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Consequences of the Crisis

Assessing the Legacy of the Great Financial Tempest
   Monday: Banking   |   Tuesday: Housing   |   Weds: Wall St.   |   Thursday: The Fed   |   Friday: Consumers

How the Financial Crisis Has Impacted Wall Street

FILE - In this Sept. 25, 2008 file photo, Dara Blumenthal, of Brooklyn, holds up a sign during a rally against Wall Street bailout in front of the New York Stock Exchange in New York. (AP Photo/Mary Altaffer, file)
FILE - In this Sept. 25, 2008 file photo, Dara Blumenthal, of Brooklyn, holds up a sign during a rally against Wall Street bailout in front of the New York Stock Exchange in New York. (AP Photo/Mary Altaffer, file) (Mary Altaffer - AP)

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Douglas Elliott
Fellow, Economic Studies, The Brookings Institution
Monday, September 14, 2009; 11:00 AM

On Monday, Sept. 15, 2008, investment banking firm Lehman Brothers filed for bankruptcy protection, kicking off a week of massive shifts on Wall Street that was the beginning of the largest financial crisis in recent memory.

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Brookings Institution fellow Douglas Elliott was online Monday, Sept. 14 at 11 a.m. ET to discuss the effect the financial crisis has had on the banking industry.

A transcript follows.

Elliott was an investment banker for two decades, principally at J.P. Morgan. He was president and principal researcher for the Center on Federal Financial Institutions. He focuses on issues surrounding both public and private financial institutions.

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Douglas Elliott: Hi, this is Doug Elliott of the Brookings Institution. Welcome to our web chat. I apologize in advance that I won't be able to answer all your excellent questions, but I'll do what I can. Feel free to fire away when you're ready.

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Laurel, Md.: Has Wall Street learned that it was too big?

I was just reading that during 2006(?) the financial sector earned one-third of all the profits of the S&P 500 companies, and that doesn't even include the finance arms of conglomerates like GM and GE. A small country like Switzerland can support an economy based on finance, but a major economy like the US can't make "nothing but money."

If this lesson has been learned, is it being implemented at the education level? In other words, are more of the brightest minds going into real sciences, and fewer into finance, than a couple of years ago?

Douglas Elliott: I share your intuition that the finance industry is larger than it would ideally be, but it is a remarkably hard thing to prove. First, profits in the sector are quite volatile, so you need to look at longer term averages. The industry has given back much of the excess profits that it earned in 2005 and 2006 by losing money subsequently. I suspect that a longer term average is more like 20% of the S&P 500's profits.

Second, no one that I know has a good way of measuring what size is right for any industry from a society's point of view. Confucius thought merchants were too important in China because they didn't create anything. Modern thinkers view merchants, broadly defined, as essential contributors to the economy. We may alter our view of finance over time and view a large finance sector as a good thing.

Again, I share your view. It's just hard to prove and because it's hard to prove it becomes hard to know what the right public policy is. Certainly it's difficult to persuade Wall Street to slim down when we have no analytical approach to convincingly show them what size they should be.

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Detroit: Do you foresee a repeat negative effect of the banking industry on the stock market in the next few years?

Douglas Elliott: The banking industry is very important to the economy and it's still going through a turbulent period, with a lot more credit losses coming. So, I can't rule out negative effects on the market. However, I would be quite surprised if the effects are nearly as large as those we just experienced. Despite how things sometimes appear, the industry is being a lot more careful, financial risks are priced a lot more sensibly than a couple of years ago, and the regulators are much more focused on potential trouble.

My worry would be 10-20 years down the line if we don't reform financial regulation in the right way. Troubles this large usually take time to build up.

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Boston: The US government has West Point, Annapolis and the Air Force Academy to train its next generation military leaders. As complex and fundamental as the financial system is to our country and citizens, why isn't there similar, sophisticated training for our financial regulators where the government finances, if not runs, the schools and the individuals sign a contract to work for four or more years for a regulating agency? Because of the incredible sophistication of the financial instruments and markets, is our only current option to rely on Wall Street veterans who either made their fortune or busted out to fill regulator roles (or very inexperienced younger regulators who get recruited away quickly by Wall Street firms)? This seems like an asymmetrical relationship right now with the government/citizens on the losing end...

