedness in assessing risk.''A while ago," he says, "Wall Street was made up of private com-panies that had their own capital. And it used to be you were using thefirm's capital so it was preserved in a way that made sense. People hada greater interest in their stock in the company. The thought was,'I can't blow up my own firm because a large part of my wealth is tiedup in it."But, he notes, many of those firms began going public or weremerged with larger commercial banks with large balance sheets."Now it's shareholder's capital you're using," says Rhee. "The capitalyou can invest is whatever the executive committee or managementwill allow you to use in terms of your own trading activities. Therisk-to-return relationship got skewed heavily. It encouraged excessiverisk taking. That explains AIG. It was as if people were saying, 'Whatwe're doing now is just printing money. The more policies we write,the more we sell this type of stuff. My year-end bonus will be X million.'Under those circumstances, people inside that group were probablygetting caught up in this."It was, he says, a classic house of cards and the incentives wereperverse; even substantially employee-owned firms like Bears Stearnswere not immune to the new psychology of risk taking."We were in a bubble. The bubble psychology is that you don't thinkyou're the person without the seat when the music stops. It's alwaysgoing to be someone else. I can't imagine that these bank executiveswere immune from that type of psychology."Don't forget some of these bank executives had hundreds of millionsinvested in their own firms, so if it blew up, it blew up their entirenet worth. It leads me to think they knowingly engaged in excessiverisk taking without knowing how excessive their risk taking really was.They did not think the risks would be magnified down every chain ofevery transaction."How could supposedly savvy financiers so delude themselves?Rhee says a former colleague on Wall Street who specializes inbond insurance, told him recently, "We didn't know X would lead toY would lead to Z would lead to A would lead to B. We knew X wasa problem. Or Y was a problem. But we didn't connect all the dots."Wall Street traders understood the individual problems, says Rhee,"but there was no one sitting at the top saying, 'Okay, I see the trailof transactions and if something happens the trail of transactions willfall in a domino pattern like chis."In the meantime, a unified strategy for resolving the problem hasremained elusive. Many want to concentrate on and punish villains.Banks decry talk of new, day-to-day regulatory monitoring and insistWall Street be trusted to voluntarily clean up its mess. Reformers wanttough new legislation enacting more restrictive regulations.President Barack Obama said that the financial crisis has been aresult of "gaps and weaknesses in the supervision and regulation offinancial firms [that] presented challenges to our government's stabilityof our financial system." In response, the Obama administrationintroduced a proposal in July 2009 to reform the regulation of finan-cial markets with five key objectives: to promote robust supervisionand regulation of financial firms; establish comprehensive supervisionand regulation of financial markets; protect consumers and investorsfrom financial abuse; improve tools for managing financial crises;and raise international regulatory standards and improve interna-tional cooperation.Greenberger is concerned that President Barack Obama's objectiveswill be undercut by fierce lobbying by Wall Street and that Congresswill only take half-steps toward re-regulation."Wall Street is simply calling for a private clearinghouse to be usedby traders on a voluntary basis," he notes. "I say that's not enough.You have to have mandatory exchange trading for these derivatives soyou have transparency. Not only transparency to the federal regulators,but to the public as a whole. It gives you an added set of regulatorytools that are being overlooked."JD 2009 28Meanwhile, those in the financial services industry caution againstover-regulation."As a country we tend to legislate for the last problem and not forthe next," says Christine Edwards '83, former executive vice presidentand chief legal officer at Bank One Corporation and now a partner inWinston & Strawn's corporate practice group who represents clientsin the securities and banking industries on regulatory issues. "Tryingto look forward to determine what is the next meltdown ready tohappen is much more difficult."The question of too much or too little regulation, she notes, or therype of legislation needed right now is less pressing than asking whetheror not the right regulatory structure is in place to clearly inform andmonitor key financial industry players and consumers."Do we need to address the duplication of effort between federaland state regulations?" she asks. "Or should we have a patchwork quiltof regulations between federal, state, local, certain law enforcementagencies and federal agencies? Because that's what we have right now."Brown supports the general idea of regulating for systemic risk "nowthat we've actually come face-to-face with the realities of our inter-locked financial system." However, she says, "We need to think notonly about counterparty risk and all of the relationships that madeBear Stearns, Lehman Brothers, and Merrill Lynch so vulnerable,but also to the nature of global systemic risk, across institutions andmarkets worldwide."The entire issue of risk regulation, she says, "is perilous territory-the danger being that over-regulation will impede the innovationnecessary to grow our economy." By definition, she says, innovation ofany sort requires risk."It is one thing for government regulators to be concerned about,and move to regulate outrageous leverage ratios," says Brown. "It isquite another thing to ask a regulator to assess the risk inherent in anew financial product or service. Having been a regulator myself, Iknow very well that regulation is a defensive art form. Regulators aren'tout there in the market thinking up new products and services. Theregulators' mission is to prevent problems. Thus, the regulators' incli-nation is to say 'no' rather than risk being wrong by embracing anythingnew and different."29 JD 2009

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Anatomy of a Meltdown

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