To blame the bankers themselves implies that free markets do not work as advertised by The Wall Street Journal's editorialists and by the economics profession, whose hallowed doctrines are incompatible with that thesis. It would make hash out of the profession's hallowed "Efficient Market Credo," according to which the smart folks on Wall Street at all times rationally and efficiently price real and financial assets at their proper values, given all publicly available information. What would economists teach instead?
As such an economist, I therefore point the finger at government, which is always the skunk at free-market garden parties.
First, the Federal Reserve pumped too much liquidity into the economy. That excess liquidity drove banking executives to finance hundreds of billions of dodgy mortgage loans granted to low-income, mom-and-pop borrowers with shaky or unknown credit worthiness. Can anyone fairly blame free-market executives for reacting instinctively to government-manufactured excess liquidity, any more than one would blame a puppy for overeating when too much dog food had been poured into its bowl?
The bankers' instincts told them that, through a modern financial engineering feat called "securitization," the risk inherent in dodgy mortgages can be so vaporized and diffused that the risks somehow evaporate altogether. With the aid of computers, the bank's financial engineers manufactured synthetic securities called Collateralized Debt Obligations (CDOs) whose promised cash flows were backed up ("collateralized") by the contractual cash flows of other financial securities, among them - you guessed it - zillions of dodgy mom-and-pop mortgage contracts that had been purchased by the big banks from local banks, the original lenders. For handsome fees, CDOs based on dodgy mortgages could be "securitized" in this way into yet other CDOs, which, in turn, were securitized for a fee once again until, in the end, no one could trace any more the risk in a dodgy mortgage to the final CDO. In the minds of the bankers and of the rating agencies they pay to rate those CDOs, the risk thus vanished.
The bankers not only peddled the CDOs they had manufactured to trusting outside investors, but also borrowed heavily to invest in the CDOs themselves. Thus, much of the risk inherent in dodgy mom-and-pop mortgages ended up on the balance sheets of large investment banks here and abroad. Alas, when the housing bubble fueled by the bankers burst and more and more dodgy mortgages defaulted, some genius in our efficient financial market hit upon the brilliant insight that CDOs based on securitized dodgy mortgages might themselves be dodgy, too. There arose the fear that the true value of many banks' assets might be less than the dollar value of their debt. Panic befell the efficient market.
Blame for this fiasco also can be placed on the U.S. Treasury and the Security and Exchange Commission (SEC) whose head Sen. John McCain (R-Ariz.) now wants to see fired. These government agencies can be accused of having regulated the financial market too much or too little, depending on which argument one prefers.
On the "insufficient regulation" argument, one holds that the absence of stricter regulation allowed the investment banks to load much too much debt onto their balance sheet to buy dodgy assets - up to $40 of debt for every $1 of owners' equity. One then argues that, in the absence of regulatory strictures to the contrary, one can no more blame bankers for assuming too much debt to buy shaky assets than one can blame a teenager for freezing to death when Mommy forgot to tell him to wear a warm jacket.
The "too-much-regulation" argument holds that the SEC and the Treasury requires financial institutions to mark the assets on their balance sheets to market values, and to adhere to certain statutory "Basel II" minimal capital requirements. Absent these regulations, the argument goes, no one would ever have known, certainly not at this time, how frail the banks' balance sheets actually are and business could go on as usual - at least for a while.
Thus, because government can be blamed for making the doo-doo in which the bankers now sit, it seems only fair that government now bail them out with taxpayers' money. After all, absent a bailout, the bankers might have to work for mere salaries of a million or two, without their customary humongous bonuses. As every molecular biology student knows, absent rich bonuses, the body temperature of banking executives drops to Kelvin (minus 276 degrees Fahrenheit), a temperature at which molecules cease to move. Should that happen, America as we know it would cease to exist and so would the entire world.
Uwe E. Reinhardt is the James Madison Professor of Political Economy and a professor inthe Wilson School. He can be reached at reinhardt@princeton.edu.
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