Banks must be allowed to fail in an orderly fashion. According to Simon Johnson in the NY Times, the Dodd-Frank bill has taken this is the right direction - but is still unlikely to apply to the biggest banks. The FDIC will be in charge of the clean up. 

The  award – winning HBO television series ‘The Wire’ opens with a bleak view of an inner city neighborhood. At first glance a viewer might be mistaken in thinking the location is war torn Sarajevo; however it is soon revealed to be drug infested, dilapidated west Baltimore. Detective, James McNulty, interviews a youth about a shooting homicide. The witness confides that the victim,  player at the weekly dice game, would regularly attempt to abscond with mone being wagered. When the detective asks why the victim was allowed to continue his participation despite continual attempts to rob the game, the witness responds “Got to. This (is) America, man.”  This scene is a metaphor for one of the program’s recurring themes – that despite repeated examples of rampant abuses and systematic gaming, institutions seem resistant to meaningful change.  

“The  Wire” is a poignant meditation on “the game” of life and how the rules of the game influence behavior in institutions. It dramatizes the manner in which weaknesses in market design, individuals chasing statistics for personal gain, and game playing within institutions often lead to tragedy and a tremendous waste of resources. The evolution of the global financial crisis is replete with examples of individuals and corporations gaming the financial regulator framework.

A  housing bubble is fueled by short term interest rates that are kept too low for too long in the wake of September 11, 2001. US consumers through home equity refinancing begin to use their homes as ATMs.  Individuals game the system by taking out loans they can not afford.

As the housing boom matures and most good quality borrowers have either bought or refinanced, the market looks for ways to keep the housing boom going. Credit standards weaken.  At a retail  level, mortgage originators fail to verify income. Since mortgage originators do  not keep mortgages on their books but instead sell them to financial institutions they are able to game the system by not having proper lending standards. 

At  the wholesale level, financial institutions buy mortgages from originators and  in turn repackage them as derivatives, mortgage back securities (MBS), and  resell the mortgages in pieces. Rating agencies fail to properly rate MBS products because they depend on the revenue of the financial institutions that issue them. In retrospect, it is not surprising that a MBS issue comprised of  80% subprime mortgages was given the highest possible investment grade rating. Investment banks game the system by shopping for ratings and selling paper that they know is substandard. 

In order to curry favor with Wall Street and voters, Congress and the Federal Reserve promote homeownership and financial innovation at the expense of Financial system stability. Financial institutions successfully lobby to have leverage restrictions relaxed -allowing them to shift from 10-12 times leverage to 30 to 40 times leverage. Products such as subprime mortgages and adjustable rate mortgages allow weaker borrowers to access the mortgage market. Quasi government entities, such as Fannie Mae and Freddie Mac, become some of the largest holders of MBS portfolios. Credit levels in the private US economy balloon to a multiple of 2.5 times average levels. 

The over-the-counter (OTC) derivatives market, with hundreds of billions of dollars of notional exposure, is left completely unregulated and opaque. AIG, the world’s largest insurance company, is allowed to sell tens of billions of dollars of OTC derivatives and credit defaults swaps (CDS) –insurance on MBS, without being required to allocate any capital as a reserve. The individuals within AIG game the system by selling insurance products whose claims they can not pay.

Then, in the fall of 2008, in the space of a few weeks, the entire global financial system unravels. A system wide bailout, the Troubled Asset Relief Program (TARP), is implemented. Financial institutions and individuals that took enormous risk, issued “toxic waste” products, and profited from gaming the system in good times, are now allowed to socialize their losses.
  
 In response to the crisis Congress passed the Frank-Dodd financial reform bill that is seen by many market observers and participants as not being a substantive modification of the regulatory framework.  David  Einhorn, president of Greenlight Capital, a hedge fund with $7 billion dollars in assets under management, recently talked about the reforms on Charlie Rose.
He characterized the measures as Washington letting Wall Street off the hook with the understanding that Wall Street would let Washingtonoff the hook. “And so I think that the reform -- it doesn’t go after any of the obvious issues  that were identified in the crisis.” Among other changes, Einhorn believes credit rating agencies should  be abolished and reserve capital requirements need to be imposed on CDS.  

