“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.”