The Crash: Risk and Regulation

Jill Drew, Anthony Faiola and Ellen Nakashima
Washington Post Staff Writers
Wednesday, October 15, 2008; 1:00 PM

Washington Post staff writers Jill Drew, Anthony Faiola and Ellen Nakashima were online Wednesday, Oct. 15 at 1 p.m. ET to answer questions about their story detailing the regulatory decisions that were made as long as a decade ago that contributed to the current financial crisis.

A transcript follows.


Jill Drew: Good afternoon and welcome to this chat. Anthony, Ellen and Jill are all here to try to answer your questions about this important, but complicated topic.


Cleveland, Ohio: Among the key players, Born is the only woman and right all along. Is that a coincidence or do women in general see things differently and are they better at security issues?

Another question, how can banks not see the risk in lending money to someone who cannot pay? Did short- term, huge profit blind bank executives, so they didn't care what would happen as long as they got the money and still keep theirs today?

Anthony Faiola: It's certainly an interesting observation. We can see now that Iceland, a country currently in total financial meltdown, is bringing in women to sweep up the mess than men have supposedly created.


Colonial Heights, Va.: Will Congress repeal the Gramm-Leach-Bliley Act and the 2000 Commodity Futures Modernization Act? Is fractional reserve banking also a problem that caused this crisis?

Anthony Faiola: There was some discussion of this already during the recent passage of the bail out bill by Congress. The sense then, it seems, was that there needed to be a discussion on this issue outside of the context of the bail out. So stay tuned. It seems likely to come up soon.


Chicago, Ill.: Hi guys; great article.

It seems one question/issue is not being talked about. As I understand this, there is a huge market for Credit Default Swaps ($50 Trillion?), and they lie at the heart of the credit insecurity. Banks do not know if other banks have a ticking time bomb of CDS on their books.

Is there any talk about setting up a CDS exchange/clearinghouse ???

Jill Drew: Thanks. The idea of setting up a CDS clearinghouse is topic A now for most of the major players in this market. New York Fed chief Timothy Geithner has been hosting a series of meetings to encourage firms to come together and support a clearinghouse. There are now four separate entities interested in hosting the clearinghouse, including a team from the Chicago Mercantile Exchange (where stock index futures and other financial contracts are currently traded)and Citadel Holdings, a big hedge fund.

This being Washington, there are some turf questions to answer. What regulator will oversee the clearinghouse? Both the CFTC and the Fed take the responsibility. People are focused now on trying to work that out, along with other operational issues. They pledge to have a clearinghouse up and running by December.


Washington, D.C.: Don't buy the deregulation mantra. This was about greedy politicians wanting to let the good times keep rolling.

The deregulation spiel is just convenient; and politicians know the average citizen will buy it.

Anthony Faiola: I think you would get a counter argument that the greed of Wall Street played a pretty big role too. Our piece sought to illustrate how government ultimately opted to let Wall Street rule itself. It does seem there is enough blame to go around.


Suburban Detroit, Mich.: Great story and very frustrating.

"Easy credit" for people who wanted to live beyond their means is often cited as a beginning domino in this crash. Here in Michigan, we feel like consumers like us are getting blamed when, in fact, the worst excesses seem to have been located where housing and living costs were the highest -- on the coasts. Yet, there is no question that we are suffering the consequences as fully as anyone else if not more so. My question: have you considered teasing out the consumer aspect in more detail?

Jill Drew: We did a few large graphics with the story that tried to make some of the connections you are mentioning, showing how years of easy credit fueled a lifestyle that people could only afford with more and more borrowed money.

Wall Street definately encouraged this consumer lending by creating securities backed by mortgages (as well as credit cards, car leases, etc.). Wall Street wanted to sell more and more of these securities, so they scoured the country for more and more consumer and mortgage loans. The lenders could make a big fee by selling these loans to Wall Street and, after they had been sold, the lender had no skin in the game: if the loan failed, it was someone else's problem. Now most everyone who got overextended is feeling the affects of the binge.


The Cove, Conn.: Why isn't anyone blaming Congress and Washington? They are the rule makers and regulators.

When Wall street fails, people clean out their desks. When the SEC or Fed fails, Bureaucrats just avoid the press.

