Leadership in financial regulatory agencies and the 2008 housing crisis

Banking Regulation

Captain -- You Do See That Blinking Light, Don't You?

An apocryphal story about an unnamed navy captain goes like this. The ship in question is sailing at a not insignificant clip on a very overcast night close to shore in preparation for docking. A number of sailors who are above deck see a blinking light in the distance that clearly -- to them -- appears to be a lighthouse. The captain, however, gives no orders either to slow or turn the boat. Each of the sailors thinks that perhaps he should ask the captain if he does indeed see what is becoming with each passing minute ever more clearly the lighthouse. But each in turn says to himself: "He's the captain. He must see the light. He'll make sure that we don't run aground." And then there is the terrible sound of the bow of the ship being shredded on the reef below the lighthouse.

Something rather like this happened during the American financial crisis of 2008, the consequences of which are still very much with us in the ongoing recession, which at this moment may well be transforming itself into a double-dip recession. While there were certainly signs that to those who are educated about the financial markets were as clear as a lighthouse beacon that there was something fundamentally rotten and systemically so about the American financial system, those who were tasked with turning the financial ship aside in time were derelict.

This paper examines how the leadership of U.S. regulatory agencies failed their constituents during the run-up to the horribly spectacular conflagration that overtook the U.S. financial sector, and especially the U.S. housing market. Those constituents included essentially the entire American population, but they also included everyone in other countries whose life and livelihood is affected by the state of the American economy, which is effectively a very large portion of the earth's population. The failure was in no way a simple misunderstanding of the rules of economics or a misapplication of them: It was a failure of human leadership and human intelligence, and its cost must be counted in human terms.

A number of forces came together to produce what is usually referred to as the financial meltdown of 2008 -- a meltdown that is often compared to various natural disasters, perhaps most commonly a tsunami. The invocation of natural disasters to explain (or excuse) the financial devastation of that year is significant, because it suggests that what happened was not something that could have been prevented by any human intervention. Like a volcano rising from the sea to spew forth lava, the financial institutions (primarily banks, but others as well) that support the nation's economic health were overtaken by unexpected and uncontrollable forces.

The limits of such analogies should be obvious, of course, for financial institutions, unlike volcanoes, can in fact be controlled by human intervention. And even in the case of actual natural disasters, there are things that humans can do, such as not building near fault lines or in flood zones. As the American financial system unraveled throughout 2008 and into 2009 (and arguably continues to do so), it was clear that the regulatory agencies that should have stepped in and warned about those economic seismic zones and been paying attention to the seismographs on their desks had been astonishingly inattentive.

The Players

Part of the reason that the U.S. banking and financial system came so thoroughly undone in 2008 was that there was no single regulatory agency that oversaw the entire system. This fact resulted from the historical way in which the regulatory system has been built up, with different agencies being added as the financial landscape itself changed. (The Framers did not have to worry about hedge funds, after all.) The regulatory system thus existed as something of a patchwork, with many aspects of the financial system being covered while other aspects fell between the cracks.

The regulatory system was also generally limited in its effectiveness -- and this was far more significant in the case of the current economic downturn than the historically less-than-linear path taken by the formation of federal agencies -- by the fact that the previous eight years had led to significantly increasing laxity in the system (Frank, 2010). The Bush Administration, being true to its conservative ideology, had fought to reduce the amount of regulation throughout American society. While some conservatives have argued in the wake of the economic collapse that the recession (the pernicious effects of which the federal government has attempted to reduce) was the result of over-regulation and a lack of trust in the free market, in fact the opposite was the case.

The following summarizes this perspective:

A dramatic spending increase to fund the S.E.C. And C.F.T.C., as envisioned by the authors of the Dodd-Frank legislation, would further the mind-set that our nation's problems can be solved with more spending, not more efficiency," Representative Scott Garrett, the New Jersey Republican who leads the House Financial Services Committee's Capital Markets panel, said in a statement earlier this year. (Protess, 2011)

Guarded enthusiasm of the regulatory process arises not only from conservative ideology (although this is the case most of he time) but also from some bipartisan concerns about how well some agencies have been able to tend to their internal affairs (Protess, 2011).

