Joe Nocera on the Crisis and All the Devils Are Here
Dec 20 2010

Joe Nocera, New York Times columnist and co-author with Bethany McLean of All the Devils Are Here, talks with EconTalk host Russ Roberts about the origins of the financial crisis. Drawing on his book, Nocera identifies many people he considers devils for contributing to the crisis and a few angels who tried but failed to stop it. The discussion covers the history and development of securitization and the peculiar incentives created by securitization and the relative lack of regulation of the securitization process. The conversation also includes a discussion of whether past bailouts contributed to the crisis.

Vincent Reinhart on Bear Stearns, Lehman Brothers, and the Financial Crisis
Vincent Reinhart of the American Enterprise Institute talks with EconTalk host Russ Roberts about the government interventions and non-interventions into financial markets in 2008. Conventional wisdom holds that the failure to intervene in the collapse of Lehman Brothers precipitated the...
Barry Ritholtz on Bailouts, the Fed, and the Crisis
Barry Ritholtz, author of Bailout Nation: How Greed and Easy Money Corrupted Wall Street and Shook the World Economy, talks with EconTalk host Russ Roberts about the history of bailouts in recent times, beginning with Lockheed and Chrysler in the...
Explore audio transcript, further reading that will help you delve deeper into this week’s episode, and vigorous conversations in the form of our comments section below.


David B. Collum
Dec 20 2010 at 9:50am

James Grant wrote about the froth in the mortgage market as early as 2001 as well. The cracks under the surface were also being described in living color by a woman writing under the pen name “Tanta” at Calculated Risk in late 2006. One of the messages is that you have to ride the blogs pretty hard to have any sense of contemporary events and even then a monstrous filter is necessary.

For a book that came out in early 2008 but clearly shows anticipation of a catastrophic problem during the writing phase, I would recommend Kevin Phillips “Bad Money”. The crisis was also foreshadowed in its predecessor “American Theocracy”.

So here is a question to which I have not been able to get an unequivocal answer: Did the synthetic CDOs and CDOs become legally indistinguishable? If so, then it suggests not only ambiguity but rather a redundancy to claims during the foreclosure process.

Dec 20 2010 at 10:38am

You know I am a libertarian but I am willing to put the blame for the collapse on the economic freedom. I also put the credit for our great prosperity economic freedom. Economic freedom may produce booms and busts. In North Korea and Cuba they do not have booms and bubble they have long slow decline. I prefer the booms and busts.

Further I do not think that Government can help.

David B. Collum
Dec 20 2010 at 11:25am

I think it all traces to the interventions of the Federal Reserve that is the fuel pumping the boom-bust cycles. Free money kills. Free-market-priced capital does not. Along a related vein, I have yet to see a carry trade that I liked; they all appear to be premeditated, state-sponsored scams. The current carry trade in which the source and the destination is the Federal Reserve is a new low.

Dec 20 2010 at 12:01pm

I think that feedback is the real problem with the monetary system. People are prone to bubbles weather they work in Government or private organizations so we need a monetary system that is robust to bursting bubbles (and I wouldn’t hurt if it were also resistant to bubbles). I think that a free banking monetary system where money was only backed by bank assets would produce such a system. IMO Government stopped the evolution of money at a bad point and created this monopoly currency system with serious feedback problems.

Dec 20 2010 at 12:35pm

Thank you Mr. Roberts for this excellent addition to the “crisis” podcasts. As always, I sincerely appreciate the time and effort you, your guests and Mr. Goyette put into a product that you’re giving away for free. Thanks for the entertainment and the knowledge.

BTW, Joe Nocera’s Friday NYTimes piece adds a bit more to his position regarding Fannie and Freddie’s role in the crisis by taking on the Peter Wallison faction of folks on the “crisis commission” who think Fannie and Freddie are wholly to blame. His piece brings out the hypocrisy and wishful thinking-ness of this position. For instance:

The F.C.I.C. commissioner who has complained loudest about Fannie and Freddie is Peter Wallison, a former Reagan-era Treasury official who for the last two decades or so has been a fellow at the conservative American Enterprise Institute. Long before it was popular to criticize Fannie and Freddie, they were Mr. Wallison’s bugaboo. Back then, he was a lonely — indeed a brave — voice arguing that the enormous portfolios of mortgages of the G.S.E.’s — combined with their quasi-governmental status — created systemic risk.

He was right about this, though it’s worth nothing that his precrisis prognosis of Fannie and Freddie’s ills was wrong in a number of key ways. Like most Fannie and Freddie critics at the time, he believed the risk they posed was interest-rate risk, rather than credit risk, which is what actually brought the two companies low. He also argued that Fannie and Freddie were consistently ignoring their mission to help make affordable housing available to Americans.

As he wrote in 2004, “Study after study have shown that Fannie Mae and Freddie Mac, despite full-throated claims about trillion-dollar commitments and the like, have failed to lead the private market in assisting the development and financing of affordable housing.”

After the crisis, his tune changed considerably — as did that of many other Republicans, who tended to follow his intellectual lead on this issue. Now, he said, it was government policy aimed at increasing homeownership that essentially forced the private sector to make bad subprime loans.

And Fannie and Freddie, with their enormous power in the securitization market, were the government’s vehicles in leading Wall Street and the other market participants down this garden path. “Fannie and Freddie were in competition to reduce underwriting standards,” Mr. Wallison told me when I spoke to him this week. This of course directly contradicts his criticism of six years ago, but never mind.

Read it all here:

Explaining the Crisis With Dogma

[Link changed to permanent link, excessive number of quotes reduced, formatting fixed.–Econlib Ed.]

Don Crawford
Dec 20 2010 at 12:35pm

The discussion of how Glass-Steagall was not up to regulating the new, innovative financial services industry suggests the fatal flaw with depending upon government regulation. Like central planning it assumes people who write the regulations have sufficient knowledge to do a good job of it. As the pace of innovation increases it becomes less feasible to assume regulators know enough to do a good job. Far better to have proper incentives so that financial folks have enough “skin in the game” to regulate themselves. This podcast also adds to the evidence that when we allow the government to call the shots, we will end up with both regulatory capture and crony capitalism.
While many extol the virtues of political compromise to bring us to good policy, the half-measures described here are the problem. Greenspan let things slide as if we had real free markets with free-market discipline in place to correct errors when we did not. We either need to have full free-markets without government protections for Wall Street or we need way more regulation than we have. The problem is that political compromise leaves us in the middle with socialized risks (taxpayer funded rescues) and capitalist rewards (free rein to reward risk-taking).

David B. Collum
Dec 20 2010 at 3:49pm


You are right, but Greenspan was worse than that. He extolled the virtues of the garbage that got us in trouble. Fed transparency would help a lot. Brooksley Born was a heroin, and Greenspan helped snuff her opinion as well. Fleckenstein’s and Sheehan’s “Greenspan’s Bubbles” is a timeless read for anybody who wonders why Greenspan detractors are so quick to point a finger. He is condemned by his own words. The perception that he was watching the store when in fact he was the inside man was certainly at the heart of some of the crisis.

Dec 20 2010 at 4:35pm

Writing as a former and recovering “Big 4” auditor who participated in the testing of mortgages at a publicly traded regional bank that was swallowed up by a larger bank that was itself swallowed up by a foreign bank with TARP money, there was one glaring omission in this discussion.