Congress is to blame too, easy credit for risky housing and risky mortgage-holders. Veiled threats of racism when people tried to investigate F&F.

The Problem is not Wall Street, it is the Beltway.

The Media can be considered a branch of the Washington establishment, rarely do they assail the power of the bureaucracy.

Ellen Nakashima: What Congress did or did not do is certainly a part of the story. There have been a number of bills introduced over the years to regulate derivatives that have gone nowhere. The culprits? Committee and agency turf battles. Partisan politics. A lack of political will. All played a role.


big fan: Ellen - No question, just a comment. I just wanted to let you know that I very much enjoy your writing and even make sure to seek out articles with your byline. You are one of the very few writers who understands technology and related policy, and who can articulate these complex thoughts to the reader without dumbing them down to the point where the facts are lost. These issues are growing in importance every day, and without knowledgeable journalists such as yourself, the vast majority of people may never know these issues even exist. Kudos!

Anthony Faiola: All should see these well deserved kudos for Ellen Nakashima


McLean, Va.: Do you have plans for another article of the same scope as part l, or follow-up?

Jill Drew: We are always looking for good stories, so send tips our way!

The Washington Post makes a huge commitment to what we call "accountability journalism," which means that we are encouraged to dig into stories, find out what went wrong, and then lay it out for readers in all the detail we can. Given the scope of this financial crisis, I expect there will be many such stories like the one published today. At this point, we don't plan a particular series.


Edina, Minn. (Minneapolis suburb): I just finished reading your series. Congratulations on a great job. My question is, now that funding has been promised to prop up AIG and other institutions, where does the money come from? I assume the Treasury will borrow it, but from whom?

Anthony Faiola: One major source of funding will be sales of new treasury bonds, or the debt the U.S. sells. A big portion of those bonds are bought by foreign governments, or agencies representing those governments, which means countries around the world including China, Japan and nations in the Middle East will effectively be giving Washington its own bail out. But who will pay? Well you, your children, and probably their children, in the form of larger U.S. debt.


Raleigh, N.C.: Good afternoon. With the most recent round of consolidations, I, as a taxpayer, worry that there is an ever-shrinking number of financial entities controlling ever-growing proportions of the market. And the reason this worries me is that now, they're ALL "too big to fail." Should the next administration seriously consider breaking them up into smaller, less risky pieces? What would be the pros and cons?

Jill Drew: You raise a serious issue. Several economists and financial experts worry about the concentration of power -- and risk -- in these emerging mega-institutions. It seems the financial world goes in cycles and that we're now in the phase in which "big" and "stable" are deemed to be better. After markets stabilize and financial institututions start lending again, many on Wall Street predict we'll start to see new, entrepreneurial shops start to emerge. People go into finance to make money. After the crisis passes, if they find the big institutions are too stodgy, they'll start their own. As for whether the government should break up the big institututions, I'll bet that will certainly be a topic of discussion for the next administration. The current team is certainly more concentrated on getting stable institutions to buy shakier ones.


Alexandria, Va.: Your story on derivatives and leveraged credit default swaps is interesting but incomplete. It fails to answer the fundamental question posed in the lede, "how did the world's markets come to the brink of collapse?" You even admit in the article that "Derivatives did not trigger what has erupted into the biggest economic crisis since the Great Depression". So what did? If you want to ask the question "How did we get here?", you should do the homework necessary to provide an answer.

I suggest you point your readers to a place where they can find the answer: Two shows done on NPR's "This American Life": Episode #355, "The Giant Pool of Money", which explains how the huge pool of investment money available worldwide provided incentives via mortgage backed securities that led to riskier and riskier mortgages being written over the last decade, tying huge amounts of risk to investors who thought they had "safe as money" investments, and Episode #365, "Another Frightening Show About the Economy", which explains how the derivatives and credit default swaps your article alludes to acted as an accelerant to the fire started by the mortgage crisis/US housing bubble, and also discusses whether the recent bailout package will have a chance to unfreeze the credit market (this being the occurrence that made economic experts in the government and private sector sit up and take notice of what was happening).

Ellen Nakashima: Our piece was an effort to explore how the debate over derivatives regulation--one element of the larger story of what went wrong--got waylaid in 1998. The parties, though well-meaning, essentially were talking past one another. And as a result, the debate was largely shut down.

