The causes of the financial crisis

A Wall Street insider explains how Greenspan contributed to the mortgage crisis and how to restore economic sanity

Published April 9, 2012 11:30AM (EDT)

 Alan Greenspan   (Reuters/Kevin Lamarque)
Alan Greenspan (Reuters/Kevin Lamarque)

This interview first appeared in The Browser, as part of the FiveBooks series. Previous contributors include Paul Krugman, Woody Allen and Ian McEwan. For a daily selection of new article suggestions and FiveBooks interviews, check out The Browser or follow @TheBrowser on Twitter.

Wall Street money manager Barry Ritholtz diagnoses the ills of America’s political and economic system in a fizzing, irreverent analysis (with promised f-bombs thrown in).

The BrowserI originally thought we were going to be talking about Wall Street today. But I got the sense from some of your book choices that one of the biggest offenders wasn’t based on Wall Street at all, but on Constitution Avenue in Washington, D.C.

When you get bit by a dog, you don’t just look at the dog, you have to look at the owner who is holding the leash. To me, a lot of the regulatory changes, and a lot of what the Federal Reserve did, stand on their own as a major factor. But if you’ve read David Hume, if you’ve studied the philosophy of causation, you have to look at what motivated those changes. I have these debates with friends. One group blames everything on big government; the other group blames everything on big corporations. The sad news is that there’s really no difference between the two: Big government and big corporations work hand-in-hand. If you want to know who is the puppet and who is the puppet master, it sure looks like Wall Street has been pulling the strings of Congress for many, many, many years.

But the Federal Reserve itself should be insulated from those kinds of pressures.

They should be, except in the person of Alan Greenspan. He’s just this gnarly mass of contradictions. He’s an acolyte of Ayn Rand – believes that no intervention in free markets is the right approach – and yet he proceeded to spend his entire career, from 1987 through 2005, with his hands on the levers of Federal Reserve policy. He manipulated interest rates and money supply in order to win the love of traders. In 2001 he took rates down to unprecedented levels – below 2 percent – and kept them there for three years. Rates were at 1 percent for a full year! That had simply never occurred before in history. If you look at the late 1950s and early 1960s, rates would dip below 2 percent, but only for weeks at a time. In the “Who is to blame?” game Alan Greenspan is number one with the bullet, he’s top of the list. You can’t blame everything on him, but he’s the one who let all the gas fumes into the enclosed warehouse, knowing that a bunch of smokers were coming in to have a cigarette. Taking rates down to irresponsibly low rates is what set the stage for everything that took place over the next decade.

Are you saying that just as Ben Bernanke admitted the Federal Reserve had caused the first Great Depression, this crisis can also be blamed on our central bank?

The world isn’t black and white. We can’t just say, “The butler did it.” There were many causes, lots of poor judgements... The Federal Reserve was a significant element. But if you want to do it chronologically, you may want to go back further into the history. The bailout of Chrysler in 1980 set the stage. The rescue of Long Term Capital Management (LTCM) in 1998 encouraged a lot of moral hazard. Then there was all the radical deregulation, the undoing of some of the post-Depression rules that had operated so successfully for 75 years to prevent a major meltdown. The undoing of Glass-Steagall didn’t cause the crisis, but it made it much worse. Then there was the Commodity Futures Monetization Act (CFMA) of 2000, which completely exempted derivatives from any oversight or regulation and removed all reserve requirements. These all built to set up a situation that was extremely dangerous. So maybe the fumes were already in the warehouse and Greenspan taking rates down to 1 percent was the spark that ignited the conflagration.

So what are the take-homes? What do we do now?

It’s really simple. Go back through the past 20 years of radical deregulation and overturn all the rules that were changed. You don’t need all this Dodd-Frank legislation. Just reinstate Glass-Steagall, overturn CFMA. Just undo everything that was done in 2003, 2004, 2005 and 2006, remembering that old expression: If it ain’t broke, don’t fix it.

OK, let’s talk about some of the issues in the context of the books. Your first choice goes into the history of the Federal Reserve, and is called "Lords of Finance: The Bankers Who Broke the World" by Liaquat Ahamed.

This book won a Pulitzer – it’s a wonderful narrative covering a 50-year period from before World War I through the Weimar Republic, the Great Depression, and leading up to World War II. It tells that story through the lives of four central bankers – the head of the Federal Reserve in the U.S., of the Bank of England in the UK, of the German Bundesbank, and the French central bank. It looks at these four players, their professional actions on behalf of their countries as well as their personal relations. It tells the story of the economy, of the global crises that arose, of how people interacted, how governments interacted, what took place with monetary policy. It’s really a fascinating story.