That omission is the role of the Community Reinvestment Act of 1977 (CRA). At the time I was participating in the audit of the bank (about five years ago), you might think that as a publicly traded entity would be most concerned by the then-new Sarbanes-Oxley Sec. 404 Internal Control requirements. You would be wrong-banks had plenty of experience with internal control examinations since the IC requirements of Sox were piloted by the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA).

Although noxious in design, the CRA was relatively innocuous in effect until the 1990’s, when it was “strengthened” and specific lending targets and grading were developed, courtesy of the Clinton Administration.

The bank staff explained (behind closed doors) that they were afraid that a failure to achieve a high CRA grade would invite a lawsuit by “civil rights” groups. This bank almost immediately sold most of its mortgages to large money center banks in part to mitigate the geographic risk and in part to comply with FASB 133 derivative rules that required the bank to record the interest rate lock on its balance sheet, unless effectively hedged (by an agreement by another institution to buy the loan at a specific price) and to allow recognition of up-front fees that were treated as “deferred interest”(received but not yet earned) until the loan was fully amortized or sold as required by FASB 91.

I know there are plenty of studies that assert the CRA portfolios do not exhibit a significantly poorer default rate than non-CRA, but I find those studies suspect, since the CRA drove the genies of “NINJA” (no income, no job or assets) mortgages and securitization out of the bottle.

I distinctly remember watching a story on network news around this time about some young twenty-something that had utilized NINJA mortgages to acquire a multimillion dollar inventory of homes, many he had purchased sight unseen. When property values fell and average sale periods lengthened, he couldn’t make the mortgage payments. He probably wasn’t taking CRA loans-but he was using tools developed because of CRA and other government laws and regulations that attempt to allocate capital by political, not economic means.

Its not that securitization is bad (its not)-its that when a bank is forced to do “wink and nod” underwriting, securitization becomes the mechanism by which it engages in Gresham’s Law-circulating poorer quality loans while retaining those it prefers-and don’t think for a minute local banks don’t possess asymmetric information.

As an aside, please don’t let your guests assert that the credit crisis is due to a lack of regulation, there’s almost nothing other than healthcare that is as heavily regulated as depository institutions.

[This comment can also be found at Please do not re-post the identical comments you have already posted elsewhere.–Econlib Ed.]

Ole commenter
Dec 20 2010 at 7:22pm

Thanks to Russ Roberts for this clear and interesting discussion about the fundamental causes for the 2008 crisis. While the actions and decisions in 2008 of Henrik Paulson makes a good story worthy of many dramatic movies, its much more interesting for me to undestand the financial engineering the caused the crash. Similary, I prefer watching air craft investigations documentaries that explain all the factors leading to an air crash, rather than watching a dramatic movie of an air captain trying to save his plain.

I do have problems deciding of what to make of the current economic situation. I have no idea if the stock market, gold market or the bond market are bubbles. Are the dollar a bubble? Probably I am too dumb to understand, lol.

For example, when hedge fund manager David Einhorn was recently interviewed on the Charlie Rose show, he said he had become convinced that the Fed determined their policy on Wall Steets performance. Basically, he thought that the Fed was trying to inflate the Dow Jones index. If this is true, one have to wonder about the true independence of the Fed. There is something about the interconectedness between the Fed, the big banks, Wall Street and Congress that doesnt feel right.

Can it be that money contributions from Wall Street to Congress act as an “invisible hand” on Fed? After all, the big stick politicians in Washington have over the Fed are their ability to abolish or change that institution at any time. The Fed is certeinly not immune to outside pressure from powerful money interests.

I dont want to sound as a conspiracy nut, but it appears to me that what the 2008 bailots really was about, was preserving the interests and wealth of the elites in New York and Washington. If one takes into account the political instablity an economic hit on the financial elites in New York could have caused, this in understandable. But it is certainly not FAIR when the system acts as socialist one for the rich upper class.
So when a huge amount of the investments of the elites fails, the government comes in and gives bail outs and artificially pumps up their investments in the stock market.

Dec 20 2010 at 8:21pm

Enjoyed the podcast.

Any more I tend to avoid discussing this topic with most people because they get stuck in one of the two camps mentioned; either it’s all Fannie/Freddie, or all Wall Street.

If forced to summarize however I still have to blame government. It’s cliche among us nutty libertarian types, but the state is supposed to provide a legal infrastructure that allows for trade with protection against force and fraud.

We know the fraudsters are going to be there with us always, but the government was too deeply in bed with them on this. I do try to be careful not to throw the “oligarchy” word around too much, but that’s pretty much where we’re at now in my opinion.

Also, I liked Joe, but the comment “I’m just too much of a centrist journalist” almost made me heave. Kind of like the job interviewee that states as his worst flaw “I’m just too much of a perfectionist.”

Dec 20 2010 at 8:28pm

I agree with Superheater. I first thought I misheard when Nocera said the community activists were “one of the angels.” Didn’t “community activists” such as ACORN picket banks during the 1990s and 00’s who weren’t sufficiently aggressive about CRA lending targets? Sure, after the bust they complained that Wall Street engaged in fraudulent and predatory lending, but jumping on a bandwagon is hardly sufficient qualification for beatification. On the other hand, following up on Russ’s point that we’re all self-interested, putting a halo on community activists should certainly help win Nocera approval from big-city newspaper book reviewers (and most others, for that matter) such as those at the NYT, Boston Globe, and LA Times.

Dec 20 2010 at 9:25pm

Put in a simple sentence: What happend in 2008 was the elite showing how much influence they have got over the government and the treasury. It was really sad to see the illusion of a fair econimic system brake apart in front of our eyes.
The elite are basically living in a welfare state protected by their monetary contributions to politicians. The elites universities are sponsored by government and corporations so that the unfair advantages are multiplied. Companies like Google and Facebook both came out of this heavily subsidised elitist, university system.

I dont pretend to have any illusion that government main interest is any other than to protect the elites and their money. Nowadays a dysfunctional banking system is kept barely running because the banks is in such a bad shape that they only want sit on their money and not lend.

Its really depressing.

The Feds main objective is to inflate the value of Wall street. This was confirmed by president of a succesful hedge fund, David Einhorn, when he visited the talk show Charlie Rose a few weeks ago.

I think the main problem of the current system is big corporations/the elites ability to influence the political process. The insurance industry is so powerful that they was able to block president Obama attempt to reform the health care system.

Whatever happens in the future, we know the elites will be able to protect themselves and their own money.

Robert Kennedy
Dec 21 2010 at 11:38am

I can accept the assertion that Wall Street investment firms, not Fannie & Freddie, were the driving force behind the subprime securitization market. And that Fannie & Freddie ended up following those firms later on. But presumably the primary reason that these Wall Street firms did such was because they were frozen out of the conforming market by Fannie & Freddie. I would think that if Fannie & Freddie did not exist, that Wall Street firms would have little motivation to chase down these riskier assets. Yeah, I expect that there would always be firms and traders seeking out high risk/high return assets but presumably not in the volume that was ultimately generated.

In that context, I’m still persuaded that government interventions in the housing market were the primary drivers. Wall Street firms were merely responding to the incentives created by those interventions.

On the subject of Greenspan, a recent book called “The Alchemists of Loss” had an unusual spin. The authors of that book suggested that Greenspan changed his economic philosophies after he got involved with and eventually married Andrea Mitchell in 1997. They suggested that Mitchell influenced him towards a more activist philosophy and away from his Libertarian tendencies. Whether true or not, it is fun to consider. That said, I agree with Russ & Joe that Greenspan was not really a Libertarian. He got the taste of the payback from intervening in 1987 and never looked back.

