A Fine Mess

Financial Shock: A 360 Look at the Subprime Mortgage Implosion, and How to Avoid the Next Financial Crisis by Mark Zandi, FT Press, 270 pages, $24.99

Banking on Basel: The Future of International Financial Regulation by Daniel K. Tarullo, Peterson Institute for International Economics, 310 pages, $26.95

The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means by George Soros, PublicAffairs, 162 pages, $22.95

Unlike Tolstoy's unhappy families, bouts of extreme financial unhappiness are all basically alike, with variations only in the details. At bottom, they all involve speculation, deception, and failed regulation. The beginning of wisdom is to understand what went wrong and to grasp the parallels to history's other financial catastrophes. The paramount challenge of the Obama administration will be to repair the consequences of financial collapse and make sure it doesn't recur -- something we thought had been accomplished once and for all by the New Deal. It is an ill wind that blows no good, and books are already starting to appear on the crash's causes and cures.

If you need a concise guide to the collapse in all its dimensions, you can't do better than Mark Zandi's Financial Shock. The man has a gift for explaining in clear lay language, say, a credit-default swap or what a "liquidity squeeze" means in practice. Zandi is that rarest of creatures, the celebrity financial commentator who is also a competent economist and an honest one. Far too many of the other financial "experts" who dominate the cable channels are basically stock touts. Zandi is probably quoted more than any other economist, and he may also be the only author ever to have book blurbs from both conservative CNBC host Larry Kudlow, who is one of the prime cable offenders, and liberal Congressman Barney Frank, chair of the House Financial Services Committee.

Financial Shock, which seems to have been rushed into print as the financial slide turned critical, is a tour of the entire horizon. It includes accessible discussions on the creation and metastasis of complex financial products, the collapse of regulation and supervision, and the overreliance on debt throughout the economy, as well as illuminating charts and graphs.

The best and most extensive section addresses the housing meltdown in all its facets -- the regulators asleep at the switch, the opportunists on Wall Street who underwrote sub-prime bonds, the predatory storefront mortgage brokers, the foreign bankers who naively bought increasingly risky paper, and the insurance conglomerates like American International Group that went broke insuring the bonds. Well, not quite all its facets. Zandi, who sold his company Economy.com to Moody's Corporation in 2005, explicitly declares that he will not write about the bond-rating agencies "to avoid any appearance of a conflict of interest." The agencies enabled the entire alchemy, by turning dross into triple-A securities. A few pages later, however, he can't resist a couple of paragraphs observing how and why "the rating agencies badly misjudged the risks."

Close readers of the financial press are already familiar with much of this material, but the book is also full of new insights, generally fine syntheses, and little-publicized statistics. Did you know that in the 15 years between 1989 and 2004, the indebtedness of the lowest-income Americans more than trebled? Or that upward of 80 percent of the bond products backed by sub-prime mortgages got triple-A ratings?

Zandi, whom the McCain campaign listed as an adviser, nonetheless plays it straight and usefully contradicts the Republican storyline. After the Bush administration passed the American Dream Downpayment Act in 2003, as part of the so-called Ownership Society, Zandi writes that the administration "put substantial pressure on Fannie Mae and Freddie Mac to increase their funding of mortgage loans to lower-income groups." It was this pressure, and not the Community Reinvestment Act, that pushed Fannie to purchase sub-prime loans.

The book, which went to press in early summer, is marred by a few small mistakes and a recovery plan that aims too low. Securitization, he writes, was born in the 1970s, but the original Federal National Mortgage Association was turning mortgages into bonds in the 1930s. In fact, big banks were converting sketchy loans into securities back in the 1920s, and this practice was one of the causes of the Crash of 1929. Zandi also declares prematurely that "the worst of the crisis appears to be over." Well, no. And his rather feeble remedies match his optimism: voluntary write-downs of distressed mortgages, licensing of mortgage brokers, better data. He also calls the Paulson "Blueprint for Financial Regulatory Reform" a "reasonable roadmap," which is far too kind. Still, his history of how the crisis came about makes the book a useful read.


Who will clean up the mess? One person who may play a leading role is Daniel Tarullo, a senior economic adviser to Barack Obama who despite his low profile in the campaign has been the president-elect's top man on financial regulation. A professor of law at Georgetown, Tarullo is one of the world's leading critics of what turned out to be perverse efforts to regulate banking internationally. Those who wonder whether Obama will have the nerve and the will to do what is necessary should be reassured by Tarullo's new book, Banking on Basel.

This is a fairly technical book, but it can be read and appreciated by the non-economist who wants to understand how global efforts to keep up with speculative bank maneuvers failed as dismally as domestic regulation did, and what should be done now. The crisis showed how toxic products that originate in one country can infect the entire system and why a lot of regulation will need to be done globally. Next time, we had better get this right.

Tarullo begins by recounting the gradual appreciation by national regulators three decades ago that global banks presented a thicket of global problems, involving both fair competition and adequate regulation. As banking became global but regulation remained national, a bank with more lenient regulatory standards in its home country could take those lax rules along when it operated elsewhere.

But as Tarullo explains, the resulting global standards on bank capital known as the Basel Accords intensified the potential for financial collapse. They were far too weak, relied on the bank's own models of risk, and had the unintended consequence of encouraging banks to move financial transactions off their balance sheets -- one of the main causes of the meltdown. This is the kind of specialized book that typically does well to sell a thousand copies, yet it deserves a much wider readership.