How bad a job did the Fed do in the Great Depression, then?

Let’s put it into a broader context. The U.S. has always had a problem with the concept of a central bank. The initial central bank lasted for 20 years, and was then dissolved. Without a central bank modulating the currency, you tend to have wild swings in money supply, and in the economy you had a series of panics and depressions. So then we had the second Federal Reserve bank. Same thing – it had a 20-year lifespan, and then it died. The result is that by the time we get to the Great Depression the Federal Reserve is a relatively new institution, it’s only 15 years or so old. Its basic approach is rather modest – there’s not a lot of intervention, not a lot of pulling on the levers, there’s very much a recognition that historically, a democratic nation does not like an unelected central bank dictating economic policy. They had a hands-off approach. You really get the concept of that in "Lords of Finance," not just within the U.S., but internationally. How it affected the post-World War I, pre-World War II period, what the central bank should have been doing – now that we have the benefit of hindsight – to moderate the effects of the downturn caused by the market crash and the Great Depression. And yes, it’s fairly obvious that had the central bank been a little looser in its credit policy, we would have had a less severe downturn. They may not have caused the Depression, but they certainly didn’t help it and they probably made it a lot worse.

The Great Depression is, of course, the period Ben Bernanke is an expert on. I got the sense from your book, "Bailout Nation," that you don’t think he’s done such a great job, though.

My biggest problem with Bernanke is not so much him as chairman, as him as Fed governor under Greenspan. He didn’t see the problem coming and he enabled the ongoing reign of error of Alan Greenspan. When the economy is in an utter freefall, when everything is going to hell in a hand-basket, [Walter] Bagehot had the right ideas. The central bank should be the lender of last resort, it should lend on good credit at high rates. What the Federal Reserve did is that, in an attempt to save the banking system, they focused on saving the individual banks. I don’t want to get too wonky, but there are two approaches to respond to a banking crisis. There’s the Japanese way, or the Swedish way. The Swedish approach, which, by the way, is followed by the FDIC, is, “To hell with the banks, save the banking system.” If any given bank is insolvent, you fire the senior management, you wipe out the shareholders, you take the assets, you sell them to the highest bidder and whatever is left over goes to the bondholders. What you’re left with is good assets and preserved accounts. People who ran a bank poorly or invested in bad banks are suitably chastened by the market, and the system is saved.

Japan has its own keiretsu system [whereby banks are owned by companies and vice versa across the economy]. When Japan’s crisis began in 1989, if they had let Bank of Mitsubishi fail, the whole of Mitsubishi would have collapsed. So Japan’s approach was, “To hell with the banking system, save the banks, because if we don’t, everything else is going to go down.” Unfortunately, we took a page from the Japanese approach. Now it’s 30 years later, and Japan is still in a long-term recession.

Do you really believe we should have let those banks go bankrupt then?

Well, the way we let Lehman go down – just take a leap, face down, 50 storeys onto the concrete – no. That’s not the ideal way to do it. What we ended up doing with GM and Chrysler was a pre-packaged bankruptcy: You fire the senior management, wipe out the shareholders, renegotiate all the bad deals, and sell off all the bad assets. GM is having its best year in history! Had we done that with the bigger banks, we would be much healthier today. That tearing off the Band-Aid is much more painful at the time, but it would be healthier today, and more importantly, you don’t set up the [moral hazard] problems going forward. So five to 10 years from now, we don’t have some guy on a trading desk coming up with an idea and saying, “You know, if I take a little more risk, and use a little more leverage, if it works out, it’s a home run for me. But if it crashes and burns, it’s someone else’s problem!”

So how should the banks have been dealt with? You work on Wall Street, give me the specifics.

When Bear Stearns starts to wobble, a few people said, “Hey! We can’t let Bear Stearns go belly-up.” That’s where the mistakes start.

So they should have just been left to go under?

No, no. Here’s what happened. Jamie Dimon [the chief executive of JP Morgan] completely outplayed Ben Bernanke. Dimon went to Bernanke and said, “Look, we’re a counterparty with Bear Stearns, we could probably absorb them – but why should we step up? Normally we wouldn’t do this in a shotgun wedding, it would take a year to negotiate. I have a weekend to make this decision, so you have to guarantee $29bn of losses.” And the Fed did that.

