|The New York Times
Six Errors on the Path to the Financial Crisis
By ALAN S. BLINDER
WHAT'S a nice economy like ours doing in a place like this? As the
country descends into what is likely to be its worst postwar
recession, Americans are distressed, bewildered and asking serious
questions: Didn't we learn how to avoid such catastrophes decades ago?
Has American-style capitalism failed us so badly that it needs a
The answers, I believe, are yes and no. Our capitalist system did not
condemn us to this fate. Instead, it was largely a series of avoidable
--yes, avoidable--human errors. Recognizing and understanding these
errors will help us fix the system so that it doesn't malfunction so
badly again. And we can do so without ending capitalism as we know it.
My list of errors has six whoppers, in chronologically order. I omit
mistakes that became clear only in hindsight, limiting myself to those
where prominent voices advocated a different course at the time. Had
these six choices been different, I believe the inevitable bursting of
the housing bubble would have caused far less harm.
WILD DERIVATIVES In 1998, when Brooksley E. Born, then chairwoman of
the Commodity Futures Trading Commission, sought to extend its
regulatory reach into the derivatives world, top officials of the
Treasury Department, the Federal Reserve and the Securities and
Exchange Commission squelched the idea. While her specific plan may
not have been ideal, does anyone doubt that the financial turmoil
would have been less severe if derivatives trading had acquired a
zookeeper a decade ago?
SKY-HIGH LEVERAGE The second error came in 2004, when the S.E.C. let
securities firms raise their leverage sharply. Before then, leverage
of 12 to 1 was typical; afterward, it shot up to more like 33 to 1.
What were the S.E.C. and the heads of the firms thinking? Remember,
under 33-to-1 leverage, a mere 3 percent decline in asset values wipes
out a company. Had leverage stayed at 12 to 1, these firms wouldn't
have grown as big or been as fragile.
A SUBPRIME SURGE The next error came in stages, from 2004 to 2007, as
subprime lending grew from a small corner of the mortgage market into
a large, dangerous one. Lending standards fell disgracefully, and
dubious transactions became common.
Why wasn't this insanity stopped? There are two answers, and each
holds a lesson. One is that bank regulators were asleep at the switch.
Entranced by laissez faire-y tales, [great phrase!] they ignored
warnings from those like Edward M. Gramlich, then a Fed governor, who
saw the problem brewing years before the fall.
The other answer is that many of the worst subprime mortgages
originated outside the banking system, beyond the reach of any federal
regulator. That regulatory hole needs to be plugged.
FIDDLING ON FORECLOSURES The government's continuing failure to do
anything large and serious to limit foreclosures is tragic. The broad
contours of the foreclosure tsunami were clear more than a year ago —
and people like Representative Barney Frank, Democrat of
Massachusetts, and Sheila C. Bair, chairwoman of the Federal Deposit
Insurance Corporation, were sounding alarms.
Yet the Treasury and Congress fiddled while homes burned. Why?
Free-market ideology, denial and an unwillingness to commit taxpayer
funds all played roles. Sadly, the problem should now be much smaller
than it is.
LETTING LEHMAN GO The next whopper came in September, when Lehman
Brothers, unlike Bear Stearns before it, was allowed to fail. Perhaps
it was a case of misjudgment by officials who deemed Lehman neither
too big nor too entangled (with other financial institutions) to
fail. Or perhaps they wanted to make an offering to the moral-hazard
gods. Regardless, everything fell apart after Lehman.
People in the market often say they can make money under any set of
rules, as long as they know what they are. Coming just six months
after Bear's rescue, the Lehman decision tossed the presumed rule book
out the window. If Bear was too big to fail, how could Lehman, at
twice its size, not be? If Bear was too entangled to fail, why was
After Lehman went over the cliff, no financial institution seemed
safe. So lending froze, and the economy sank like a stone. It was a
colossal error, and many people said so at the time.
TARP'S DETOUR The final major error is mismanagement of the Troubled
Asset Relief Program, the $700 billion bailout fund. As I wrote here
last month, decisions of Henry M. Paulson Jr., the former Treasury
secretary, about using the TARP's first $350 billion were an
inconsistent mess. Instead of pursuing the TARP's intended purposes,
he used most of the funds to inject capital into banks - which he did
To illustrate what might have been, consider Fed programs to buy
commercial paper and mortgage-backed securities. These facilities do
roughly what TARP was supposed to do: buy troubled assets. And they
have breathed some life into those moribund markets. The lesson for
the new Treasury secretary is clear: use TARP money to buy troubled
assets and to mitigate foreclosures.
Six fateful decisions - all made the wrong way. Imagine what the world
would be like now if the housing bubble burst but those six things
were different: if derivatives were traded on organized exchanges, if
leverage were far lower, if subprime lending were smaller and done
responsibly, if strong actions to limit foreclosures were taken right
away, if Lehman were not allowed to fail, and if the TARP funds were
used as directed.
All of this was possible. And if history had gone that way, I believe
that the financial world and the economy would look far less grim than
they do today.
For this litany of errors, many people in authority owe millions of
Americans an apology. Richard A. Clarke, former national security
adviser, set a good example when he told the commission investigating
the 9/11 attacks that he wanted victims' families "to know why we
failed and what I think we need to do to ensure that nothing like that
ever happens again." I'm waiting for similar words from our financial
leaders, both public and private.
Alan S. Blinder is a professor of economics and public affairs at
Princeton and former vice chairman of the Federal Reserve. He has
advised many Democratic politicians.
Copyright 2009 The New York Times Company