Dec 21 2010 at 12:26pm

Russ, you have said on other podcasts that CRA was not a major factor in the crisis. It would be nice if he chimed in on this thread to that effect because it is again being used to portray government as the major factor in this crisis and implicitly, at least, let Wall Street off the hook.

Russ can discuss the reasons he has made that statement much better than I can but I would note that New Century, Countrywide, Goldman Sachs, Merrill Lynch, Fannie Mae, Freddie Mac, AIG were not affected by CRA at all. Citicorp, etc. were subject to CRA but their involvement in subprime was motivated by profits, not CRA.

I have more to say about Fannie Mae / Freddie Mac which I will post separately.

Dec 21 2010 at 1:48pm

As someone who thinks that Wall Street bears about 80% of the blame for the crisis, it bothers we when Fannie Mae and Freddie Mac are viewed as “Government”. It is true that both 1) were created by the government 2) have headquarters in Washington 3) are called “government sponsored enterprises. But, it is also true that Fannie Mae was fully shareholder-owned since 1968 while Freddie Mac was fully shareholder owned since about 1990 (I’m having trouble finding the exact date).

Of course, the F-twins were behemoths with small explicit and large implicit guarantees from the US Government. So, is Citicorp and many other institutions we are all familiar with.

As behemoths trying to enrich their stockholders, they did extensively lobby Washington (as did the other private companies) and they were quite successful at it. They did play on their origins and the supposedly public-oriented “mission” that they claimed but other private companies often present themselves as doing things that are beneficial to the public (and it is even true in many cases).

I DO think there is a huge political-economy problem. One part of this is excessive influence of large corporations (and particularly Wall Street) on government decisions. But to consider Fannie/Freddie’s faults a problem of “government” seems disingenuous.

Unfortunately, I don’t have a good solution to propose to the political economy problem. I would love to hear suggestions on this thread or on future podcasts.

Dec 21 2010 at 1:54pm

Russ says there is a “Famous paper by the Orszag brothers and Joseph Stiglitz, who was a Nobel Laureate, showing how remote it is that Fannie or Freddie would ever go bankrupt“.

Could you please provide a reference?

Russ Roberts
Dec 21 2010 at 4:14pm


Thanks for the reminder. You can find it here.

Dec 21 2010 at 4:32pm

Responding to my own request, I found the Orszag and Stiglitz paper (not so hard once I spelled Orszag correctly).

Even recognizing that all of us write things we regret in hindsight, it does seem quite appalling in parts.

However, I would note that, for better or worse, the last paragraph had a caveat that is all too prophetic.

Fannie Mae and Freddie
Mac would likely require government assistance only in a
severe housing market downturn.
Such a severe housing
downturn would, in turn, likely occur only in the presence
of a substantial economic shock. Regardless of the
structure of the mortgage market, the government would
almost surely be forced to intervene in a variety of
markets — including the mortgage market — in such a
Fundamentally, given the public’s aspirations to homeownership and the myriad ways in which government
subsidies are channeled to homeownership, the
government is indirectly exposed to risks from the
mortgage market regardless of the existence of the GSEs.

So, you can’t say you weren’t warned.

Dec 21 2010 at 5:33pm

Jonathan writes ‘… it bothers we when Fannie Mae and Freddie Mac are viewed as “Government”….’. I don’t see how we can look at them as anything other than government. They were both created by the federal government and have charters controlled by the US Congress. They have operated since their founding as institutions that are backed by the full faith of the federal government. The fact that they are both shareholder owned just seems like an accounting gimmick to keep their assets off the federal books.

I agree that their implicit & explicit guarantees are at least somewhat similar to other financial institutions, all of which is problematic, imo. But there is at least a chance that a Citicorp could go bankrupt, unlike the F-twins.

Dec 21 2010 at 6:52pm

Robert writes:

“I don’t see how we can look at them [Fannie Mae/ Freddie Mac] as anything other than government. They were both created by the federal government and have charters controlled by the US Congress. They have operated since their founding as institutions that are backed by the full faith of the federal government. ”

They did not have full faith and credit (or any other explicit guarantees) from the US government since, at least, there spinoffs to become shareholder-owned entities. In the case of Fannie Mae, the spinoff occurred in 1968 (Lyndon Johnson was President).

They were federally-chartered but so is Citicorp and most other banks. Yes, I agree they had somewhat special status but fundamentally they reported to their boards/shareholders.

I am not saying they were exactly like any other bank. They did have a small, explicit credit line with the Treasury (but, of course Citi can borrow from the Fed). They did have an implicit guarantee (which I agree is unfortunate) but that hardly is evidence of government control. They operated more as private entities than public. To the extent there was control between Congress and Fannie Mae, Fannie Mae was doing the controlling (as Nocera discusses in the podcast and book).

Robert Richards
Dec 22 2010 at 2:44am

Thank you for this very interesting program. State laws that regulate securities are called “blue sky laws”: A dictionary of modern legal usage by Bryan A. Garner.

[link edited for clarity–Econlib Ed.]

Dec 22 2010 at 4:21am

What about pension funds? They provided a lot of combustant (and still do), but I haven’t heard much of an analysis of their role in the big picture of the financial crisis. Any pointers would be appreciated.

For starters, ratings agencies owe a lot of their clout to the need for securing (or being perceived to secure) “people’s retirement savings” against bad outcomes, yet it seems these funds were inexorably drawn to chasing higher and higher yields, which must have put a lot of pressure on the system for putting AAA ratings on huge volumes of riskier and riskier investments.

A future Econtalk perhaps?

Dec 22 2010 at 8:26am

Enlightening podcast that gave me more background after finishing Sorkin’s “Too Big To Fail”.

I still have a problem with the moral hazard argument.
Assuming they all counted on being bailed out, they still would have the incentive to be better capitalized than a big chunk of competing institutions.
Why? Because a few institutions will have to fail before people think that they have a crisis on their hands. Bear Stearns after all was sold for 10$ a share instead of the 170+$ in 2007 and Lehman was left to fail. No CEO wants to be that company.
Assuming all institutions have good information about their competitors capitalization and a few people start prophesizing a bubble, companies would always try to be better capitalized than a big chunk of their competitors. This in turn would lead to a good capitalization of everyone even in an environment of the moral hazard is supposed to create.

There was a better explanation hinted at in this podcast and I think it even was Russ Roberts, that gave it explicitly in an earlier one:

Even realizing that your institution is under-capitalized, believing that a down-turn would come and you should get out of the market, any one institution can’t.
Why? If you leave the market before a down-turn your shareholders will see that other companies are still making 20% on their capital and you don’t. They will sell their shares and you will take a hit in the market.
You now know that you will take a huge loss anyway whether you are in the market or not. If you are in the market though, you might think that you can always get out before the worst of the crisis hits and keep a bit of the profits. Your shareholders will be happy and you will be better off by staying in the market.

Now assuming that every company thinks like this, everyone will stay in the market till it just crashes and nobody can get out.

Dec 22 2010 at 8:40am

Moral Hazard:

Stephan (and Russ),

I think the more insidious impact of moral hazard is on the creditors/lenders. Without moral hazard, lenders would not allow the degree of leverage that they did at these institutions (or would charge higher interest rates that would make that amount of leverage uneconomic. AIG’s counterparties may have questioned how much CDS they were writing. (Note: may is an important word because there was a lot of blindness, too.)