Regulatory agencies, including those such as the Securities and Exchange Commission, an absolutely key governmental defense of the economic well-being of the nation as a whole, can work only when properly funded and staffed. They also work more effectively when officials at these agencies can reasonably expect that their work will be taken seriously by the executive and legislative branches of government. None of these aspects of support for regulation was in place during the eight years of the Bush Administration. The following summarizes this attitude:

Some people have blamed such regulatory lapses on the inherent incompetence of the federal government. But these failures have little to do with incompetence and everything to do with the rise of a conservative, anti-government ideology that has been fundamentally hostile to regulation. "Deregulation" was the mantra of President George W. Bush and his Republican predecessors, and many of the problems we are now facing are the predictable result of this failed political philosophy. Importantly, these conservatives not only undermined federal oversight of the energy industry, the food system, and the financial sector, they also worked to reduce broad protections for consumers, workers, and the environment. (Amy, 2007)

Certainly the heads of various regulatory agencies remain responsible for their actions and their inactions.

However, the Bush Administration must also be held accountable for the economic malfeasance. The buck does indeed stop at 1600 Pennsylvania, and the failure of leadership in the economic sector was led by Bush and his conservative ideology.

However, the fault does not lay only with a Republican White House, but has also more recently occurred with a Democratic president and a Republican House:

Until recently, employees from the commission were instructed not to order certain office supplies -- items like three-hole punches and heavy-duty staplers. The ban was lifted after the new budget was instituted.

Some regulators were also paying for their own travel. When Mr. Gensler, a former Goldman Sachs executive, headed to Brussels to help the European Parliament create new derivatives rules, he paid out of his own pocket.

Another commissioner from the commodities agency who attended a conference in Boca Raton, Fla., paid for a night at the Sheraton using his family's promotional points. (Protess, 2011)

The Congressional subcommittee headed by Carl Levin that investigated the root causes and regulatory failures that brought about the domino of economic failures summarized the need for regulation in the economic sector:

In a market economy, the purpose of regulation within the financial markets is to provide a level playing field that works for everyone involved, from the financial institutions, to the investors, to the consumers and businesses that rely on well functioning financial systems. When financial regulators fail to enforce the rules in an effective and even handed manner, they not only tilt the playing field in favor of some and not others, but also risk creating systemic problems that can damage the markets and even the entire economy. (Levin, 2011, p. 208)

This last point is an extremely important one, for it underscores the fact that the regulators at such governmental agencies as the Office of Thrift Supervision failed in two distinct ways.

They were generally delinquent in their duties, failing to provide the degree and force of oversight that was needed to the economy as a whole. But it was not that they simply failed to act sufficiently forcefully, but rather that the ways in which they acted gave an advantage to institutions that were inclined to act in particularly reckless ways. This was most apparent in the housing industry.

A Little Regulation is a Dangerous Thing

During the Congressional hearings on the issue, Senator Coburn made the trenchant point that having a poorly run regulatory agency could do more harm than not having a regulatory agency at all. If there had been (for example) no Office of Thrifty Supervision (which was responsible for allowing WaMu to make home loans with a giddy disregard for economic realities), at least many individuals would have taken it upon themselves to pursue some investigation on their own. However, with the knowledge that there were government agencies that were supposed to be overseeing the banking industry and other financial institutions, individuals were left to assume that these institutions were economically healthy. Senator Coburn made the following statement to officers of the Office of Thrift Supervision:

As I sat here and listened to both the opening statement of the Chairman and to your statements, I come to the conclusion that actually investors would have been better off had there been no OTS because, in essence, the investors could not get behind the scene to see what was essentially misled by OTS because they had faith the regulators were not finding any problems, when, in fact, the record shows there are tons of problems, just there was no action taken on it. ... I mean, we had people continually investing in this business on the basis & #8230; that OTS said everything was fine, when, in fact, OTS knew everything was not fine and was not getting it changed. (Levin, 2011, p. 208)

The Congressional subcommittee, after both hearing testimony and conducting a wide-ranging investigation into the paper trail detritus of the economic disaster.

The subcommittee members came to a number of conclusions about why the regulatory agencies had failed to do their job and so failed to protect Americans from financial chicanery by the nation's banks, thrifts, etc. They summarized the key failings on the part of the agency leadership. Key among their findings was the fact that regulators, and especially those at the Office of Thrift Supervision, showed far too much deference to the corporate officers of the institutions that they were supposed to be supervising. (This phenomenon is known as "regulatory capture." )

Even one of those corporate officers who was supposed to be under regulatory supervision described the situation as one in which the Office of Thrift Supervision believed strongly that thrifts should practice 'self-supervision'. That regulators were so inclined came about from a variety of factors, Congress found, including the fact that on-the-ground investigators received little support from their supervisors and the additional fact (which was a direct result of the political direction of the Bush Administration) that their regulatory brief was so narrowly focused. The investigators had been rendered effectively toothless (Levin, 2011, p. 211).