Let’s face it: You won’t read every page of the Financial Crisis Inquiry Commission report. But FrumForum will, over the next days. So let’s proceed together, page by page, identifying the key points.
An editorial in National Review criticizes the FCIC report as an exercise in “evil-man economics.”
[T]he commission’s report is both implausible and nakedly political: The Evil Men are greedy corporate executives and Wall Street moneymen, and the crisis might have been averted if only they had been endowed with sufficient moral fiber — or had an appropriately mindful policeman appointed over them, which is the real point of the Angelides report.
Yet as of page 61, the report’s main culprit is not an executive or a money man. It is Federal Reserve chairman Alan Greenspan.
The “Greenspan put” was analysts’ shorthand for investors’ faith that the Fed would keep the capital markets functioning no matter what. The Fed’s policy was clear: to restrain growth of an asset bubble, it would take only small steps, such as warning investors some asset prices might fall; but after a bubble burst, it would use all the tools available to stabilize the markets. Greenspan argued that intentionally bursting a bubble would heavily damage the economy. “Instead of trying to contain a putative bubble by drastic actions with largely unpredictable consequences,” he said in 2004, when housing prices were ballooning, “we chose . . . to focus on policies ‘to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion.’”
This asymmetric policy—allowing unrestrained growth, then working hard to cushion the impact of a bust—raised the question of “moral hazard”: did the policy encourage investors and financial institutions to gamble because their upside was unlimited while the full power and influence of the Fed protected their downside (at least against catastrophic losses)? Greenspan himself warned about this in a 2005 speech, noting that higher asset prices were “in part the indirect result of investors accepting lower compensation for risk” and cautioning that “newly abundant liquidity can readily disappear.” Yet the only real action would be an upward march of the federal funds rate that had begun in the summer of 2004, although, as he pointed out in the same 2005 speech, this had little effect.
And the markets were undeterred. “We had convinced ourselves that we were in a less risky world,” former Federal Reserve governor and National Economic Council director under President George W. Bush Lawrence Lindsey told the Commission. “And how should any rational investor respond to a less risky world? They should lay on more risk.”
Still, the report does point out on page 62, that sometime around 1980, people in the financial sector did begin awarding themselves more pay.
From 1945 until 1980, people in finance did not significantly outearn on average people in other sectors. After 1980, nonfinancial pay flattened, while financial pay accelerated. By 2008, the average employee in finance was earning double the average employee in non-finance.
The trouble was not just that such people were arguably overpaid. (Although in the wake of revelations that CEOs at major financial institutions knew little or nothing about what was going on at their firms, it’s hard to avoid the conclusion that such executives were indeed paid too much. Like everything about the first $1.) The trouble rather was that the widespread use of stock options as pay systematically misaligned executive incentives, encouraging them to run risks in the knowledge that profits would be shared with them in the form of higher pay, while losses would be borne by shareholders alone.
Worse yet, pay structures could encourage outright fraud, as happened at Fannie Mae and Freddie Mac.
Former Fannie Mae regulator Armando Falcon Jr. told the FCIC, “Fannie began the last decade with an ambitious goal—double earnings in 5 years to $6.46 [per share]. A large part of the executives’ compensation was tied to meeting that goal.” Achieving it brought CEO Franklin Raines $52 million of his $90 million pay from 1998 to 2003. However, Falcon said, the goal “turned out to be unachievable without breaking rules and hiding risks. Fannie and Freddie executives worked hard to persuade investors that mortgage-related assets were a riskless investment, while at the same time covering up the volatility and risks of their own mortgage portfolios and balance sheets.” Fannie’s estimate of how many mortgage holders would pay off was off by $400 million at year-end 1998, which meant no bonuses. So Fannie counted only half the $400 million on its books, enabling Raines and other executives to meet the earnings target and receive 100% of their bonuses.
More to come…