If I had been the Fed chief, I would have said: “Let me explain this to you, Jamie. I know the history of JP Morgan.” (Everybody thinks Dimon is this genius who avoided the subprime situation, but that’s actually not true. They just ran into their subprime problem way earlier than everybody else, so when they had to liquidate, there was a bid there.) “I’m looking at the derivative book of Bear Stearns. It’s $8 trillion and you’re the single biggest counterparty. So if they go down, it’s your problem. So here is what I am willing to do. When you go into receivership, I’ll promise not to put you in jail! If you want to buy them, buy them. If you don’t want to buy them, we’re going to put them into a pre-packaged bankruptcy and if it ultimately causes JP Morgan to go bankrupt, well, put it this way, this is your opportunity to avoid it. So take a walk once around the park, and have a good think. As Fed chair, I have no problem testifying that I suggested you buy Bear Stearns because, if you didn’t, it really looked like they were going to blow up JP Morgan – and good luck with the shareholder lawsuits for the rest of your life.”

Instead, Dimon outplayed Bernanke. Bernanke is an academic, he was learning on the job. When the head of one of America’s biggest banks says “I’ll save your bacon, but you’ve got to do this for me...” He didn’t know better. Even at the time, a lot of people, including me, said, “This is outrageous for the Fed to give $29bn to JP Morgan to buy Bear Stearns.”

Going back to the underlying causes, the American obsession with deregulation played a big part. Your second book, "The Myth of the Rational Market" looks at the intellectual underpinnings of that worldview.

Yes, so everything was working fine. The original concept – which started under Carter but was accelerated under Reagan – was that government has gotten too unwieldy. Regulation is too costly, too time-consuming and there’s too much red tape. There is a legitimate argument that bureaucracies tend to feed on themselves, and you have to constantly hack back at some of the vines and undergrowth. But somehow, “Let’s clear out some regulations and make it easier for business,” morphed over time to become, “The market knows better than anybody else, let’s get rid of any and all oversight, any and all regulation, any and all things that get in the way of the efficient market.” So what started out as, “Let’s clear out some of the excesses,” became, “Let’s get rid of all the rules.”

In "The Myth of the Rational Market" Justin Fox explains all of the bad ideas that took root and allowed a very legitimate and worthwhile objective – getting rid of some of the really time-consuming, unjustifiable, expensive regulations that had grown over time – get so wildly imbalanced. He looks at why academics and many market theorists were so wrong about how markets actually operate. He does a wonderful job of telling the story of how the simple concept of the efficient market, the rational economic actor, got completely out of whack. You don’t have to be an economist or market theorist to appreciate the personalities, the story and some of the obvious delusions that took place and helped set the table for the collapse.

Yes, one review said, “It reads like an intellectual whodunit.”

It really does. By the way there are a bunch of other books along the same concept – "Zombie Economics" by John Quiggin, Yves Smith’s "Econned," and Kevin Phillips’s "Bad Money." There are a slew of these that are all about how academic economists – and especially the Chicago School and other believers in the Efficient Market Hypothesis (EMH) – got this totally wrong. There’s a simple reason for that, which is that when you build a model, you’re building a Platonic shadow of reality. It’s not reality; it’s a depiction of reality. Naturally, there’s going to be some variance and modelling errors. There’s that great George Box quote: “All theoretical models are wrong, but some are useful.” What that means is that you have to always remember, when you’re working from a model, especially a financial model making projections into the future, that you’re not dealing with a perfect reflection of everything that takes place in the real world. There are irrational things that take place that models typically don’t forecast. Human beings are not perfectly efficient, profit-maximising actors.

Tell me about your next book, "The Quants," and their role in the crisis.