Douglas Elliott: It's a great idea. Certainly we need to do something about the gap in sophistication between the regulators and the industry. The difference exists in most industries, but finance pays so much more than government that the problem is quite severe.

One thing we should certainly do is pay financial regulators substantially more. But, it's very hard to convince the public and Congress that "bureaucrats" deserve compensation at levels much higher than the average American earns.

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New York: Do you think that we have made celebrities out of financial titans and that has contributed to bad public perception of CEOS? Jamie Dimon is smart, but we act as if he runs the entire industry himself.

Douglas Elliott: Yes, I do. However, even if this weren't the case, the fact that they led an industry that just put us into the worst recession since the Great Depression would make them unpopular. It doesn't help that they are extremely well-paid.

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Chicago: Given the fact that bundled mortgages traded as derivatives contributed so greatly to last year's economic meltdown, how can it be that doing the same thing by grouping life insurance policies into bundles traded as derivatives can be remotely acceptable this year?!? And will losses be insured as they were in the mortgage mess, so that TWO institutions are yet again tied to each other's failure?

Douglas Elliott: Derivatives are a valuable part of our financial system and have been around for decades. The problem comes when they are misused. Many of the mortgage derivatives that were "plain vanilla" in nature played a positive role even in recent years. The big problem came from the unnecessarily complex ones and from the willingness of many investors to buy mortgage derivatives that were based on badly underwritten loans, such as those with minimum documentation.

Derivatives based on life insurance can make sense. It depends on how they are done.

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Washington, D.C.: Mr. Elliott, thanks for doing this chat.

You may have spotted the numerous tax protesters in town this weekend. One stopped me on the street near the FDIC, while I was innocently minding my own business, and asked me what the FDIC is. I told him that it's the Federal agency that monitors the solvency and market-conduct of most Federally-chartered banks, and steps in if a bank requires supervision or liquidation to protect depositors. He steeled his eyes and said "you mean welfare, right?" I said, no, it's financial institutions solvency protection. He harshly said "you should just deregulate people, and start going after businesses that get welfare."

I admit it - I was floored. I realize that events of this nature don't attract a terribly smart crowd, but have we reached the point at which the average idiot doesn't even know what the Government does any more?

Help!

Douglas Elliott: For what it's worth, my strong impression is that most Americans are looking for more regulation of banks, not less. Certainly that is what the politicians believe they are hearing.

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Raleigh, N.C.: Can we tell Wall Street that we will NOT back them up next time?

Would they believe us?

Will any adults hold them accountable?

Douglas Elliott: My view is that the financial markets will NOT believe that we would fail to back up the largest banks, because I find it hard to imagine a future crisis of this nature where the politicians decided to gamble on a depression. For that reason, I think it is very important that we take actions now that will make the largest banks less risky and give the regulators greater ability to intervene when things start to go wrong.

There is a great deal in the proposed financial regulatory reforms that would substantially reduce the risk of a future banking crisis and the cost if one does occur. There is, unfortunately, no way to completely prevent such a crisis. Banks, markets, and their regulators are made up of humans and we seem to be prone to over-exuberance at times which leads to bubbles.

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New York: Two questions:

1) Which administration is most responsible for the contraction of credit spreads (in other words, with the curing of the financial markets ), the Obama Administration or the Bush Administration? More specifically, how much of the credit for the fix goes to each?

2) The current administration is still no closer to finding new capital requirements for financial institutions. How important is firmly establishing new capital requirements to true rebirth of the financial services sector?

Douglas Elliott: I don't know how to allocate the credit for curing the financial markets, so I won't even try.

On the second question, I think significantly higher capital requirements are a very important part of regulatory reform and that they will be good for the industry as well in the long run. Capital represents the portion of a bank's assets that are not promised to anyone except the stockholders and are therefore available to pay for mistakes and accidents. Finance is inherently risky, so you need enough capital to handle the things that can go wrong. It's pretty clear now that we didn't have enough a couple of years ago.

Fortunately, this seems to be one point on which virtually everyone agrees. There will be fights about how to do it and how far to move, but I am confident we will move substantially in the right direction.