As Tarullo recounts the history, by the 1970s the ratio of banks' capital to their loans had been gradually declining everywhere, as banks increasingly borrowed money that they could re-lend at higher rates, or financed long-term loans with short-term deposits, and began experimenting with more complex products. Capital ratios, however, were particularly low in Japan, where the Ministry of Finance kept a close watch on bank activity and in return tolerated high ratios of leverage. Japan's industrial miracle was heavily bank-financed. Its industries enjoyed not just government protections but low capital costs.

As Tarullo reminds us, the 1970s were also the era when many Americans were worrying that Japan's government-led industrial policy was crowding out U.S. industry. Something of the same was occurring in banking. In 1974, the three largest banks were American, followed by four French, British, and German banks. By 1988, the seven largest were all Japanese.

One possible remedy was to negotiate common global floors on capital ratios, to prevent high leverage in Japan or elsewhere from producing artificial competitive advantage. With high leverage, you could be a very large bank with very little capital. Moreover, high leverage also increased systemic risk, since a few bad bets could wipe out a thinly capitalized bank with ramifying effects through the world economy. But when experts brought this concept of global capital regulation before the House Banking Committee in April 1988, Tarullo reports, all of the questions were about the effect on banks' market share: "Not a single member of the committee inquired whether the proposal was adequate to protect the safety and soundness of the financial system."

Because this was also an era when proponents of deregulation or self-regulation were in power in the major nations, the first Basel Accord, negotiated in 1988, relied heavily on the banking industry's own definitions of risk. Riskier assets required more capital reserves. But the ink was scarcely dry on the first Basel Accord when it was overtaken by more complex financial products. So a second agreement was negotiated in this decade. The details are extremely technical, but the basic system of "risk buckets" was preserved. When critics took a close look, however, they realized that the new criteria -- again largely defined by banks themselves -- would actually allow some big banks to reduce their capital ratios.

Citibank, which has twice been rescued by emergency infusions of Saudi equity capital, actually boasted after the release of the Basel II formula in 2004 that it could reduce its minimum capital by about 15 percent. Even worse, Basel II made private bond-rating agencies official arbiters of risks.

By putting all their eggs in the basket of capital regulation, the designers of an embryonic process of global bank regulation bypassed all the other possible regulatory instruments such as tighter supervision of actual bank behavior. By the time Basel II was endorsed by major nations, the credit crisis was upon us.

Over time, an approach that was conceived and structured primarily to address concerns of fair competition came to be relied on as a core regulatory source of safety and soundness. Only after the damage was done, Tarullo reports, did the experts at Basel recommend that banks be required to reserve more capital against risky assets like off-balance-sheet entities and sub-prime loans.

Tarullo, in polite and guarded language, judges the Basel process a failure. The Basel experience, he writes, should "strengthen the case for more robust supervisory attention." He adds, "It seems improbable that any form of capital regulation will be able to bear the regulatory weight."

The venue for negotiation of these two agreements is a little-known group called the Basel Committee, first created in 1974. Its deliberations are secret; it takes no public testimony; its constituents are national governments and the banking industry. The failure of the two Basel Accords to prevent the collapse of 2007–2008 is a powerful indictment of what passes for global financial regulation, both in terms of process and outcome. As we do the job of banking regulation properly, both nationally and globally, it needs to be not just more robust but more transparent. Devising proper global regulation can be understood as an aspect of expanding global civil society. Facing this challenge, Obama is fortunate to have an adviser as expert and public-minded as Tarullo.


In Albert Camus' novel, La Chute (The Fall), the narrator is a former successful Parisian lawyer tormented with guilt after he fails to rescue a young woman committing suicide. The character calls himself a "judge-penitent." Consumed with remorse, he is also the judge in his own case.

George Soros has appointed himself the judge-penitent in the case of civil society versus global capitalism. He is in the morally ambiguous role of having profited handsomely by exploiting the anomalies and perversities of an unregulated global financial system that he deplores in his role as citizen. He wishes that the system would be reformed to the point where people like himself would have to find some other use for their talents.

In addition to being one of the world's most successful hedge-fund managers, Soros has long been a philanthropist on behalf of global open society, a crusading reformer, as well as a philosopher of capitalism and its ills. (Disclosure: The Prospect has been a grantee of one of his charities, the Open Society Institute.)

In his latest book, Soros includes a pithy and persuasive discussion of the dynamics of the financial collapse, as well as a recapitulation and updating of his basic theory of "reflexivity," which he has explained in greater detail in earlier books. Reflexivity is Soros' word for irrational positive-feedback loops. He describes how speculative bubbles can feed on themselves, far removed from economic realities. Because human behavior will never be totally rational and the future will never exactly replicate the past, relying on financial models to govern capitalism is doomed to produce more cycles of bubble-and-bust. He writes, "In the realm of natural phenomena, events occur independently of what anybody thinks; therefore, natural science can explain and predict the course of events with reasonable certainty." But in social phenomena, Soros continues, "people base their decisions not on the situation that confronts them but on their perception or interpretation of that situation." And in turn, "their decisions make an impact on the situation."

This is a nice description of how human psychology produces financial bubbles and of the need for greater regulation. The book includes several illuminating examples of how banks managed to evade regulation, as well as Soros' own experiences as a speculator. The book is more a series of essays than a comprehensive recipe for reform but still well worth reading.

In contrast to the Camus character, Soros has earned a clear conscience. And in contrast to other successful global financial speculators, Soros has spent much of his fortune on social reform and crusaded to end the abuses whose exploitation has made him a rich man. As a believer in his own theory of imperfect knowledge, Soros concludes by noting that even though "we have to make decisions without having sufficient knowledge at our disposal," letting financial markets go berserk based on unreal assumptions of self-correcting markets is an even worse alternative. The crash surely proves him right.

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