And that is also where the biggest bailouts occurred. The shareholders of Fannie, Freddie, AIG and Bear were largely wiped out. However, their creditors generally did not take losses at all.

Shareholders participate for the upside. Bondholders are not concerned about the downside.
“Everyone” is happy.

Russ Roberts
Dec 22 2010 at 9:40am


The interaction between moral hazard, creditors and shareholders and how it reduced the incentives for prudent risk-taking is the story I tell here in more detail. Jonathan has the essence of it.

Mads Lindstrøm
Dec 22 2010 at 1:40pm

Hi Superheater,

You point out that we already have much government regulation in the financial market. But when people say they want “more government regulation”, it seems that they can mean one of two distinct things. The first is literally more rules, and thus more fine grained regulation. The second is that they want stricter rules, for example the banks must have 10 % reserve requirements rather than 5 % reserve requirements.

The former (literally more rules) seems very dangerous to me for three reasons. First, more rules also means more loopholes for financial institutions to exploit. Second, I don’t believe regulators have enough knowledge or information to make sensible fine grained rules. Third, it may lead to the illusions of control, which could cause regulators to loosen the rules (less strict, but more rules).

The latter (more strict rules) makes sense to me and it also seems to be our only option. We could try market discipline, but that requires a _credible_ commitment to let banks fail and I can see no short term way to achieve such a commitment.


Mads Lindstrøm
Dec 22 2010 at 2:34pm

On second thought, maybe a credible commitment to not save banks is possible. What if the USA amended the constitution with rules saying that the government could not make bailouts. Also we would properly need something draconian to keep the politicians in line, like holding the politicians financially responsible if they tried to circumvent the no-bailouts amendment.

Trent Whitney
Dec 22 2010 at 3:21pm

Another excellent podcast, and I still think you’re on the right track with your focus on second homes, particularly when you consider where the housing crisis has hit the worst: Nevada, Arizona, Florida…where people buy the most second homes.

But I want to post about the issue of how the markets contributed to this crisis, particulary in the light of Krugman’s latest column, where he blames the free market crowd for the woes of the economy.

What the pro-regulation crowd never says is that just because some regulations were relaxed or removed does NOT mean there are no regulations in place. Housing, banking, finances, etc., were still a regulated, if not highly regulated, industry when this crisis was forming.

I believe it’s Thomas Sowell who points out that we have to ask ourselves “What then?” whenever new legislation is passed. Meaning we have to look at what new incentives (and disincentives) have been created, as well as what has been removed. How will we function within this new regulatory scheme?

To blame this crisis (or the economic crisis as a whole a la Krugman) on a free market is horribly incorrect and inaccurate. Any market failure resulted stemmed from a differently-regulated market operating within a new scheme. Or in plainer words, instead of 1,250 rules and regulations, we had 1,126….or 856….or some lower number; but it wasn’t 0, nor was it anywhere near 0! Do the likes of Krugman actually understand this and they’re writing wickedly slanted pieces, or are they actually woefully ignorant?

David B. Collum
Dec 22 2010 at 5:50pm

John Hussman has been a beautifully grounded market analyst for years. Of late, however, he is getting increasingly agitated. Here is an interesting analysis that touches on some of the points discussed (especially making the bond holders take their haircuts)…

As to Krugman, Henderson and Roberts put a body check on him pretty enthusiastically in this 2007 podcast about where economists agree and disagree…

John Mininger
Dec 24 2010 at 8:25am

I still hope for the day when I can hear Russ ask “challenging questions” in an interview with Peter Wallison.

Krzysztof Ostaszewski
Dec 26 2010 at 11:16pm

I find it quite amazing that all of the analysis in this podcast and in the previous podcasts on the crisis does not ever refer to the fact that the Federal Government has acted as explicit and implicit insurer of all the risks, with the Federal Reserve acting as the reinsurer of the Federal Government. Why is the word “insurance” completely absent in this podcast?

Yes, there was plenty of moral hazard, because there was insurance that created it. Let me ask this: given that you are insured by the U.S. Federal Government, with reinsurance from the Federal Reserve, and then you capture the regulators, why exactly would you not take all the risks? Is there any rational reason not to? Other than the sense of duty to your country, desire not to bring it down (which is most likely to happen after you die anyway)? And of course, that sense of duty to the country is vilified by the elitist media as at best silly and at worst evil right-wing conspiracy — because it just might get in the way of the get-rich quick schemes of the “elite”.

There is a similarity of this absence of insurance in this podcast and the the past podcast on immigration not even once noting that open borders pose a serious national security risk. Isn’t it obvious that the central issue of immigration is the military and criminal threat of open borders? Isn’t it obvious that the central issue of financial crisis is that all risks are absorbed by the Feds and the Fed, without any pricing and reserving of the insurance provided?

I do not mind being told that my ideas are cooky, as long as I am given the reason why — but I have not seen any argument giving those reasons, in fact both of my arguments are ignored. No “national security” in immigration debate, and no “insurance” in financial crisis debate.

My immodest proposal is that all insurance for financial institutions should be accounted for the way it is accounted for in the private sector. Or better yet, no insurance whatsoever from the Feds and the Fed. You want insurance, buddy, you’re gonna have to pay for it in the private sector.

Dec 27 2010 at 5:26am

The “moral hazard” cancept is almost entirely a crock. The people who were promoted at the institutions that should have failed were compensated at rates that made the question of ultimate failure personally relatively unimportant to them. The shareholders might have had reason to experience moral hazard even if their agents did not… but they weren’t necessarily the ones bailed out (the creditors were) and “they” were mostly entities like pension funds operating through agents who were similarly unconcerned about long term results. The agency problem dwarfed the moral hazard problem. And does still.

Brian Clendinen
Dec 28 2010 at 1:54pm

Great interview, however what I was upset about was Russ Roberts letting Joe Nocera get away with the regulation argument. He should of asked based on past experience and what was know at the time. what could regulators done. What information was fairly apparent if examined closely that would off allowed regulators to prevent or at lest soften the blow of the crises?

Everyone was caught with their pants down. The regulators had no idea what was coming. We bring up these people who were right. However, this is almost always going to be someone who is right. The real question with-out hindsight what were the problem that were ignored, incompetency, and outright corruption with made the crises worse.