"The Quants" explains how math, combined with a lot of leverage and a bit of modelling error led to a lot of disasters. It’s about the mathematicians and, literally, rocket scientists who came up with a series of concepts as to how to use mathematics to try to game the market. The fun thing about mathematics is that you can identify these really small, really tiny edges that you wouldn’t find otherwise. But if you have a 0.015 percent edge, you can’t really make a lot of money unless you really ramp up the leverage, so most of these guys traded with a lot of leverage. But the laws of mathematics are all the same – no matter which firm you’re at – so you ended up with lots of people doing, if not identical trades, certainly very similar trades. Then you have a series of wobbles. The first one was LTCM and the Asian contagion. But really it hit in the summer of 2007, when the first errors took place with the Bear Stearns hedge fund. You have a huge correlated move with all the quant shops. That was really problematic, and it only got worse over the next couple of years. That really exacerbated a lot of the moves. It’s a very entertaining book. There’s a lot of really interesting personalities in it. I have a math background, but it’s written for really pretty much anybody. You only need to know two plus two is four and you’ll enjoy it. Same thing with "The Myth of the Rational Market" – it’s good wonky fun.

Let’s go on to Michael Lewis’s book, "The Big Short."

Michael Lewis, to me, is the preeminent narrator [of this crisis]. He is the guy who constructs the story better than anybody else. He tells the narrative in just an utterly fascinating and delightful way. I have a review of "The Big Short" that I haven’t published yet, because it’s too profane. There’s a story in there of a fund manager who starts out as an archconservative, and ends up, at the end of the crisis, as this staunch liberal. That’s because he sees the entire subprime, securitisation thing as nothing more than Wall Street finally figuring how to extract profit from the poor. There’s a whole section of the book where he rails about it being an attempt to “fuck the poor."

He does what he does in all his books, which is he identifies these quirky, off-kilter guys that have some odd defect. One of them has Asperger’s, I think. They’re outsiders, not in the mainstream. Lewis just tells the same story over and over again, whether it’s technology or baseball or football or subprime mortgages. And the story is essentially a few people looking at the universe from outside, and seeing something everyone else misses. In this case, you have guys who not only capitalized on it, but also managed to raise a stink about how things are done, which of course we’ve promptly forgotten all about.

So it really was about fucking the poor?

I don’t know if the guy who said that was being a little flamboyant, but, ultimately, yes. Here’s the problem with banking. People have described a banker as someone who is willing to lend you an umbrella on a sunny day, ie, if you really need the money, you can’t get it. As I said in "Bailout Nation," the history of commercial credit has, for millions of years, been based on the borrower’s ability to service the debt. What took place from 2002 to 2007 is that the borrower’s ability to service the debt was replaced with a new standard for making loans. That standard wasn’t, “Hey, how do we fuck the poor?” but it was the ability of the lender to sell that debt to a Wall Street securitiser.

My favorite example [of egregious subprime mortgage lending] was the two grape-pickers in California, who each made $14,000 a year and qualified for a $750,000 mortgage. If they took 100 percent of their salary and used it to pay the mortgage, they would still default. Also, by the way, these 30-year mortgages were sold with a 90-day warranty. You can buy a toaster that has a longer warranty than a 30-year mortgage! Your obligation, when finding a borrower, is “Just don’t default these first three months. Whatever you do after that is not my concern.”

Let’s get on to your last book, which you’ve chosen because it best expresses outrage about what happened: "Griftopia" by Matt Taibbi.

Matt Taibbi is the poet laureate of vitriol. There is no one better to capture the gestalt of the country’s angst, fury, and anger, and how upset people are that, essentially, these banks blew themselves up, and then managed to twist Congress’s arm to give them billions of dollars, much of which, by the way, has not been repaid. Every time I see some idiot say all the TARP [Troubled Asset Relief Program] and bailouts have been repaid, it’s nonsense. Even if you count all the Citigroup stock, all the Bank of America stock and the GM stock – none of which you can really sell because you’ll crush the stock price – we’re not back to break-even. We still have massive liabilities thanks to the huge losses at Freddie [Mac] and Fannie [Mae] and the losses at AIG. And anyway, who undertakes a trillion dollars’ worth of risk in order to break even? The deals that were negotiated were just so absurd, so ridiculous. It’s outrageous. That sense of outrage is just throughout "Griftopia." Matt Taibbi is the guy who coined the phrase “Vampire Squid”, he’s the one who put Goldman Sachs as a great evil on the map. I’ve been reading him for years, I think he’s a really fascinating guy. There are few people who are angrier, who are more incensed, and have an ability to express it in prose, better than him. It’s poetry to read. The prose is flowery and full of profanities, and by the time you’re done with each chapter, you’re pretty angry. It very much appeals to your sense of “I can’t believe these sons-of-bitches got away with this.”

He doesn’t seem to hold back, does he? I see he’s got “Alan Greenspan – Biggest A-Hole in the Universe”.

