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Roots of the 2008 Financial Crisis By Robert Mankin

I. Introduction "On one side of the table sat Treasury Secretary Henry Paulson, flanked by Federal Reserve Chairman Ben Bernanke and Federal Deposit Insurance Corp. Chairman Sheila Bair. On the other side sat the nation's top bank executives, who had flown in from around the country, lined up in alphabetical order by bank, with Bank of America Corp. at one end of the table and Wells Fargo & Co. at another. It was Monday afternoon at 3 p.m. at the Treasury headquarters. Messrs. Paulson and Bernanke had called one of the most important gatherings of bankers in American history. For an hour, the nine executives drank coffee and water and listened to the two men paint a dire portrait of the U.S. economy and the unfolding financial crisis. As the meeting neared a close, each banker was handed a term sheet detailing how the government would take stakes valued at a combined $125 billion in their banks, and impose new restrictions on executive pay and dividend policies. The participants, among the nation's best deal makers, were in a peculiar position. They weren't allowed to negotiate. Mr. Paulson requested that each of them sign. It was for their own good and the good of the country, he said, according to a person in the room. During the discussion, the most animated response came from Wells Fargo Chairman Richard Kovacevich, say people present. Why was this necessary? he asked. Why did the government need to buy stakes in these banks? Morgan Stanley Chief Executive John Mack, whose company was among the most vulnerable in the group to the swirling financial crisis, quickly signed. Bank of America's Kenneth Lewis acknowledged the obvious, that everyone at the table would participate. "Any one of us who doesn't have a healthy fear of the unknown isn't paying attention," he said."-The Wall Street Journal, 10-15-2008. In a period of just a few months: "Wall Street"s major independent investment banks have disappeared, two of the nation's largest banks were acquired just before they failed, Fannie Mae and Freddie Mac were placed into U.S. Government (the "Government") conservatorship, the largest insurance company, for all practical purposes, was nationalized, bank deposit insurance ceilings were raised, certain money market funds received Government guarantees that their price would not fall below a dollar and certain commercial paper received Government guarantees, etc Additionally, a "bailout" or "rescue" package, take your choice, was enacted by Congress. The package provided the use of $700 billion for the: purchase of:

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preferred equity and warrants in commercial banks (with stipulations concerning executive compensation), possible acquisition or infusion of capital into other entities, the acquisition of tarnished mortgage securities and loans, etc. In a series of actions focused on stemming what is perceived to be a financial system "crisis" of historic proportions, including a freeezing of credit throughout the system and a residential mortgage emergency, the Government has committed vast sums of money, and profoundly changed its relationship, to the banking sector; indicating it might do the same with other sectors. These actions have been defensive, without a clear strategic context; their long-term consequences are barely discerned, let alone weighed. The patient was seen to be threatened by a catastrophy. The crisis had already begun to ripple throughout the world. We were counseled by our leaders in government that there was no time to engage in long-term thinking prior to approving and carrying-out these actions. We don't know if the short-term remedies will stem the bleeding nor the feared coming disaster. This is partly because the underlying causes have not been definitively identified and weighed in terms of their individual and combined impacts. Some of the remedies might cause a further erosion of the financial system. Clear goals and metrics for the emergency actions against which progress can be measured have not been made public. There is no shared understanding by the Public, and probably by those charged with governing, to signal that the immediate emergency has been met and the bleeding stopped. Additionally, there is an absence of a robust shared transparent strategic framework for the financial system, a framework that constrains the Government's efforts, that reflects our national objectives, that helps to assure that we understand the likely systemic consequences and risks of contemplated actions. Some basic decisions will be made over the coming year, either openly and carefully considered within a rational framework reflecting shared American values, weighing their strategic consequences or behind closed doors, reflecting narrow, transient interests. This is the time for the best thinkers to come forth and help with this effort. This paper, impressionistic rather than academic, constrains itself to the United States banking and investment banking system, but recognizes that there are major, related financial system issues to be dealt with outside of this area. It presents a list of some possible, but not exhaustive, factors underlying the crisis and makes explicit some of the decisions that need to be made. II. Possible U.S. Banking System Crisis Factors The crisis seemed to have sprung in an instant and the causes have commonly been attributed to abuses by a collection of actors, dramatically named "Wall Street", "Washington" and "Main Street", all of the preceeding and then some. More specifically, these are investment, thrift and commercial bankers ("bankers"), their