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0:36Intro. [Recording date: December 13, 2010.] Why did you call the book the "hidden history of the financial crisis?" What do you reveal here for what you think is important for what happened? The way we were thinking about it is the following. In the wake of the crisis, most of the journalism and early literature really focused on the events surrounding the beginning of the Bear Stearns collapse following through those hairy weeks in September when it looked like the financial world was about to come to an end. We thought the second draft of journalism should go back further and go a little deeper in trying to understand where all this stuff came from. What was the evolution that led us to collateralized debt obligations, synthetic CDOs, a housing bubble the likes of which the country has rarely seen, the growth of a subprime industry that was largely out of control, rather than taking as our starting point that these elements all existed and then suddenly, out of nowhere, it all blew up. Think that's a very fair characterization of the book; important and nice point. A lot of the histories of the crisis seem to start around 2008; you do a superb job in the book weaving together the things you just mentioned--the push of home ownership, the birth and growth of securitization, which most Americans had no idea about even when it blew up, and still struggle to understand. The book does a really nice job explaining to a non-specialist how many of these complex processes work. You start with the securitization process, which underlies one of the important themes of the book--the complexity and misunderstood nature of the securitization process as it evolved. You go back to the beginning and go back to Lew Ranieri. Talk about what happened politically and in terms of Wall Street that made that process get started. Complicated bundle of questions. In terms of Wall Street: Lew Ranieri and Larry Fink had the core idea that if you bundled mortgages together into a security, you could sell pieces of them as a bond. Larry Fink invented the process of tranching, which allowed you to rate some of the bonds as triple A and some of them B; you created a ladder of risk, thus making these bonds much more appealing to Wall Street than they had been, where everybody had to accept some form of credit risk or prepayment risk and there was no tiered structure of risk. What's important to understand is that you couldn't just do this without the Federal government passing laws to exempt mortgage-backed securities from the state blue laws--it's in the book. They didn't have to regulate every bond in every state. Secondly, there were tax issues that had to be dealt with; and thirdly there were these institutions Fannie and Freddie, which were powerful in their own right and which wanted to create a system of securitization where they played an important middleman-type role. There was a lot of fighting between Ranieri and his people, and David Maxwell, then the head of Fannie Mae and his people, over where this power would come from. Out of these battles where Fannie and Freddie were sometimes aligned with and sometimes fighting with Wall Street, you wind up with a system where for prime 30-year fixed rate mortgages, Fannie and Freddie really were immensely powerful. The most attractive bonds were the ones they guaranteed, and in order to guarantee those bonds the mortgages had to conform to Fannie and Freddie. That's where the word "conforming" comes from, conforming to the government enterprises. Wind up with a system, prior to subprime, where much to Wall Street's dismay it couldn't securitize bonds in a large way without Fannie and Freddie being in the middle of it and taking what a bettor would call the vig.
6:45The book is the best treatment I've seen so far of the political power of Fannie and Freddie, below the surface for most Americans. Most Americans think of Fannie and Freddie as this cheerful semi-private semi-government agency that helps make home ownership more affordable. Turns out most studies suggest it doesn't make much of a difference, but most Americans have warm fuzzy feelings about them. Book reveals how powerful they were. Not just powerful--they were bullies; wound up being their downfall as well. They used the mantra of home ownership to get anything they wanted; to steamroll anyone who got in their way. Wasn't just Democrats who supported them, but Republicans too; very few naysayers on the subject of Fanny and Freddie in Washington, D.C.; they had local offices that counted practically mortgage they guaranteed in a Congressman's district. Anybody who was a critic, they didn't just criticize back; went out of their way to steamroller them, to bloody them, to bludgeon them into submission. Journalism question: that's my impression, drawn partly from my biases--I don't think it's a good idea to have social policy done in the way we did it with Fannie and Freddie; I don't think it was transparent; it was opaque and ended up being a rather expensive strategy for increasing home ownership. I've talked to some people in the business, some insiders; you've talked to a lot more--who say nothing every happened that they didn't approve. All the affordable mortgage stuff was good for them; if it hadn't been good for them, they would have stopped it. I'm curious: As a journalist who doesn't have the same biases I have, I suspect, how you came to that conclusion about Fanny and Freddie; who you talked to and how you came to the conclusion they were bullies. We came to the conclusion they were bullies by talking to the people they bullied, like James Bosworth at the GAO, who wrote a study criticizing Fanny and Freddie and then was completely submarined at a Congressional hearing where all he was doing was saying that Fanny and Freddie posed risks to the economy. Which, by the way, they did. Of all the things that drove Fanny and Freddie crazy, they couldn't stand anybody saying that. We had examples of people who got bullied. We had people on the inside telling us some of the stories about how for instance David Maxwell threatened Lew Ranieri and said if you don't side with me on this, First Boston will never get a mortgage bond with us ever again. That's raw power--not even political power, raw business power. We did it by reporting. Our conclusion about Fanny and Freddie I suspect is not in accord with what your biases tell you happened. Surprised where we came out about Fanny and Freddie; but we came out where we came out because we talked to a lot of people. I liked almost everything you said about Fanny and Freddie, in particular the fact that it's measured. One mistake people make about the crisis is they look for one villain. For the right it's Fannie and Freddie--could call them twins--for the left it might be Alan Greenspan. Here's why I believe that's the case. I believe the right finds Fannie and Freddie a convenient villain because it means you can blame the crisis on government and not on the market. The left wants to blame it all on Greenspan--or Wall Street--because the left wants to say it's all the fault of the market and not the fault of the government. One of our points is that you needed both a faulty market mechanism and you needed a faulty government policy to make all this happen. You needed both. I think both the right and the left are wrong--the right says it's all Fanny and Freddie and the left says they have nothing to do with it. Both wielding ideological sticks. Fanny was not a victim like they want to portray them, but they were not the driving force moving the country to subprime loans that people couldn't pay back. And those of us who are friends of the market have to deal with the fact that Wall Street was the driving force--we'll come to that later.
12:33Let's talk about the failures of government oversight. There's a lot in the book about the failure of the regulatory process to do its job and how attempts to either enforce existing regulation or bring in regulations for new markets were torpedoed by various forces. What might have gone differently. Hank Paulson, who says: There's nothing we could have done; it's too late. Some point where someone could have done something differently--did you have a feel for where that might be? I would list several things. First, and this is Bethany McLean's insight but I embraced it immediately: The consumer activists were saying the subprime lenders were making predatory loans and the government regulators were basically saying this is what the marketplace is asking for; this is what people want; who are we to say what kind of loans people can and cannot get. Bethany's point was: Who cares whether the loans were predatory or not? When you are making tens of millions of loans to people who can never pay them back, that's a problem, and that will inevitably lead to some kind of credit crisis. Has to. So, point number 1 was that the Federal Reserve, which does have a consumer function, and the OTC and the OTS should have been much more focused on the quality of underwriting that was going on the banking system. You could argue that Countrywide and mortgage originators were outside the banking system, but I believe that the Fed at least had more wide-ranging powers that would have allowed it to crack down on lending it viewed as inappropriate, which never happened. They certainly had no compunction about expanding their activities in other places when it was convenient for them. The reason they didn't do it was Greenspan was an ideologue who believed firmly that all regulation was bad; just not something that interested him. Because he was so important and powerful and because his mindset permeated the regulatory apparatus, there was no way anybody was going to buck his will on this. Disagree; we'll come to that in a little bit. Point number 2: You have Bob Rubin, Treasury Secretary, turning to one of his aides during the Korean crisis and asking: Do we know, with the credit