by Alan S. Blinder
Penguin Press 2013
496 pages
Focus
Leadership & Management
Strategy
Sales & Marketing
Finance
Human Resources
IT, Production & Logistics
Small Business
Economics & Politics
Industries
Global Business
Career & Self-Development
Concepts & Trends
Take-Aways
Most people dont understand the underlying causes of 2008s financial crisis.
Seven villains are responsible, led by the double bubble of housing and bonds, too
much leverage, absent or passive regulators, and poor lending practices.
Overly complex securities, overrated ratings agencies and crazy compensation
systems round out the list.
A virulent financial crisis began the day Lehman Brothers collapsed.
The $700 billion Troubled Asset Relief Program (TARP) was flawed, but it kept the
economy from flatlining and saved the banking and auto industries.
TARP made a profit and returned all but $32 billion to taxpayers as of March 2012.
The 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act tightened bank
capital, mandated consumer protection and banned bailouts.
Officials and bankers must remember the lessons of the crisis, follow 10 financial
commandments and not rely on self-regulation.
They must respect shareholders, measure risk, use less leverage and keep it simple.
Derivatives, bank equity and compensation need attention, as do consumer-citizens.
Importance
Innovation
Style
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Relevance
What You Will Learn
In this summary, you will learn:r1) What seven villains share the blame for the 2008
financial crisis; 2) How government actions and regulatory reform addressed the crisis;
and 3) What 10 financial commandments bankers, regulators and market participants
should heed in the future.
Recommendation
Youll be surprised at what former Federal Reserve Board vice chairman Alan S. Blinder
has to say about the 2008 financial crisis. After years of research, Blinder fills nearly
500 pages exploring not so much what occurred in 2008 particularly over that fateful
September weekend when Lehman Brothers, AIG and Merrill Lynch hung in the balance
as whats come to pass since. He recognizes that the complexity of the issues, further
muddled by corporate interests, politicization and plain lies, has left most Americans
angry and confused. He also knows that if people dont understand the truth of what
happened, then the US and the world could end up reliving those shattering times, and all
too soon. He sets out to untangle in simple, everyday, often witty prose a knotty web of
issues. He mostly succeeds, but his book requires patience. Reading it is like chatting with
a droll, knowledgeable friend who gives you the straight talk. getAbstract recommends
this forward-looking work to anyone seeking for an honest, clear-headed explication of
past recklessness and current uncertainty.
Summary
We wont restore
trust in government
until Americans
better understand
what happened to
them and what was
done to help.
Whos Responsible?
Most people dont understand what was behind the financial crisis of 2008-2009.
However, they feel its repercussions: vanishing jobs, disappearing credit and diminishing
prosperity. To place blame where its most deserved, let these seven villains take the rap:
1. Double bubble Everyone knows about the housing bubble, and how low interest
rates, easy credit and rising home prices galvanized investors and homeowners to
speculate in real estate. Home building topped out in 2005 and prices reached their
zenith shortly thereafter, but investors kept the momentum going until 2008, feeding
the bond bubble. Mortgages historically were among the safest loans a bank
could make. Financiers saw a market for bundling mortgages into mortgage-backed
securities (MBS). Because no one thought the underlying mortgages assured
against properties all across the nation could all go bad at once, demand surged for
these asset-backed bonds. Investors saw MBS as almost risk-free and considered them
an easy way to earn more than they could on low-yield Treasury securities. Bubbles
are unpreventable; they stem from a basic human construct of greed, herding behavior
and belief that the future will be like the past.
2. Leverage Borrowing, whether corporate or personal, can be necessary or even
useful. Using leverage to speculate and amplify returns is risky. You boost your gains,
but at the same time you boost your losses. Indebtedness soared, from households
that piled on mortgage debt to commercial and investment banks that leveraged their
balance sheets to unprecedented levels. Leverage limits for financial institutions are
a much-needed reform.
After the Music Stopped
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Make the
loan, pocket the
commission, pass
it downstream and
let someone else
worry about the
consequences.
Watching...foreclosures
sweep across the
American landscape
was like watching
a slow-motion train
wreck... But unlike
most train wrecks,
the government
was not a helpless
bystander... It had
the power to do
something...it just
didnt.
It is vital
that we reach
some...verdicts ...quickly
because
Americans welljustified anger is
affecting...poisoning
our political
discourse.
3. Faulty regulatory environment You may well ask, Where were the regulators?
The patchwork of banking industry supervisors, especially the Federal Reserve Board,
looked away when subprime mortgages became 20% of all new mortgages in 2005.
Not all regulators were silent, but many subscribed to a laissez-faire, free-market
belief that saw rules as constraints on capitalism. Regulators did not act when
credit default swaps went from hedging instruments to active, speculative gambles.
Regulatory reform is crucial.
4. Disgraceful practices in subprime lending When a California farm worker
earning less than $15,000 annually could get a $720,000 mortgage, something was
awry. Less-than-scrupulous bankers and mortgage brokers piled loans onto anyone to
reap commissions. They passed those loans onto securitizers, who couldnt handle
the demand for MBS as the subprime market grew far faster than the number of creditworthy borrowers. While US government policy encouraged homeownership as an
American value, Fannie Mae- and Freddie Mac-guaranteed loans had and still have
far lower default rates than private mortgages.
