Negligent Homicide

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Ross Levine of Brown University has performed an 'autopsy' of the Great Recession and concludes that 'negligent homicide' played an important role in the demise. By negligent homicide Levine is referring to the silence and inactivity of the regulatory agencies in the late 1990s and early 2000s. In Levine's opinion, these agencies - mainly the Fed and SEC - and Congress designed, implemented and maintained "policies that spurred excessive risk taking and the eventual failure of the financial system". He is not saying that greed and overly complex financial products did not play a role in the failure, but they would not have been able to play that role if the regulators had done their jobs. The regulators knew that problems were looming, however they did nothing to prevent them.

The first agency Levine looks at is the SEC and its decision to establish Nationally Recognized Statistical Rating Organizations (NRSRO), which essentially meant anointing Moody's, S&P, Fitch etal as gatekeepers to the securities markets. The SEC used the ratings of the NRSROs to establish the capital requirements for institutions the SEC regulated. Eventually, these ratings became de rigeur for any company that wanted to play in the big leagues. At heart, the NRSROs were given the "right to sell license to issue securities". The money for these licenses was quite good and the rating agencies succumbed to the temptation. If you paid enough money, you got the rating you wanted. Is there any wonder that so much garbage was rated AAA? Did the SEC do anything to get the NRSROs to produce realistic ratings?

The Fed is the next agency Levine looked at. He considers the effect of the Fed's decision in 1996 to allow banks to use credit default swaps to reduce their need for capital, which enabled the banks to invest in higher-risk situations. The Fed did not keep a close watch on the derivative markets, although in 1992 the NYFRB noted their concerns about the markets and did threaten to do something about them. And in 2004 my friend, Tim Geithner, as head of the NYFRB, was concerned about the lack of information on these swaps. Plus the Fed was aware that the subprime mortgage market was getting shakier. Did the Fed do anything to try to get banks to increase their capital?

Levine goes on to talk about the Brooksley Born fiasco where Greenspan, Rubin, Summer and the SEC put the kibosh on Born's attempt to bring some transparency to the derivatives market.

Back to the SEC. In 2004 they made it easier for the five largest investment banks to gamble; the SEC ruled that these banks were exempt from the net capital rule and, thus, were able to take more risks. Then, the SEC allowed the banks to use their own risk assessment models. Levine really slams Christopher Cox, the previous head of the SEC. Cox eliminated the risk management office, and did not inspect any investment banks in the 18 months before Armageddon. Why should Cox have bothered? The banks were only handling $4 trillion in assets.

Fannie Mae and Freddie Mac - and ultimately Congress - are also blasted for their lack of control.

Levine has certainly done a fine job in making his points.