The avoidable and inevitable in the banking crisis

What caused the financial crisis? The US government's inquiry has now closed and its report – all 662 pages of it, plus many supporting documents and studies – paint a picture that the members of the Financial Crisis Inquiry Commission itself could not agree upon. Three of the 10 members joined in a dissenting statement. Another wrote a separate dissent. The other six, writing as "the Commission", concluded that the crisis was avoidable, the result of human actions, inactions, and misjudgments. Warnings were ignored. "The greatest tragedy would be to accept the refrain that no one could have seen this coming and thus nothing could have been done. If we accept this notion, it will happen again."

The split was largely partisan: Democrats concurred, Republicans dissented. That isn't the best starting point for legislative or regulatory action, given the lack of consensus on Capitol Hill and with the White House in control of one party and the House of Representatives in the hands of the other. But whatever the political basis of the split, a deeper logic rests in the divisions. To what extent can we really foretell the future? How do we know where the limits to our foresight are?

It matters: "The Commission" wrote: "As this report goes to print, there are more than 26 million Americans who are out of work, cannot find full-time work, or have given up looking for work. About four million families have lost their homes to foreclosure and another four and a half million have slipped into the foreclosure process or are seriously behind on their mortgage payments. Nearly $11 trillion in household wealth has vanished, with retirement accounts and life savings swept away."

It's emotive: Because it matters, those drafting the report let their language rip. The report points to the failure of regulation and supervision, and especially of the Federal Reserve Board, as the root of the problem. The spread of toxic mortgage was preventable. The Securities and Exchange Commission could have forced investment banks to hold more capital. The Federal Reserve Bank of New York could have "clamped down on Citigroup's excesses". Policy-makers and regulators "could have stopped the runaway mortgage securitization train". Where they lacked power the regulators could have sought it. "Too often, they lacked the political will – in a political and ideological environment that constrained it – as well as the fortitude to critically challenge the institutions and the entire system they were entrusted to oversee," the report says.

But there was more to it than that. Bank boards ignored issues in risk. "There was a view that instincts for self-preservation inside major financial firms would shield them from fatal risk-taking without the need for a steady regulatory hand, which, the firms argued, would stifle innovation," it says. AIG's senior management was ignorant of the risks of a $79 billion exposure to derivatives. Merrill Lynch's top management was surprised to find it held $55 billion of mortgage-related securities that were supposed to be "super-safe" and weren't.

Moreover, "there was a systemic breakdown in accountability and ethics." But to blame the crisis on greed and hubris would be simplistic, it said. Rather, the issue lay with the failure to take human weakness into account.

The dissenters: The three commissioners who joined in dissent included the vice chairman, Bill Thomas. They accused the majority of writing more than 500 pages of description, without really analysing why the crisis happen. The report is simply too simple: "Both the 'too little government' and 'too much government' approaches are too broad-brush to explain the crisis," they say. The housing bubble wasn't just in the US, and in other countries it wasn't tied to mortgage securitisation. How could the crisis be a result of political paralysis in Washington, if the same bubble characteristics can be seen in Dublin, Amsterdam and Reykjavík? "How," they ask, "can the 'runaway mortgage securitization train' detailed in the majority's report explain housing bubbles in Spain, Australia, and the United Kingdom, countries with mortgage finance systems vastly different than that in the United States?" This wasn't a runaway train, they dissenter might have written, it was "Murder on the Orient Express" – everybody was to blame.

A different dissent: Peter Wallison thinks that's too easy an answer, and too difficult an explanation to guide policy. Other countries had housing bubbles, it's true, but they didn't suffer from the same collapse that the US did. Moreover, no major financial deregulation had occurred in the past 30 years, Even the repeal of part of the Glass-Steagall Act in 1999, which had prevented retail banks from affiliating with securities houses, seemed to have no connection to how the crisis unfolded. Wallison thinks there's a simpler answer: government policy of promoting home ownership by people who couldn't afford created the bubble. Expansive actions under both Presidents Clinton and Bush, efforts by Fannie Mae and Freddie Mac to boost volume, and policies of the Federal Housing Administration pumped up the market. The decision by government to orchestrate a rescue of Bear Stearns in early 2008 then led the market to conclude that the pressure was off. Government would rescue anyone who failed, so self-restraint vanished. Mark-to-market accounting then made many appear to have been weakened when little had happened.

So, what now? The policy implications of this analysis are far from clear. The split along political lines in the commission combined with the split in government will mean that no major initiative is likely to arise from all the testimony, reports and writing that went into this study. A pragmatist would look, therefore, for little things to do that might do something. That's were Wallison's dissent is instructive. Fannie Mae and Freddie Mac won't go back to business-as-usual any time soon. Government's role will get smaller because it can't get larger. Equilibrium will be restored to the housing market, we guess, but at a lower velocity. And perhaps that's good enough. For the next crisis won't be the same as the last. For that, the attention of policy-makers should be on education, innovation, and the imbalances in trade that makes a sovereign debt crisis loom on the horizon. Those have the look of the inevitable, not just the avoidable.

Source documents: The website of the commission has links to the conclusions and dissents as well as a library of the studies and comments that led to its findings. The full report is a 662-page pdf file.