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broker allies, the Administration and Congress together with the Fed and those mysterious entities Fannie Mae and Freddie Mac, and finally greedy investors and non-credit worthy home owners. Underlying these "causes" are more deep seated factors, a number of which have been playing out over decades. These include: 1. Fierce competition in an overbanked system led banks, since at least the 1970s, to seek riskier loans and fee-based, non-loan products and services in order to survive. Competition from non-bank competitors (e.g. investment banks, hedge funds, private equity firms) has only exacerbated the situation. In order to support the acheivement of desired profits, while meeting balance sheet restrictions and client demands, banks and investment banks developed complex financial instruments that were distributed domesticly and globally to vital institutions. At times these instruments relied upon low quality assets in order to achieve desired investor yields and issuer and trader revenue, e.g. CDOs, backed by mortgage loans to low credit quality clients. An astounding volume of credit default swaps were created with inadequate means of dealing with major collapses of counterparties. This made them very vulnerable to major losses. A high toll was taken by many of the highly leveraged firms. The list goes on. The risk that a small percentage of these products had enormous damage potential in and of themselves, as well as to other higher quality instruments, was not fully recognized by the banks, investment banks ("IB"s) and their regulators.They largely ignored the potential negative consequences. Additionally, investment banks utilized very high and risky leverage (assets to equity), sometimes as high as 30 to 1, to magnify profits. 2. Market forces have been in the process of dramatically reducing the number of banks for many years, shrinking the number from 15,158 in 1990 to 8,883 by year-end of 2005. This trend has continued while the concentration of assets and deposits in a small subset of the banks has become intense. Assuming the planned acquisitions of Washington Mutual and Wachovia by JP Morgan Chase and Wells Fargo, four banks possess about 50% of the total assets in banking. By the end of March 2008, nearly all of the assets in banking, over $14 trillion, were held by the top 150 banks. The top 10 banks held nearly 69% of the total assets of the top 150 banks. Nearly 8,000 banks each had a billion dollars or less in assets. The largest banks were able to do things on an extremely large scale including adding a huge amount of assets to their balance sheets as well as generating them. The smaller banks were in an existential struggle. They needed to grow and/or find a profitable, protective niche or disappear. 3. The dramatic lessening of the number of banks combined with the concentration of assets in a handful, has led to the emergence of a handful of

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banks that are massively capitalized, with the ability to exploit information, telecommunications and financial technology in order to offer an extremely wide menu of banking services and products almost anywhere on the globe to clients in all sectors of the banking market -consumer, business, government and not-for-profit. The size and capital of these institutions make them very good operators of massive, traditional banking services, deploying expensive technology and human resources. They were, and are, in effect, "wired" to do things on a massive scale. These are referred to in this paper as the "financial utilities". 4. The enactment of Gramm-Leach- Bliley in 1999 repealed the Glass-Steagle restrictions on banks affiliating with securities firms. It allowed a new "financial holding company", under section 4 of the Bank Holding Company Act, to engage in a statutorily provided list of financial activities, including insurance and securities underwriting and agency activities, merchant banking and insurance company portfolio investment activities. This removed restrictions that had been eroding for a number of years and eased the way to bring invesment and commercial banking together. Many banks formed financial holding companies containing the bank and created or bought investment banks and added them to the holding company. Thus, low risktaking banks, with management systems and cultures wed to risk avoidance, joined with high risk-taking cultures needing more capital and enhanced distribution. The bureaucratic nature of banks tended to stifle innovation, while the culture of investment banks encouraged fairly high risk-taking and much less bureaucracy than found in banks. The independent Investment banks, seeking bank capital and distribution, continued, in an accelerated way to assume, a more bank-like profile. The ending of Glass-Steagle was not complemented with the necessary reengineering of the regulatory system. Creaky, inadequate banking and investment banking regulations enforced by outgunned regulatory staffs resulted, which grew more inadequate over time. 5. The tensions created by the competing cultures was at times counterproductive and heightened the risk of the firm. The financial utilities operated with business models that were not strenuously tested, had few successful analogs in other businesses to learn from and often rested on the unproven assumption that the business portfolio being as broad as it was, would offer the diversification necessary to protect the firm against catastrophies. The utilities, very complexly organized across multiple cultures (national, business and functional), became increasingly opaque to their senior executives and regulators and a major challenge to manage. The much heralded, and somewhat loosely defined, "risk management function" failed to stave off major losses arising from imprudent risk-taking. The reasons for the failure of this function probably lie in some combination

