The Fight Over What Caused the Crisis

Financial Crisis
Financial Crisis

Roger Lowenstein has been taking a beating from bloggers over his big piece out in Bloomberg BusinessWeek titled “Wall Street: Not Guilty.” Over at Forbes, Francine McKenna has a good summary of those blasting Lowenstein, and adds a few blast of her own.

What has outraged a lot of readers is their perception that Lowenstein is minimizing the fraud and malfeasance committed in the years leading up to the financial crisis. But he’s not really doing this at all.

Instead, he’s making a more complex claim: that fraud may have accompanied the financial crisis, but it didn’t cause it. What caused it was a speculative bubble in mortgages that took in bankers, regulators, homebuyers, and investors alike.

You can see a good example of this in the actions of Ralph Cioffi and Matthew Tanin, two guys who actually were accused of fraud by government prosecutors. Cioffi ran the two Bear Stearns subprime hedge funds that collapsed a year before the financial crisis came to a head.

When news that subprime defaults were much higher than expected, many of the investors in Cioffi’s funds grew concerned. Cioffi reportedly reassured them that he was selling subprime CDOs—when in fact he was buying them.

It’s pretty clear that Cioffi and Tanin just thought the panic about subprime was misplaced. Markets were misbehaving, prices were "dislocated." E-mails between to Cioffi from Tanin the were uncovered by the F.B.I. show that Tannin thought subprime was a winning asset as late as February 28, 2007. This may have even been why they felt comfortable lying about what their fund was doing: they were confident that when their strategy turned out to be right, no one would be mad at them for executing it deceptively.

"If Tannin and Cioffi were guilty of anything, it was the mistake of believing the triple-A ratings," Jeffrey Friedman wrote in "Causes of the Crisis."

Did these lies cause the funds to collapse? Of course not. What caused the funds to collapse was the market turning against subprime in a decisive way. Fraud may have accompanied the collapse—but it wasn’t its cause.

(By the way, Cioffi and Tanin were acquitted by a jury—so please read every accusation of lying and committing fraud in the previous three paragraphs as surrounded by lots of backside covering “alleged.”)

For a lot of people this narrative of error is a lot less psychologically satisfying than the prevailing fraud narrative. For one thing, the picture of a world where so many well-educated financial brainiacs can get things so badly wrong is unsettling. It reminds us that future events are far too unpredictable for our comfort. For another, it’s hard to hold anyone accountable for this unpredictability. It almost seems to be a call for nihilism: this is just the way the world is, dark and unpredictable; there’s nothing we can do; so we just have to accept occasional economic catastrophes.

But just because we know that errors—rather than fraud—caused the crisis, doesn't mean we have to become nihilists. There’s actually a lot we can do.

What we should do is reduce the costs of our errant forecasts.

That means, for starters, we should throw out anything that seems to homogenize the financial system—encouraging all the firms to adopt the similar views of the future. Requiring institutional investors, for example, to respect the views of ratings agencies is a disastrous policy. This should be abolished—and not replaced with any other homogenizing policy, such as a government ratings board.

Likewise, we need to investigate the regulatory forces that contributed to the rise of the megabank. There are no real economic or market justifications for a bank to grow as large as Bank of America , JPMorgan Chase , Citigroup or Wells Fargo . Their scale, therefore, is a product of non-market, non-economic factors—most likely regulatory burdens that make smaller scale banking less profitable and regulatory privileges of larger scale banking more profitable. It’s very likely that the key advantage to being as big as Bank of America is that it buys you influence with policy makers and an implicit guarantee against failing.

Diversity really is strength in financial systems, just as it is in ecological systems. Unfortunately, many of the reforms undertaken in the wake of the financial crisis have pushed us in the opposite direction—toward more regulatory homogenization.


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