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Atlanta: Well, if companies are too large - why are we allowing them to merge these days? It's so strange. I am a huge fan of capitalism. I'd prefer smaller companies and less regulation. Why isn't that the solution? Force the banks to be smaller. I know - we'd pay because those banks wouldn't have the scale that larger banks would have, but to me, it's preferable to pay that way than to have more government agencies (who, honestly, don't ever live up to what they're supposed to do - see: what's happening now, Madoff scandal, etc). Honestly, those on Wall Street DO know better than the government how to run their businesses! But we don't want them running roughshod over us, right?

Douglas Elliott: You raise a question that is hotly debated. There are those who call for drastic action to force the large banks and securities firms to become a lot smaller, hopefully small enough that we could live with them failing.

I'm afraid that I'm in the other camp, which believes that our modern global economy dictates that major institutions in this country, in almost all industries, become very large. (There's plenty of room for smaller companies to contribute as well, but here I'm talking about the size of the largest institutions in each industry.) I believe that we would handicap our economy if we tried chopping JP Morgan, or Citigroup, or Bank of America into 15 pieces. Further, I'm not sure how much it would really help if we ran into a crisis like this again. Having 15 smaller banks that all bet on house prices going up is not necessarily particularly better than having one very large one do the same thing. If a herd of banks all run off a cliff together, we'll still end up erecting an expensive safety net for them, just as we would for one elephant.

Again, there is lively debate on this. I'm in the majority camp, but you'll certainly find an intelligent vocal minority that disagrees.

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Harrisburg, Pa.: Behind many financial losers, there is a financial winner dancing with happiness. Didn't J.P. Morgan wind up a big winner when Bear Stearns was sold?

Douglas Elliott: As a former J.P. Morgan employee I agree that Management was very happy to have the opportunity to acquire Bear Stearns at what seemed like a fire sale price. On the other hand, there were a lot more losses on the assets than I think Morgan anticipated. I expect they'll be happy in the end to have done it, but it's still early to tell.

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Charles Town, W.V.: Shouldn't the question be, has America learned? The job of a business executive is to maximize profits. Without robust (T.Roosevelt) regulation, free enterprise tends to monopolize power with all of the excesses of monopolies. When the regulators get too enamored with the rhetoric of "economy of scale", and "government is the problem", then we get lax regulation, companies too big to fail. In short, we get the excesses that led to this disaster. Will we ever get over Reagan's homonym, "Government is not the answer, Government is the problem!" Shouldn't we use the concept of moderation in both government regulation and free markets?

Douglas Elliott: I agree with what I think is the core of your argument. We need a proper balance between markets and regulations. Markets work badly when there is no regulation and when there is too much regulation. It appears that we went too far in the direction of letting markets rule, which is why I support many of the proposed regulatory reforms. However, we do need to be careful not to overshoot by hobbling the markets.

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Philadelphia: How effectively are financial institutions regulated? While many are debating what the regulations are, isn't there a more important debate on how well the regulators keep tabs on them?

Douglas Elliott: There have been a lot of mistakes in financial regulation in the last few years, building on even earlier mistakes. Of course, what I just said is also true for banks, other investors, homeowners who speculated on housing, rating agencies that got too relaxed, etc.

A number of questions have been coming in which revolve around how to apportion the blame. I don't know the exact way to do that, but my own view is that almost every class of organization or people became too careless about risk during the 25 years preceding the crisis. The stock market bottomed in 1982 with the Dow Jones at 800. It went up by a factor of almost twenty over the succeeding 20+ years. Most other financial markets, including housing, did well during that period. We had some bumps along the way, but almost everyone learned the lesson that it was okay to take risk. If you just held on long enough you'd be very happy that you had.

In a long-term environment like that, it is no surprise that virtually every group started acting like risk didn't matter very much. My belief is that this carelessness would have created a major crisis even if housing hadn't blown up. It might have been an old-fashioned stock market bubble that got us or a commodities bubble or something else. This, to my mind, is why virtually every financial market fell apart once people got properly worried again.

So, yes, regulators made major mistakes. My hope, and belief, is that they will do a lot better over the next years, at least until we have all gotten excessively relaxed again.

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Atlanta: One thing I heard at the beginning of this mess was something I haven't heard since.

When the mortgages were bundled, plenty of people were happy to buy the A and AA rated. But they couldn't sell the riskier ones. So they just took the riskiest loans and started to 'bundle' them in with the top rated bundles. Apparently, no one looked at it that closely, so they weren't appropriately valuing the risks, and that's part of what happened here (i.e., there were 100 loans, and the person buying them were assured 100 of them were a+, but only, say 98 were). Is there any truth to that?