You're right that there were other underlying causes and we did not attempt to analyze all of them in this one piece. An earlier series in The Post detailed the credit crisis and the housing bubble. There has been and still ought to be more reporting on the role of collateralized debt obligations, the credit rating agencies, the lack of strict and clear underwriting standards across the mortgage lending industry, to name a few.

You might also want to check out two shows done on NPR's "This American Life": Episode #355, "The Giant Pool of Money", which explains how the huge pool of investment money provided incentives via mortgage backed securities that led to riskier and riskier mortgages being written over the last decade. And Episode #365, "Another Frightening Show About the Economy", which explains how the derivatives and credit default swaps added fuel to the fire.

Thanks for your question.


Fremont, Calif.: So all the folks that have responsibility for allowing this mess to happen, the people who created and sold the tainted securities, are they subject to any legal consequences?

Jill Drew: Lawyers say there could be legal consequences for those who packaged the securities, especially if there is solid evidence that the firms that sold these securities knew they would likely default and essentially lied about it, telling investors they were safe. The ratings agencies that gave these collateralized debt obligations AAA ratings, even calling many of them "super senior," are being called onto the carpet by government regulators. These ratings agencies have always existed with a potential conflict of interest: they collect fees from the issuer for every batch of securities they rate. So, they had an incentive to give the bonds high ratings so they could collect their fees. These firms, the biggest are Standard & Poor's and Moody's Investors Service, have elaborate policies against conflicts of interest, but the effectiveness of those policies are now being scrutinized.

Ellen Nakashima: And, as our colleague Carrie Johnson has reported, Justice Department officials have said they will generally seek criminal charges against individual brokers and bankers, rather than companies themselves. For instance, two former fund managers at Bear Stearns are fighting criminal charges that they misled investors about their unit's financial health.

Stay tuned.


Oakton, Va.: It seems like the two GSE's Freddie Mac and Fannie Mae took on too much risk which has played a major role in the meltdown. As the recovery takes place wouldn't it be better to eventually privatize these two entities and get the government guarantee out of their decision making so they do not take on too much risk in the future and potentially cause another house of cards to come crashing down again?

Anthony Faiola: Your smart question/comment echoes the spirit of what many believers in the free market are arguing - that the best way to move forward from this mess is to have government get in, then out, of the financial sector as soon as possible.

There is a strong debate going on now about another point you make - that private enterprise may police itself better if it doesn't have a safety net of government guarantees. Some feel that discussion should go hand and hand with a debate over whether tighter government regulation could be part of answer, too.


Missoula, Mont.: Al Greenspan has been the Fed Reserve Chief who has led this economy into one bubble after another - He had the choice to keep interest rates higher causing more short-term pain for some and avoiding a big crash like we've just seen. Why save $ when interest rates were so low?

Jill Drew: Good question! During the bubble years there was active debate within the Fed and among economists about whether Greenspan could have done more, by advocating higher interest rates, to burst the bubble. Although I can't speak for Greenspan, I can point out a couple of things: 1. The Fed's controls influence mainly short-term interest rates. It has only an indirect effect on long-term rates, which are the ones that encourage things like a housing bubble. There have been studies showing that central bankers around the world have far less influence these days over long-term rates than they did 20 years ago.(The huge size of the global markets in bond and currency trading have cut into the Fed's influence.) Greenspan has argued that to burst this housing bubble, and the stock market bubble, the Fed would have had to raise short-term rates to an eye-popping level that would have cut off economic growth entirely. At the same time, Greenspan did not go out of his way to use the bully pulpit to rail against the bubble economy. He did mention in (was it 1996??) that the stock market seemed to be exhibiting "irrational exuberance." Stocks tanked, for a few days, and then kept roaring ahead. The .com bubble eventually did burst in 2000, but Greenspan has noted that anyone who sold immediately after his comments missed 80 percent of the stock market upside. All that said, many, many people now say interest rates were too low for way too long and they therefore encouraged all kinds of bad behavior in the name of greed. Now we're seeing what happens when fear returns.