default swaps, what's the exposure to Korea? In the U.S. financial system. And the answer is: We don't know. Shocking. I actually blame him more than any other person to at a minimum make derivatives more transparent so that the government knew who the counter-parties were, where the danger points were, what problems might be arising in the system. They did none of that. They took the position that all smart people realize that derivatives make the world safer and not more dangerous; therefore anybody who says likewise is an idiot and we won't listen to them. When Brooksley Born came along and said I would at least like to look at this stuff and see if there's a problem, they stomped all over her--to use the technical term. She was the head of the Commodity Futures Trading Commission (CFTC), regulatory body; lost on a technicality--they weren't futures so she had no say over them. But that wasn't what it was about. During the tail end of the Clinton Administration, a law was passed that basically made it impossible for derivatives to be regulated; and a law was also passed abolishing Glass-Steagall. I'm not one of these people who say if you'd only kept Glass-Steagall everything would have been fine; I think that's crazy. Glass Steagall was on its last legs anyway. Financial innovation had outrun it. One of the points I've made often in the wake of the crisis is the regulations that were passed and the creation of the SEC and Glass-Steagall really did keep the United States pretty safe for about 50 years. That's about as long a time as you can expect financial regulation to do it's job because financial innovation will find holes in it or ways around it, or it will become outmoded. That's what happened with Glass Steagall. It kind of deserved to die. The problem was not that they abolished Glass Steagall, but they didn't believe they had to create some other modern regulatory framework that could have both allowed flexibility and innovation and yet kept track of systemic risk, understood the importance of capital requirements, did basic things to keep the world safe. And that's what they didn't do. In fact, the Rubin story--sense of deja vu when reading the book when Paulson goes to Camp David and says something about being a little nervous about credit default swaps; asked, well how much is there; answer: I don't know. There was a lot of ignorance about the potential scope of the problem. Goes all through the system. There was a lot of lack of awareness of what kind of loans were being made, whether that was because of the thrill of a homeowner being able to close with no money down and closing costs included, or the thrill of the originator who signed up somebody for something they really didn't know what they were signing for--both unattractive activities. Didn't really matter--those were going to blow up. Don't forget also, another of Bethany's many great insights is that so little of this activity actually had to do with home ownership. So much of it was turning your house into a piggy bank. The refinancing phenomenon and second home lottery. But a big company like New Century openly admitted that between 85-90% of the loans they made were cash-out refinancings. There were data on that; people just didn't pay much attention to it early on. Josh Rosner, one of the first to realize the extent to which refinancing was driving the housing bubble. He had that other great line: A home without equity is just a renter with debt. That paper, which I also cite in my writings, written in 2001; he understood we were taking on more debt than we were aware of and understood the ramifications, the appraisal process. Underappreciated seer.
21:32Securitization: it sort of steamrolled, partly through competition on Wall Street, Fanny and Freddie; but eventually it becomes a process where a lot of people are originating a lot of really bad loans--because they are being securitized. So messy, what actually happens. For many years, Fanny and Freddie would have nothing to do with subprime loans. They were all about the prime loans; dominated that part of the market. So Wall Street's incentive was to get out from under Fanny and Freddie. Second, because the subprime companies weren't banks, they were entirely dependent on Wall Street, both to make the wholesale loans that were basically their up-front cash, and then to buy their loans once they made them so they could get more money to make more loans. In some ways they were completely a creature of Wall Street. One of the shocking facts to me was that Wall Street was ultimately dictating the riskiness of the loans, because Wall Street got to decide what loans they would buy and what ones they wouldn't. As interest rates continued to drop, as the push for yield became more urgent, among money market funds and pension funds and everybody who wanted and depended on triple-A securities, it was important for Wall Street to have ever-more-degraded loans to bundle, because they generated higher yields. And it allowed the creation of derivative products, CDOs, mortgage-backed securities that were triple-A rated on paper by ratings agencies, which gave them ways to get around their capital requirements. And capital requirements is really at the heart and soul of the financial crisis. Hard to grapple with. Why were all the banks undercapitalized when the crisis came? The answer is they didn't have to put any capital against their triple-A assets because they were supposedly risk-free. Guess what: they weren't risk free. One of my disagreements; want to challenge you on this. They weren't; they made a mistake. There was obviously an immense amount of hubris. The problem I have with that explanation, though I think it's obviously true, is that most of the players in that world didn't pay that much of a price for that miscalculation. They were insulated from their decisions by the bailout, as they had been with past bailouts. So, you have to be open to the possibility that we have been subsidizing Wall Street's risky behavior and through the policy of bailouts in the past we've helped create that lack of attention they've paid to the things they were buying. What do you think of that argument? Well, which bailouts are you talking about? Long Term Capital Management (LTCM)? That would be one; Continental Illinois in 1984; the Mexican peso crisis in the mid-1990s; the savings and loan crisis. Basically creditors--people who made those possible, if they came from a large institution, they got saved. I don't disagree with that at all. Where I would differ with you, at least in the way you are phrasing the question--you are making it sound conscious. I would make a distinction. I agree; say it better. I think the fact of government bailouts was not consciously on their mind as this was going on. I don't even think it was necessarily subconsciously on their mind. What I do think was on their mind and what was a kind of almost overt corruption was the short-term incentive compensation that they got for making deals and then not having to care ultimately whether the bonds turned out to be good or not. Especially as you get to the end of the line and you are a year away from the crisis; everybody's stuffed to the gills with triple-As, banks don't want them any more; the only way you can keep the machine going is to sell to short-sellers, who are doing this complicated buy-the-equity, short to triple A, have to put the triple A on your own books, keep the machine going. But you are making so much money for yourself that you are not willing to stop even though every fiber of your being is shouting: This is about to collapse. And if you are Richard Fuld or Jimmy Cayne you are maxing out on what part of your options you can cash out. You do take a hit when it collapses, but you've put aside a good chunk. Stan O'Neal, one of the characters in our book, who gets pushed out before the crisis but walks out with a hundred million dollars in retirement. Kind of offensive. Agree. Point about the conscious/sub-conscious is important, but I focus on the moral hazard. Your book opens with this guy, Breit, risk management guy at Merrill; suddenly out of power there. A lot of the wise worriers were shunted away; realized correctly that if they all went down in flames, they'd get saved, so if most people were going down in flames you'd be a fool to be prudent in the meanwhile. I think there was a systemic risk in that sense created by that whole Wall Street protection. Differ with you in that I'm not convinced they saw--I don't think a guy like Stan O'Neal sat around thinking: If I go down, everybody else is going to have to go down, too, so I might as well just do this. I think he just said: Goldman's making so much money, so I'll take the same amount of risk even though it turns out Merrill Lynch didn't have anywhere near the risk management capabilities that Goldman Sachs did. I agree with that. I think people were not induced to be prudent. I've always thought ultimately that so much of this could have been avoided had they just let Bear Stearns go under. Yeah, I agree. Bear Stearns was one-fifth the size of Lehman; it didn't create the kind of systemic risk that Lehman would have. If Bear Stearns had gone bankrupt it would have woken everybody up to the notion that we weren't going to bail everybody out and they had to get their house in order fast. I think you maybe, maybe, maybe could have averted the crisis if you let Bear go bankrupt. That was the wrong signal; others with bigger balance sheets continued to fund themselves. Dick Fuld in particular--probably no better example in modern history--a walking, talking example of moral hazard. There's no question that having seen them save Bear Stearns, he thought: They will do the same for me. Not unreasonable. Wrong, but it wasn't unreasonable. Do you think Paulson, at the time Secretary of the Treasury and former CEO--do you think his personal relationship with Fuld, not good, had something to do with that? Did you talk to anybody about that? One of the things we didn't do in our book was spend a lot of time on Lehman. Didn't think it was illustrative; had better ways to illustrate the larger point. Having said that, I guess the way I would phrase it is I think Paulson would have been just as tough on whoever was next in line with the possible exception of Goldman Sachs. Because his empathy for Goldman would have overridden, I think, moral hazard.