Douglas Elliott: There's some truth to that, but it's a very complicated topic. An underlying cause of the problems is that the markets bought the argument that we would never have a housing crash which was nationwide in scope. So, they thought it was safe to have some riskier loans, as long as they were spread across the country. We'd never had a national housing crisis since the Great Depression, so it didn't seem that unreasonable. Unfortunately, it was just a pleasant illusion.

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Evanston, Ill.: Hey Doug, did you catch Stephen Roach's case against Bernanke in the FT today?

1. Bernanke argued for Central Bank agnosticism for asset bubbles and denied the housing bubble.

2. He was, "the intellectual champion of the "global saving glut" defense that exonerated the US from its bubble-prone tendencies and pinned the blame on surplus savers in Asia."

3. "derivatives' explosion, extreme leverage of regulated and shadow banks and excesses of mortgage lending were all flagrant abuses that both Mr Bernanke and Mr Greenspan could have said no to. But they did not. As a result, a complex and unstable system veered dangerously out of control."

http://www.ft.com/cms/s/0/a2ba2378-9186-11de- 879d-00144feabdc0.html

Douglas Elliott: I'm a fan of Chairman Bernanke's, but he has certainly been part of some policy mistakes. I would have liked the Fed at the time to have reacted more to the asset bubbles, but there were intellectual arguments on both sides. David Wessel's book, "In Fed We Trust" does a good job of discussing this.

I agreed with Stephen Roach about the asset bubbles at the time and I still do. However, there's enough complexity and enough people made mistakes that I would not wish to be too harsh on Bernanke. He's done some very good, courageous, and necessary things in the last year or so which lead me to forgive him.

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Capitol Hill : How about we end the protectionism, allow some creative destruction (which is inevitable anyway), and finally get some real financial market innovation? Or is the crony capital market just too profitable for whoever's in the White House?

Douglas Elliott: It is possible that we would have been better off to have accepted more pain in the Fall of last year in order to avoid storing up problems for the future. However, I doubt it. There has been a lot of good research about what happens to economies when they have a severe financial crisis. On average, their economies shrink almost 3 times as much as the severe pain that we just went through, the worst since the Great Depression. It also takes years to recover from that. If you thought the deficit exploded in this recession, think about what would have happened if our economy had shrunk that much more. The bulk of the increase in the deficit is not from stimulus or other voluntary government actions but from a collapse in tax revenue and an increase in unemployment and other payments.

I'm sure we could theoretically have found a better balance of intervention versus "creative destruction", but I think we got it broadly right, starting soon after Lehman. My big complaint is that we didn't adequately prepare during the time between Bear Stearns and Lehman.

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Wokingham UK: I agree that banks won't believe that they won't be bailed out. But doesn't that mean that somewhere down the line they will behave so recklessly that they exhaust the ability of the public to do the bailing? A gambler who knows that his rich auntie will pay his bills gambles more dangerously. He might even wish she wouldn't love him so much, but he can't remove the knowledge from his brain, and in the end he will bankrupt himself and auntie into the bargain.

Douglas Elliott: You raise a powerful point. All serious analysts are concerned about the "moral hazard" issue of letting someone know you'll rescue them and therefore lead them to take more risk. However, it's important to look at the question more closely. The fact is that the managements of the institutions that got in the most trouble lost fortunes, sometimes as much as a billion dollars of their own money. They remained rich, by and large, but, believe me, they would not have knowingly taken risks that would get them clobbered that badly. The truth is that they messed up, which is hard to prevent totally.

My bigger moral hazard concern is with the people who supply the banks with funds by buying their bonds or making deposits. As long as they are protected, or think they are, we lose the ability to harness their objective judgment and their fears to force managements that go off the deep end to recognize reality.

It distresses me not to solve the moral hazard problem, but I haven't seen a sound way to do it that wouldn't create more harm. That is why I reluctantly look to much tougher regulation of the banks that are "too big to fail."

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Douglas Elliott: I'm afraid that I have to go now. Thanks very much for a great set of questions. I'm sorry that I couldn't get to them all. If you want to see more of my opinions, you can check out my papers on www.brookings.edu. The easiest way is to go to the Experts page and look me up.

Thanks again.

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