5. Complexity run amok Pooling thousands of mortgages into securities so that
banks could make more loans is a smart risk-management tool. But investors must
understand the composition and quality of those underlying mortgages. Financial
engineers muddied the pools when they packaged portions of loans into tranches.
As mortgage defaults rose, even investors who held top-rated, supposedly safe MBS
suffered losses once considered impossible. Wall Street makes money on complexity
and opacity since clients cant comparison shop what theyre buying. Thats why
the financial industry so opposes regulation of derivatives. Treating derivatives as
tradable instruments on an exchange and requiring MBS creators to hold a financial
interest in the underlying mortgages would help reduce complexity.
6. Overrated ratings agencies Standard & Poors, Moodys and Fitch bestowed
their best ratings on senior tranches of many mortgage-backed securities that later
blew up ratings that only an elite handful of blue-chip corporations and US states
enjoy. Why did these powerful arbiters of credit-worthiness flop? For one, securities
issuers pay for a rating, which skews the agencies motivation to award the best ratings
to a clients issue. If the best possible rating wasnt forthcoming, issuers would rejigger
their securities to match what the agencies deemed worthy. Issuers werent above
shopping among the competitive agencies for the best rating. The ratings agencies
enjoyed such credibility that most investors foreswore their own due diligence and
took the ratings as quality guarantees. Some possible remedies: Have an independent
party pay for ratings to remove conflict of interest, assign rating agencies randomly,
as some courts do with judges, and make agencies legally liable for their ratings.
7. Crazy compensation systems Before investment banks went public, partners
running top financial services firms had their own money at risk. They were
conservative and cautious about their own investments and how they advised their
clients. The modern financial industry provides incentives to smart young people
with large appetites for money and risk taking to gamble with other peoples
money. If they win, they keep the massive spoils; if they lose and lose big
shareholders and taxpayers pick up the tab. Mortgage lenders were paid by the loan,
no matter what its quality. Thus, they needed little encouragement to push credit
on anyone who had a pulse. Government cant dictate compensation structures, but
boards of directors can and should.
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The Troubled
Asset Relief
Program may be
among the most
successful and
least understood
economic policy
innovations in our
nations history.
We got a double
whammy: a sharp
recession followed
by a weak recovery.
No wonder most
Americans think
the recession never
ended.
With something
as mind-numbingly
complex as
overhauling
financial regulation,
public engagement
was bound to be
low, and public
understanding lower
yet.
Steps to Reform
Regulators, politicians and bankers bickered over what happened and who was to
blame, but they agreed that change was due. Consensus grew around several issues that
eventually formed the backbone of the Dodd-Frank Wall Street Reform and Consumer
Protection Act in 2010. Those concepts include:
Too big to fail The act explicitly bans bailouts and provides for the orderly
liquidation of failing institutions.
Systemic risk regulator The Financial Stability Oversight Council will oversee
the financial system to identify macroeconomic risks in the making.
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One European
central
banker...wryly
observed, We dont
let banks fail. We
dont even let dry
cleaners fail.
Securitization Issuers must have skin in the game and keep on their books 5%
of what they issue.
Capital and liquidity requirements The act tightens rules for all banks and raises
them for SIFIs.
Executive compensation The act calls for independent oversight on bankers pay.
Lessons Learned?
Given all the suffering the 2008 crisis brought, the least that officials and executives can
do is learn its hard-won lessons and use that knowledge and experience for the good of
all. The 10 financial commandments for the future are:
1. Thou shalt remember that people forget Extended periods of financial good
times lull you into thinking theyll never end. They end, so beware risks and bubbles.
2. Thou shalt not rely on self-regulation Markets and the people who play in them
need regulators enforcing the rules; market discipline is an oxymoron.
3. Thou shalt honor thy shareholders Boards of directors must do a better job of
safeguarding shareholders interests by holding corporate executives accountable.
4. Thou shalt elevate the importance of risk management Managers should
improve risk-monitoring processes and heed their results. Dont trust, verify.
America was... a
victim of too little
regulation.
5. Thou shalt use less leverage Financiers who chase often illusory profits by
borrowing excessively take on more risk.
6. Thou shalt keep it simple Complicated financial innovations hide real dangers.
7. Thou shalt standardize derivatives and trade them in organized exchanges
Effectively handled and regulated, derivatives can be good risk-management tools,
but they can also be financial weapons of mass destruction.
8. Thou shalt keep things on the balance sheet Parking assets in off-balance-sheet
structures to dodge capital requirements ratcheted up financial institutions risks.
Dodd-Frank brings assets back in the fold for capital calculation purposes.
9. Thou shalt fix perverse compensation systems You get what you pay for. Bank
officials need to gauge whether their incentive programs reward employees for risky
behavior, particularly when incentive setups do not penalize losses.
10. Thou shalt watch out for ordinary consumer-citizens Exposing the banking
customer to predatory financial practices can plunge the entire economy into crisis.
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