31:34Did you look at all into the phone calls between Paulson and Blankfein at Goldman the week before the bailout? No, we really didn't. Got to stop somewhere. There's some other histories to be written about when the worst was in the air. Your book really focuses on the leadup and the foundations. We did a lot with the Goldman-AIG collateral call dispute, where we were able to take advantage of hundreds of pages of documents released by the financial inquiry commission. What did you find out there that was important? AIG-FP (financial products) was actually a pretty cautiously run division that made this one terrible mistake, based in part on the models of the fabled Yale economist Gary Gorton and in part on their own reading of the mortgage market. The thing that most interested me about the collateral calls that I didn't think has gotten justice elsewhere is the extent to which Joe Cassano completely misunderstood the difference between underlying credit risk and liquidity risk. Back up for a second--talk about what the collateral calls are and who Joe Cassano is. We've talked about the other folks in past podcasts, but not this one. One of the critical events leading up to the crisis is Goldman Sachs's insistence that AIG begin to pay collateral calls on the triple-A securities that it has insured with its credit default swaps. This is what begins to send tremors in the market and in particular the beginning of the end for AIG, the way it begins to crumble. Collateral calls start coming. AIG has a view that it should never have to pay a penny in collateral calls on these securities because they believe these are risk-free securities and they don't agree with Goldman's assessment. They get into this gigantic month-long fight over this. What's a collateral call? An agreement by the insurer, in this case AIG, that if the security drops in value in the market place that they will make up the difference in cash. They will turn over cash to the counterparty to make up the difference in the loss in value. Like the promise is underwater--home owner has got negative equity. This chapter illustrates the underlying tensions that were going on between AIG and Goldman, enormous fight. Joe Cassano was the man who ran AIG-FP and he kept insisting over and over again that we at AIG shouldn't have to pay a penny to Goldman because the underlying securities are fine. Completely didn't understand or refused to accept or acknowledge that like everything else on Wall Street, it doesn't matter what the underlying securities are worth. It only matters what they are worth today. If they are worth less today, then he has a responsibility at AIG to put up this money. This took place over months. AIG puts up a billion, then three billion, then five, then seven billion; winds up with AIG not just in crisis but the reason it had to be saved by the Federal government is they owed so much in collateral to so many counterparties that they were dead. Fundamentally insolvent. You could view that--one way to describe it is a run on AIG: Goldman trying to get, while they were still solvent, something out of them. They didn't know they were going to be bailed out. And Goldman at the time was buying credit default swaps against the possibility that AIG itself might default; they kind of realized from the battles they were having over the collateral that AIG was in more trouble than anyone realized.
36:52So, they are the smart devils, and you've got, as you say, hidden history, the important role that Wall Street played in funding these subprime originators. I think that's not understood and so important, to the point where Bear Stearns is operating its own subprime originator; vertically integrated. Lehman had a very large subprime originator. Merrill Lynch at the tail end of the O'Neal regime bought an originator; Goldman had a servicer. Everybody wanted to be in the origination business because they wanted to make sure they had enough of the raw materials from which they built these securities. We found it shocking ourselves. I had not realized the extent to which Wall Street and the subprime companies were interconnected. Major revelation to me. For those who want to blame Fanny and Freddie, you cannot explain the financial crisis without explaining that phenomenon. Yes, Fanny and Freddie bought some subprime securities; you talk about the size of it, not trivial; but it was not the cause of the problem. The precipitating events came from Wall Street channeling trillions of dollars into lousy mortgages. Also believe the crisis was greatly amplified by the creation of synthetic CDOs. Explain what that is. It's a collateralized debt obligation that doesn't hold actual subprime mortgages in it. It simply references mortgages that already exist. Once you created a synthetic product that didn't need the raw material any more--kind of like betting on the bets--you could, and this did happen: a particular tranche or a particular bond that shorts like John Paulson felt sire was going to blow up would get bet on 15, 20, 30, 40, 50 times. Everybody would say: I want that tranche. When you talk about that famous ABACUS deal that Goldman did where John Paulson was on the short side and allegedly helped pick the bonds, the reason he was doing that was because he had a theory of the bonds in mind that he thought were really bad, the worst of the worst, and he was betting on those bonds as frequently and in as many ways as he possibly could. I personally think the rise of synthetics took what would have been a disaster and made it a crisis. Certainly amplified, as you said. So, we had some smart devils, like at Goldman; you've faulted Rubin, you faulted Greenspan. You want to list some angels, certainly like Brooksley Born who you listed? Certainly Josh Rosner is another. I know this will make you slightly crazy but I think that community activists who were screaming from the rafters about subprime loans. Ned Graham at the Fed, who was the one person who went to Greenspan and said we really ought to take a look at this; although he was such a diffident, polite man he didn't have it in him to say anything in an aggressive fashion and it was very easy to dismiss. I think John Breit. I think there are some people who could have been angels. You mentioned John Breit, the risk manager. The reason he's unusually interesting in this case is because he was somebody who wants the institution taking on more risk than it should have noticed they didn't really want good risk managers looking over their shoulder trying to stop new deals. He gets shunted to the side, pushed to another floor where he is not given access to data that would have alerted him to the problem. I suspect that happened at a lot of firms, all the firms that dove in with both feet when it was too late. I think a lot of those folks either were shunted aside or were simply ignored. They were ruining the party. The skunk in the punch bowl.
42:24Want to come back to Greenspan now, ideology issue. I'm going to give a slightly different interpretation and let you react to it. I certainly agree with you that Greenspan used free market ideology to defend his lack of regulatory oversight. I think it's an interesting question whether he actually believed in it. The following: he's certainly famous as an acolyte of Ayn Rand, famous libertarian as a result of that. But he didn't act like a libertarian, except when it was convenient. Which as you chronicled beautifully in the book, when people questioned about oversight he tended to reject them on ideological grounds--at least that was his public statement. The irony for me, and maybe this is the way I defend or at least keep my ideology somewhat sane--he was a lousy free marketer. If anything, he was a destroyer of capitalism. Forget his Central Banking policy, which you can debate if that was good or bad, and of course John Taylor and others have been critical of his policy in the 2002-2005 period. You mention how his low interest rates certainly encouraged subprimes. What I have is this issue of moral hazard. He, with others, was instrumental in insulating Wall Street from the mistakes they made, whether it was the 1987 Crash, the Mexican peso crisis, the Long Term Capital Management. So, he's this pro-capitalist guy on paper, but in practice, he's subsidizing Wall Street like any other special interest group. So my creepy interpretation--I don't want to make it specific to him; I think it's specific to all the players--what they say about what they did is one thing. What they did is they served their masters, the people in power, kept their benefits, whether they were Secretaries of the Treasury or Central Bankers. We've got a problem with democracy in the United States and crony capitalism--not the real thing. What do you think? I guess I would have a difficult time disagreeing with that. One of the things I was struck by was re-reading this famous article, on the Committee to save the world, on the cover of Time Magazine in the late 1990s. Greenspan front and center, on one side Rubin and on the other side flanked by Larry Summers, who at that time was Rubin's Deputy and became Secretary of Treasury about six months later. And who resurfaces in the Obama Administration. The thing I found so striking about that article is that the author is talking about: first they solved the Mexican crisis, then the Russian crisis, then the Asian crisis, then Long Term Capital Management. One after another, boom, boom, boom; and nobody steps back to ask: Why are we having all these crises? What is fundamentally going wrong with the