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of: a. the size and complexity of: the bank or IB being monitored, the businesses being conducted, the products and services being offered, b. the geographical span, c. ineffective organization, including some question as to the adequate segregation of duties and appropriateness of compensation incentives, d. lack of transparency and accountability, e. inadequate risk management tools, f. organizational power politics, g. a regulatory and accounting quagmire and h. the shortcomings of the bond rating firms. Generally, the larger and more complex a firm is, the more difficult it is to adequately carry-out risk management. The financial utilities offer the biggest challenge to adequate risk management. The management skills, especially for the financial utilities, required to run a combined banking and investment banking entity are significantly more demanding than that which banks traditionally required. 6. A number of government actions/policies/regulations, some of which had successful track records, contributed to the current crisis. For example, Ginnie Mae, Fannie Mae ("Fannie") and Freddie Mac ("Freddie") were vital players in extending affordable financing to middle and lower income home buyers. They provided Government (Ginnie Mae) and/or near government (Fannie and Freddie) guarantees on the payment of principal and interest on mortgage loans and mortgage-backed securities (pass-throughs and collateralized loan obligations) to investors. The mortgage-backed securities issued by Fannie and Freddie helped extend home financing from a local resource to a global one. Fannie and Freddie supported mortgage originators by purchasing mortgages from originating banks and mortgage banks and either keeping them in portfolio or issuing securities backed by the loans, a portion of which they at times retained. This boosted the availability of funds to the orginators and freed their balance sheets so that they could originate more loans. The public benefited from the increased availability of mortgage funds at arguably lower rates than would have been available without Fannie and Freddie. Lax management practices at Fannie and Freddie, fuzzy accounting rules and weak oversight by both Congress and the regulatory agencies combined with opaque processes and high financial incentives, led to problems requiring Government intervention and takeover of Fannie and Freddie despite major efforts to correct things by more recent management. In order to come out of an economic doldrum, the Fed initiated a period of easy money. It gradually lowered interest rates to the point that housing finance became very cheap, helping to fan an unprecedented rise ("bubble") in homebuying and increasing home prices. The real estate cycle that rose in bubble fashion came crashing down. Measures targeted to increase board, CEO and CFO accountability, e.g. Sarbanes Oxley, have not demonstrated their effectiveness as preventives.

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CEOs and CFOs signed-off, under penaty of major sanctions, that their controls over their financials were adequate for their firms. The compensation systems in place in many of the firms provided handsome bonuses for taking risks that pushed back the common sense boundaries that prudent risk management would dictate. Senior executives gained major upside advantages by taking major risks, with rather strong safety nets for failing. 7. Unsuitable loans were made to low credit quality borrowers. The loans were such that they had delayed payment "surprises" that led to both an actual and feared spike in delinquencies and foreclosures among a large number of loans. A number of the mortgage securities, backed by these "subprime" mortgages were dangerously structured. This combination of low quality loans and poorly structured securities, caused severe losses in the value of the securities. These losses impacted other mortgage-backed securities of much higher quality and had a rippling, magnified effect throughout the financial system. The fact that the securities had been distributed around the globe to financial institutions, governments, pension funds, mutual funds, etc., led to losses throughout the World in a very damaging fashion.

8. There was an apparent lack of a shared understanding by the Government's top decision-makers about how the financial system's various components were interrelated at the business operations level.The appointed rescuers of the system took a number of actions they arguably might not have taken had they thoroughly understood the linkages. For example, they might not have allowed Lehman to fail. This led to unanticipated, potentially disastrous problems in the money market and credit default swap market leading to further Government rescue efforts.

The preceeding list consists of some, there are probably quite a few more, of the factors that I believe need to be understood, weighed and addressed in order to develop long-term solutions and prevent or rectify damages arising from some shortterm fixes. It will help: 1. distinguish where remediation is requred and where it isn't, 2. what the remediation should be, and 3. how and by whom it should be paced. III. A few issues to consider 1. The Structure of the Banking System Over many years, the banking system has been moving, with what seems to be inevitable certainty, towards one that is composed of significantly fewer banks dominated by a very small number of financial utilities. The current crisis provides an opportunity to openly