The lack of regulation of OTC derivatives market is a case of “déjà vu  all over again”. In the mid nineties, Brooksley Born, a Clinton appointee to chair the Commodity Futures Trading Commission, attempted to regulate the opaque market. The financial sector lobbied strongly against regulation. Robert Rubin the Secretar of Treasury, Arthur Levitt chairman of the Securities and Exchange Commission, Deputy Secretary of the Treasury Larry Summers, and Alan Greenspan chairman of the Federal Reserve, went to congress and successfully lobbied to remove her statutory ability to regulate the market. Shortly thereafter Born resigned her post. Even after the financial crisis, provoked by Long term Capital Management  in 1999, the OTC market was left unregulated. 
 
The Brooksley Born saga is reminiscent of a scene in “The Wire” where police  officers gather on both ends of a desk and attempt to move it through a door. They struggle mightily to no avail finally giving up - convinced that the desk just doesn’t fit. A moment later it becomes evident that they had been trying to push the desk in opposite directions. Born’s experience is representative of another major theme of “The Wire”. Institutional champions trying to affect  meaningful change often find themselves thwarted by those who benefit from  maintaining the status quo.     

The  recent global financial crisis is an example of life imitating art. The lack o fappropriate OTC regulatory response, despite two financial crises in the space of a decade, places us in the shoes of The Wire’s Detective McNulty. We are left to ask “why do we let the financial institutions play the same game, an unregulated OTC market, if it repeatedly leads to financial crises?” 
 
Several  lessons emerge. Markets are not self regulating. If the “market” is not correctly designed, individual and institutional optimization will be to the detriment and even collapse of the system as a whole. Absent proper changes to market design, market failures will follow a predicable repeating pattern. 
 
The  regulatory response to the financial crisis transferred a lot of private debt to  public balance sheets. It has sown the seed for the most likely next global crisis – sovereign debt. Furthermore, absent meaningful reform, it is only a matter of time before we will have another crisis sparked by the opaque unregulated OTC derivatives market. 

It  was not by accident that the Canadian financial system weathered the global financial crisis better than almost any other developed nation. Canadian  consumers or bankers are not intrinsically more ethical or risk adverse than their American counterparts. Also, one need only look to the case of  Icelandto see that being a small  country does not guarantee that markets will be more appropriately designed and  regulations more easily implemented. We were spared not by intrinsically superior virtues, but rather by the markets we designed and manner in which we regulated them.

In  the words of Omar, one of ‘The Wire’s’ most memorable characters: “I'll do what I can to help y'all. But, the game's out there, and it's play or get played. That simple.” 

A recent 60 minutes segment highlighted the peculiar situation in  Cleveland where perfectly good homes have been abandoned and are being bulldozed by the county. To preserve and protect its tax base the county has begun to bulldoze these abandoned homes. One in four mortgages in America are under water. Most are what they call “non recourse” loans where people can hand over the keys to the bank without being liable. Foreclosures rates have hit record levels due to the high rates of unemployment and depressed property values.
 
The Banks are foreclosing and evicting tenants, but to avoid paying the property tax and maintenance costs of the properties the banks are not taking possession of the properties after they have the owners evicted. As a result these homes often become targets for looters, get stripped down and become dilapidated. Abandoned homes thus become blight to their neighborhoods a  negative externality in the parlance of economics. The consequences and benefits (in this case negative) of a transaction between a homeowner and a bank have spillover effects to people who have nothing to do with the transaction.
 
By aggressively evicting tenants and foreclosing, the banks are actually depressing real estate of people who are not their customers. A county official suggested that it might be in the banks interest to lay off evictions so as to not further drive down real estate prices. The movie Margin Call shows why it may be in the competitive interest (Game theory maybe a Nash Equilibrium) to try and be the first to sell off the shoddy assets.
 
The banks would argue that any kind of leniency or accommodation might lead to moral hazard and set legal precedents. Of course this logic applied when the banks and the entire financial system was at risk due in most part because of overaggressive risk taking by financial institutions.
 
This latest chapter of the housing bubble highlights the importance of market design, a key point that is often unemphasized/overlooked in economic analysis.

 Markets do not exist naturally in nature.  In order for markets to be effective and efficient they must be designed properly. Some markets require more regulation than others. We see this at a micro level with the mortgage market and as well as at a national level with the Eurozone (and someday in the next couple of  years we will see it with China).