Wednesday, April 25, 2012

Frontline on PBS

The first part of PBS’s four hour documentary on the financial crisis aired tonight on public television stations. The segment focused most of its attention on explaining the causes of the crisis and exploring the backroom political decisions that were going on as the economy tanked. In truth, most of the issues discussed in part one have already been analyzed in depth, but it still helped to get a wide view of the years leading up to 2008. Here are a few of the highlights.

The collateralized debt obligation (CDO) and the credit default swap (CDS) are now derided as the financial instruments that nearly brought the United States a second great depression, but the Frontline program spends a good amount of time reminding us that the intentions of the people who came up the CDO and the CDS were noble. The CDO, for example, was introduced to allow small investors to buy into loan portfolios of large banks. These investors were happy because they could invest in commercial paper that they would otherwise not have access to and at the same time reap the reward of higher returns. This worked well for the banks too because it allowed them to lower their risk exposure and allowed them to charge administrative fees. The CDS, for its part, allowed banks to loan money to companies while at the same time insuring their loans in the chance of default. The dark side of these complex tools didn’t rear its head until much later on when bankers and others started abusing their use.

Banks, in one of the most egregious example of abuse, used CDSs to skirt capital requirements on loans. While technically not illegal, this practice allowed banks to load up on risky investments without being required to have the capital to cover the loss if something bad happened. In a failure of governance, the Clinton administration failed to implement a framework for the regulation of credit default swaps. This lack of transparency allowed AIG to sell $440 billion in CDSs to unknowing customers. (AIG was eventually bailed out by the government.)

Another few tidbits:
After the implosion of Bear Stearns in March 2008, policymakers had six months to come up with a roadmap for battling the coming bloodbath, but they did nothing. Tim Geithner, in particular, should have had a more sophisticated contingency plan. He was the Federal Reserve’s liaison to Wall Street, and he should have been more informed on the issues at Lehman Brothers.

Hank Paulson thought the market could adequately sort through the massive Lehman bankruptcy without government intervention. He was dead wrong. Two days after Lehman’s filing, he had to backtrack by approving an even larger bailout for American International Group.

Dick Fuld, Lehman’s longtime CEO, believed that his bank was too big to fail. Nicknamed “The Gorilla” by those on Wall Street, Fuld thought that he had an ally in Geithner. Hank Paulson, the former head of Goldman Sachs, told Fuld to find a buyer for Lehman before it was too late. Fuld didn’t listen.

As the financial mess started heating up, a German bank, IKG, continued buying CDOs of toxic mortgages, even as prices plummeted. Their bankers were always bragging about their investing prowess. They quickly went belly up.