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examine and discuss this development and its likely consequences and make changes, if desired. There are both pluses and minuses to the way the banking system is developing. The utilities, because of their size and experience, provide potentially very efficient and safe harbors for traditional, low risk financial products and processes (e.g. checking, money transfer, savings accounts, well underwritten loans, etc.) once the utilities more recent ventures with the higher risk products are ended and the appropriate repairs made. Their size and presence with depth in so many markets clearly marks them to be the banks that are too big and vital to the dayto-day operation of the economy to be allowed to fail. With proper regulation and management, ceasing the venture into high risk, they fit the criteria for Government-provided deposit insurance. Banks that have the profile of the utilities could bring reasonable stability to the banking sector, the kind of stability sought at this time. If too many smaller banks disappear, the chance to focus on the needs of specific geographies, business sectors, etc. becomes significantly reduced. Experimentation and responsiveness lessen, and clients might lose the comfort found in dealing with more familiar, sociable-sized institutions. The financial utilities, because of their very nature, are not promising environments for innovation with all of the risks that entails. If they dominate the space once held by the investment banks and some smaller banks, where will lightly regulated, economy-driving innovations be funded on the scale that is required? Do we need a new breed of financial innovation generating, relatively lightly capitalized and lightly regulated higher risk-taking entities, "gray" companies, to replace the vanishing investment banks? The banking system could end-up with the problem of all eggs being placed in the same few baskets. Given the recent problems at these banks, there is a question as to the whether this is a good thing. Do the very large banks, with special emphasis on the utilities, have the business models, practice and management that lessen the likelihood that another rescue will be required? Given the monumental losses the very large banks have recently incurred, combined with the previous problems some of them had in complying with regulations, there are serious questions concerning the viability of their business models, their regulation and the management capability required to run them. 2. Structural Alternatives If the utility-centric system is not desired, what is? How should we get there? The Government is in the process of encouraging further financial utility growth in the current crisis by using them to acquire other banks and IBs. However, it is also making funds available to smaller banks, perhaps extending their viability. 3. Regulation Reengineering Governance failed. Why did this happen? Despite heavy regulatory oversight with frequent examinations and some fairly stringent laws with severe sanctions for breaches, e.g. Sarbanes

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Oxley, we are in the midst of the purportedly greatest threat to the financial system since the Great Depression. Did management find ways around regulations? Were the regulators up to the job? Are the rules wrong? Has the development of the utilities exacerbated things? Are the products too complex for the system of risk management found in banking? Do we need a new Glass-Steagle era? Clearly, something is wrong. What needs to be done? Do we need a reengineering of the regulatory system or can a small set of changes correct things? 4. Extent of Government Ownership/Management What role should the Government play in ownership and bank management? Given the massive Government intervention and provision of capital currently unfolding, the question arises to the desirable extent of this. For example, if the financial utilities are maintained, should they be positioned as part of the Government or become quasi-government entities, responsible for only products that are proven and safe, placing Government guarantees/insurance on their domain. If the Government expands its seat at the table in banks, how will the Government be controlled? The gray companies would be the lightly regulated innovators of the future without deposit insurance. Do we want a new era of GlassSteagle, possibly one with the Government taking part in owning and managing banks? 5. Interconnection Transparency One of the missing ingredients in the rescue is the absence of a full knowledge of how the banking system is interconnected. This lack of knowledge was damaging even before the crisis. How will this understanding be gained and put into use? How should our banking system interface with the global financial system? 6. The Future of Fannie and Freddie What should be done with Fannie Mae and Freddie Mac? Do they need to exist in some form and continue their active role in the residential mortgage sector? It seems crucial that their guarantees actually be Government guarantees. Fannie and Freddie have issued and guaranteed a vast dollar volume of securities and loans that are owned by vital components of this and many other countries. Holders of sizeable amounts include pension and other retirement funds, banks and IBs, mutual funds, hedge funds, governmental entities and insurance companies. Without Fannie and Freddie or their equivalent's active participation in the mortgage market, the housing downturn could move from a downturn to a disaster. Should Fannie and Freddie be merged? The historical reasons for separate entities are long-gone. They basically perform the same function both in the economy and operationally. Their operations need to be made transparent and better supervised. Given that their activities are continued and Government guarantees are vital, should the Government maintain its ownership of them for the foreseeable future? 7.The Future of the Bond Rating System The bond rating system failed to adequately and in a timely fashion reflect the risks in products. The stability of a number of ratings was less than adequate. What can be done to improve the

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process and ratings quality? Should the fees be paid by buyers rather than issuers? Should the ratings be set by private enterprise of the Government?

IV. Conclusion These are perilous times. The economy has been shaken and an earthquake has struck the banking system. With little examination of long-term consequences, major changes are happening in the banking system challenging the Nation's economic model. The role of the Government; the adequacy of regulation and oversight, the emergence of banking behemoths with unproven business models, the disappearance of independent investment banking, the dramatic shrinking of the number of banks, the wide dissemination of toxic securities, the massive use of credit default swaps, the near collapse of Fannie Mae and Freddie Mac, an escalation in actual and expected foreclosures, etc. are all coming together. It is essential that 1. clearly communicated goals for the emergency actions be established, progress against them be measured and conditions be established for the cessation of the actions and 2. a comprehensive examination of the banking system, its problems and direction, be conducted.

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