system? And when they do answer, so glib, more or less like: There's just not enough like us yet. Insane. I found myself pretty contemptuous. I mean, obvious I'm reading it ten years later. But the lack of willingness to look deeply at the framework that they had helped create and question whether it was actually doing the good it was supposed to be doing I felt was quite striking. The "serve your masters" notion--I don't know what I think about that. I'm probably too much of a centrist journalist--I guess people act subconsciously more than we like to acknowledge and I don't think Greenspan was consciously thinking these are the steps we have to do to stay in power. But maybe that was a subconscious motivation. I don't mean to suggest anything sinister about it; I don't think he's any different than either of us or especially anyone in a position of power. I think he believed what he said. I think he believed he was a free market champion. And when he confessed on Capitol Hill, this famous view that his worldview needs re-examining, he might have been sincere. But he should have looked earlier! My interpretation of that has to do with modeling. I think one of the things that happened over the course of the last 20 years is the core idea that you could model away risk. One of the things that was striking in that apology was when he said: Several people have won Nobel Prizes for the work that has turned out to be flawed. Good point. I also think this was Larry Summers' flaw to some point, because he wants to believe he is smarter than anybody else. Could be. Believing in the mathematics of the model was part of trying to prove how smart you were. I've certainly gotten a lot less sanguine about economic modeling in the last 5 years, and I think most people have. But not everybody. To refer to John Breit again, one of the things he says is that what happened on Wall Street was they came to view modeling not as a reflection of reality or an approximation of reality, but as reality itself. So, if you had a triple-A security, even if it had 60% of its bonds were subprime mortgage bonds, you believed absolutely that it held no risk. And if you were a money market fund, you held it. Insanity. Ultimately insanity. But engineered to be safe. When you walk across the Golden Gate bridge, which is in theory a terrifying prospect, you don't get nervous. We had MBIA in the office of the NYTimes last week. Who are they? Big bond insurance company, which has struggled mildly since the crash, to say the least. One of the things we said to them, we asked them about, was their models. They said: Actually, our models were pretty accurate. If we plugged in a 20% decline in housing prices, they showed the world blowing up. But we just assumed that that could never possibly happen! Famous paper by the Orszag brothers and Joseph Stiglitz, who was a Nobel Laureate, showing how remote it is that Fannie or Freddie would ever go bankrupt. Absolutely true. A lot of embarrassing things out there that tend not to get talked about these days. Gary Gorton is another person who has had another career rehabilitation, writing a paper on the causes of the crisis that Ben Bernanke has actually praised. And yet his role as the person who created the model for AIG's credit default swap seems to be forgotten. Well, I said a lot of stupid things, but fortunately no one was listening. Some embarrassing blog posts from the 2005 period.
50:34Let's talk about securitization going forward. I think one of the things a reader learns from the book is the inherent complexity of securitization--the way it's spun innovatively and a little bit frighteningly into innovations, some into innovations they were trying to avoid. Others were responsive to interest rates, etc. But what I find remarkable is that people want to recreate it. What are your thoughts on that? I think we are stuck with securitization whether we like it or not. Banking is such that if we ever had to go back to a world where banks had to keep all their home loans on their books, they wouldn't make any home loans. They just wouldn't. They can't function in a world where they have to put that kind of capital aside, which they would have to do under the rules. The problem with the securitization market right now is that nobody trusts it. Wisely! Well, if you go back to what it used to be and you are securitizing prime mortgages and with prime borrowers, it probably is fine. The problem is the device became abused. Dramatically abused. I don't think securitization per se is really bad. I really don't! I think the abuse of securitization can be terrible. I also think in the world in which we live, the housing market, just to take one example--if the housing market is ever going to get back on its feet again, one of the things that needs to happen is you need to have a healthy securitization market again. The big banks are not going to go back to a world where you walk into the bank, look the banker in the eye, put down your firstborn as collateral, put down 25%, and send him $2000 a month. The world doesn't work that way any more. We know what that world looks like--it's called 1976 or so. Pretty good world. Home ownership was lower, but really not that much lower, a few percentage points. Let me ask the question a different way. When people tell me that Wall Street's a crucial part of the American standard of living because it allocates capital, I respond: Well, it could be. But it hasn't been, for the last 10 years. Totally agree with you on that. They don't allocate capital very well. If you look at the IPO market, if they actually wanted to allocate capital they would maximize the amount to the companies instead of trying to maximize the amount that goes to the investor. Terrible system. And then it's a cartel, so they take 7% off the top. What do we do about it? What could we do to make it better? The securitization market? No, Wall Street in general. In the way it allocates capital. We just put a few trillion dollars into making sure everybody has two homes or a large segment of the United States. Bad idea. You got me. I really don't know what you could do. People talk about realigning, compensation incentives so that the good stuff gets rewarded. I kind of think Wall Street's kind of hopeless at this point--they've kind of gone back to the bad old ways. They make money hand-over-fist. All they do is buy Treasuries. Borrow from the Fed at nothing and buy Treasuries at 3% and pocket the difference. Kind of absurd. I don't know what the answer is.
55:24Question, we touched on this. You write about the episode where Goldman goes public, in 1998. One of the last investment banks to go public. Illustrious past, history; last but a very short window where most, almost all, the major investment banks went from when they played with their own money and some of their customers' to where they could play with investors' money. I think that's part of the problem. Again, I worry about moral hazard and government backstopping with my money as a taxpayer. But certainly that change had something to do with this problem. No question about it. Once the partners' money was not at stake, you could take much more risks that they never would have taken with their own money. But then the question becomes: if they had not gone public and had not increased their capital base, would they have been swamped by Deutsche Bank and Credit Suisse and the big European banks that didn't have Glass-Steagall-type rules? That's what makes it so difficult to grapple with. The world, wasn't just the United States: the world was changing. Remember the fears the Japanese banks were going to take us all over; and now there's some fears about the Chinese banks--they felt a justifiable need to get big so they could compete on a global scale. The unintended consequences of that meant that you increase the moral hazard by 100-fold, because risk-taking became something that, if you took a risk and you were wrong, it didn't come out of your pocket. Came out of your shareholders' pocket, and who cares about the shareholders? They were rolling the dice for a long period of time. The argument that they would be swamped by Deutsche Bank and others--I think that's the argument they want us to believe. The question is, tough question: does the world need American investment banks? Come back to this question of Wall Street allocating capital: once talked to a prominent policy maker who was just horrified at the fact that if Goldman disappeared and its role were taken over by some firm like Deutsche Bank with a foreign name in its title--and I thought: So what? I don't mind using a Finnish cell phone, don't have one but wouldn't mind using Nokia. Why should I care who allocates the capital so long as they do it wisely? When they do it poorly, why should I have to pay for it? Let the Germans pay for it. I'm not necessarily hostile to that argument; but I guess what I would say in response is I don't think it's a matter of national security or something like that. But I do think that Wall Street generates a lot of jobs, and even if it generates wealth for its own pocket, I live in New York. Good for your condo! If Wall Street disappeared tomorrow it would be a very different setting. But that's not an argument. The argument I'm making has nothing to do with allocation of capital, as you rightly point out. Great example. What do you think is yet to be written? So many books already about this crisis. What are some of the stories? Future of housing hugely important. On the one hand going to be fought out in Washington, D.C. and on an ideological basis--what do we do about Fannie and Freddie? But more importantly, I feel very strongly we have become a country utterly dependent on the Federal government. The housing market is not completely dependent on the Federal government. The story of how this country tries to figure out how to create a private housing market I think is a really, really important story for the future of this country.