Edina, Minn. (Minneapolis suburb): I assume there is not an unlimited capacity to lend on the part of China, Japan and the Middle East countries. We are seeing the EU countries shoring up their budgets as well. Aren't we in danger of seeing inflation take off like what's happening in Zimbabwe?

Anthony Faiola: You're right - there is some doubt about whether the countries you mention will continue to sink their cash into the U.S. with the same gusto they have in the past. That said, U.S. treasury bonds still represent one of the safest investments on global markets today, making them, for the moment, still relatively desirable as investors run for cover.

I wouldn't worry too much about Zimbabwe-like hyper-inflation, which is fueled partly by severe import/export restrictions and an illegitimate government which investors can have little to no confidence in. In fact, after the stock market crash in Japan in 1990, that nation went through a long cycle of deflation, in which prices dropped along with weak demand from consumers. But that's no picnic either - it makes in hard, as Japan's "lost decade" in the 1990s shows us, for a country to get back on the road to economic growth.


Washington, D.C.: in response to Suburban Detroit: If I take out a subprime loan to buy prime property, that property will still exist after I default. However, if I take out a bad loan to buy bad property, or a bad American car (I just replaced a transmission on a three-year old Buick), the bad property or poorly made vehicle has no residual value when I walk out on the loan, and everybody pays. Oh, and I religiously followed GM's maintenance recommendations.

Jill Drew: You raise a good point. Asset quality is hugely important to anyone making a loan to purchase the asset. But with the chain of securities and guarantees and protections designed by Wall Street, there was a whole chain of buyers who simply decided asset quality was not important. They felt protected. And the people who made the original loans sold them quickly and therefore did not have an incentive to check the asset quality. This false set of protections is a big part of what we were trying to explain in this story.


The culprits? Committee and agency turf battles. Partisan politics. A lack of political will.: I think you're making the symmetry of sin error here. I am a sinner. You're a sinner therefore we are equal in spite of the fact you are a litterbug and I killed 23 people with a chain saw.

Behind this mess is the conservative philosophy that the "free" market knows best, that all regulation is bad, that the rich deserve more and more of the wealth of the country. To blame the Dems and the Repubs equally is simply wrong.

Ellen Nakashima: Alan Greenspan as Fed chairman, and Sen. Phil Gramm (R-Texas), while he was at the helm of the Banking Committee were very powerful forces and beat back efforts at regulation.

So you're right in that they drove the debate in the 98-2004 time period. But Democrats largely conceded that debate and were forced to work the margins.

What our story showed was that the Democratic Clinton administration did not see fit to push back hard against those forces at the time. As Treausry Secty Bob Rubin, a former Goldman Sachs sr partner, said, there wasn't the "political reality" to do so.


Great Falls, Va.: I find one of the huge disconnects today is that while the majority of investors measure the investment environment and general performance of the markets by focusing on one particular stat, the DJIA, this crisis is largely being driven by considerations that have little or nothing to do the equities market. Yet these instruments are driving down the value of portfolios so much that many are forced to re-think their retirement plans, higher education budgets, etc. In the long run will these recent events lead to wholesale abandonment of the stock market?

Jill Drew: You are right that anyone who only focuses on the level of the Dow Jones Industrial average as a gauge of economic health is missing a big, big part of the picture. This economic crisis shows the huge role that the credit markets and derivatives play. One reason stock prices have dropped so much is that equity markets are the most transparent, and are very liquid, so big investors that are losing money on exotic CDOs, for example, can dump a bunch of stocks to raise cash. That's one reason why the stock prices of company's wholly unrelated to the financial sector can get pummelled, dropping way below their value, even if you take into account a potentially deep recession on the horizon. But, I don't think people will abandon the stock market. Following sound investment principles of finding good companies that make solid products and buying their shares at a reasonable price as a long-term investment in a diversified portfolio, will return as the crisis fades.


Annandale, Va.: Were there lessons from the Savings & Loan Crisis of the 1990s that should have been learned that could have prevented the current banking crisis?

Jill Drew: One big lesson is that many of the firms that have gone belly-up were using huge amounts of short-term borrowed money to finance their positions in illiquid securities. Borrowing short (at low interest rates) to fund a long-term purchase is a dangerous game that the s&ls played in the 1980s-1990s and that Wall Street has been playing now.