Yes, that’s actually a chapter. The funny thing is I don’t fully agree with him. Some of his conclusions I think are fair but I come down on a different spot. I’m always looking at the data side of things, not just the human side. But it is a rollicking, raucous read. Some of it is hilarious. I’m on the train back and forth to the city reading "Griftopia" and every now and then I just start laughing out loud. But more than anything else I’ve seen it just sums up the fury and frustration of the American public, who just don’t believe justice has been served. This has been the greatest transfer of wealth in the history of mankind – trillions of dollars – and nothing has been fixed. The overall situation is just as precarious, if not more so, than before the crisis.

Is there anything people can do? Small acts of resistance against the big banks ordinary citizens can engage in?

There’s a website called Move Your Money. What’s crazy is that following the crisis, the big bailed-out banks are bigger than ever – 75 percent of the assets in this country are held by the top 12 banks. It used to be 50 percent by the top 30. There are lots of small regional banks, but there are always mergers in the banking world. I can’t tell you how many different chequebooks I have. First I had an account with Manufacturers Hanover, then it became Chemical, then it became Chase, now JP Morgan. So I thought, to hell with it, I’ll set up a Washington Mutual account. And then that gets bought by Chase…

What we ended up doing was setting up an account at TD Bank. They’re a Canadian bank, they don’t dabble in derivatives, they don’t do any subprime stuff. They’re just a relatively strong bank without these issues and they have lots of branches everywhere. Because, also, if you set up an account at Joe’s Local Community Bank, you’re not giving money to Chase, but wherever you travel, you’re paying a $2 fee every time you use your ATM card.

One of the ways we can avoid all these problems in the future is to put a rule that you can’t own more than 5 percent of the assets in the U.S., and you can’t have more than this much leverage. There are a number of rules you can put into effect. Canada seems to have done a much better job than the U.S. has. They have a lot of banks with big market share, but they didn’t get into trouble, because the rules didn’t allow them to.

Have you got any other specific remedies?

To go back to our original conversation about causation and David Hume: What we’ve seen over the past 30 years is an increasingly bad relationship between Congress and Wall Street, and this revolving door. Congress exists to do the bidding of the big banks. The way to fix it is to change the campaign finance laws, so you have public financing, and congressmen aren’t spending 75 percent of their time raising money for their next election. As soon as they get elected, they’re immediately raising money for their re-election campaign! So first and foremost, we have to reform the lobbying laws. It’s one thing for a bank to say, “We have a concern about this regulation and here’s what our issues are.” It’s something completely different to say, “We’re writing this regulation, we’re giving it to you to submit, and by the way here’s a $100,000 cheque for your re-election campaign.” The Romans would call that graft. The Romans had a great punishment for that. Anyone caught corrupting a public official would have their nose cut off, be tied in a burlap sack – naked with a wildcat – and thrown into the Tiber. And let me tell you, you go to one or two of those, and there’s not much corruption going forward.

Is that the solution then, the Potomac River?

I doubt it would be allowed in the U.S. I have a suspicion it wouldn’t pass Supreme Court muster. But hey! the Supreme Court is as much a problem as everybody else. No, corporations are not people, corporations should not have the right to give unlimited amounts of money to campaigns. This is supposed to be a democracy! Leaving aside the historical anachronisms – like women not being allowed to vote, or black people only counting as three-fifths of a person – it’s supposed to be “one person, one vote”! It’s not “one corporation and as much money as you can give”. I work on Wall Street, I make a nice living. I’m in the 1 percent in terms of income. And I know lots of people who are similarly situated who are really, really unhappy with the corporate takeover of America. As Matt Taibbi would say, it’s Goldman Sachs’s world – we just live in it.

It is quite astonishing, and I just don’t know what the endgame is. You have a very ineffective, uninvolved, corn-syrup medicated, endlessly entertained public. What was the book a few years ago, "Amusing Ourselves to Death"? Some of them are disgusted, but some of them are very distracted. What’s been taking place on Wall Street and in Washington DC has been nothing short of a coup d’état. Democracy has been replaced with a de facto corporatocracy.

Is there any hope?

For me the great hope for America and the world is technology. I hope that with Twitter and the blogosphere there will be a general moving away from big corporate entities to individuals and small companies. There’s an enormous potential to wrest control away. We need to get people angry enough to say, “this is ridiculous.” What the United States needs is its own Arab Spring.

By Sophie Roell

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