What does the partisan split on that question mean for preventing future economic disasters?
Updated January 30, 2011, 07:02 PM
Yves Smith writes the blog Naked Capitalism. She is the head of Aurora Advisors, a management consulting firm, and the author of "Econned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism."
Despite its length, the Financial Crisis Inquiry Commission's central conclusion, that the crisis was avoidable, merely validates conventional wisdom.
The report fails to tie together elements like excessive leverage, imprudent investment, poor risk management, lack of government oversight and opaqueness. These conclusions, in turn, rest on one foundation, namely, massive fraud in the residential mortgage-backed security and collateralized debt obligation markets. But that's insufficient. Why, starting in 2005, did investors increasingly demand not just any old subprime loans, but the "spreadiest" or worst, even as appetite for good mortgages was falling?
The answer is simple: follow the money. John Paulson made nearly $20 billion for his hedge fund by shorting subprime. This amount of money was simply inconceivable in the mortgage business prior to that point. How did this happen? Paulson didn't make this money by investing in good loans, but by investing in bad ones. A small cartel subverted the market to create bad loans so they could bet against them. By any normal standard, this activity was both fraudulent and obscenely profitable.
The failure to dig into how the industry profited from creating toxic instruments seems designed to preserve the fiction that the 2010 financial reforms are adequate. If the meltdown was the result of deliberately subverting normal checks against the creation of bad products, that implies that you cannot rely on the system to correct itself, that both root and branch reform, including replacing individuals who perpetrated and oversaw these abuses, is critical to putting the major dealer banks back on a sound footing.
Follow the money is a simple rule, and it's one the commission should have heeded. Failing to do so led the commissioners to produce a wandering, ponderous description of things in the capital markets they don't like. All versions of the report, including the dissents, are irrelevant.
Jeffry A. Frieden, professor of government
Anat R. Admati, professor, Stanford University
Nicole Gelinas, Manhattan Institute
Yves Smith, Naked Capitalism
William K. Black, professor of economics and law
Jeffrey A. Miron, economist
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