Alexandria, Va.: Why hasn't anyone proposed eliminating the entire CDS market? Questions of risk are supposed to inform every investment decision. Swaps delude investors and financial institutions into thinking that risks are lower than they really are and thereby distort our entire market system. Why on Earth would we try to reform these tools rather than just eliminate them?

Jill Drew: CDS is a global market and so no one regulator can just ban them. I suppose they could restrict the firms that they supervise from buying them, however. When firms post collateral to back their sales, and if there are concentration limits on the value of contracts sold and more transparency over who is buying what, these contracts can help disperse risk. I've heard one prominent market player talk about how, after the .com bust, CDS helped limit the damage from billions in bad loans made to telecom infrastructure builders. He was arguing that those losses would have hurt the financial system much more severely without the CDS protections. But, a CDS, like an insurance policy, is only as good as the company that sells it. If that company goes under, all bets are off.


DC--lending to minorities: There was another chat on the WaPost today about how some pundits are saying that the crisis was formed because banks had to lend to minorities and that the community reinvestment act led to all of this. Did you find any credence to this theory in your reporting?

Jill Drew: We didn't focus on that question, which has certainly been getting a lot of ink lately. Our reporting found there are many other reasons for why these loans got so out of hand.


What our story showed was that the Democratic Clinton administration did not see fit to push back hard against those forces at the time.: So what you're saying is that the good guys were not able to beat the bad guys. That doesn't make them bad guys.

Jill Drew: We didn't try to say anyone was a good guy or bad guy. We were showing there were many missed opportunities to really address the problems that were building and threatening systemic risk.


Augusta, Ga.: How about doing a story about people losing their homes because they relied on information provided to them by the people they should have been able to trust to get them the right house (in terms of price) and the right mortgage instrument(fixed rather than ARM). Few people would opt to purchase a house that they could not afford.

After looking at the buyers, work up the food chain (real estate agents, brokers, banks, etc).

Hopefully, your articles will make people understand that the consumer is not the first link in this economic downturn chain. They were/are victims much more than we are--they are homeless and have a foreclosure note on their credit report.

Ellen Nakashima: You've pointed out a critical part of the problem and one that government is belatedly addressing. The Fed in July finally issued a rule that would give consumers more protections in the suprime lending market. They include

a ban on lending based on the collateral without regard to a person's ability to repay the loan, and a ban on abusive servicing practices.

But there are questions about the rule's enforceability.

Much more still needs to be done on this front. Thanks for the question.


Jill Drew: Thanks for so many good questions! We've run over our time. You all have provided food for thought, and ideas for future stories. All best.


Ellicott City, Md.: Just saw the article and haven't had a chance to completely digest it, but I do have one question. Clearly our nation's housing policy has been to promote home ownership. I assume that the rate of home ownership is dropping or soon will be as a result of all this. Yet it's still a noble goal to put as many people in their own homes as is reasonable and financially sound. What are your thoughts on the outlook for homeownership over, say, the next 3-5 years? Or even a decade from now? Thanks.

Jill Drew: None of us are experts on homeownership policies, but here's my two cents: When a home is purchased at a reasonable price, with an affordable mortgage, it is often the biggest wealth creator in a person's life. It sounds like a no-brainer to buy a house as soon as you can, but it's not. Figuring out how much of a mortgage you can afford is a question for you to answer (do you want to take on a huge commitment that could easily last for the next 15-30 years?), not for some banker to "sell" you like a guy at mcdonald's trying to get you to supersize your order, telling you that you can clearly "flip" the house for profit in a couple of years. Also, figuring out what is a "reasonable" price can be impossible today, given that we've been living in a housing bubble for years and years. The Post recently did a story on an auction here for foreclosed homes. It was mobbed with people.


University Park, Md.: Thanks for the excellent reporting. Your article is just the type of longer-form, historical analysis I've been hoping for. My question: Can you recommend a book or two that gives a more detailed description of the various financial instruments at play (derivatives, CDOs, CDSs, MBSs, etc.), targeted at a layperson who isn't afraid of a fair bit of technical detail or even -- gasp -- math?

Ellen Nakashima: One book is Richard Bookstaber's A Demon of Our Own Design: Markets, Hedge Funds and the Perils of Financial Innovation.Another is "When Genius Failed"


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