Financial Crisis Inquiry Commission: The Private Sector Failed

Editor’s Note: Ben W. Heineman, Jr. is a former GE senior vice president for law and public affairs and a senior fellow at Harvard University’s schools of law and government. This article originally appeared in The Atlantic.

After the Congressionally appointed Financial Crisis Inquiry Commission issued its report last week, there was a virtually unanimous, critical reaction. The report said little new. Its analysis was undermined by sharp partisan division because the six Democratic members differed with the four Republicans about the role of regulation. And its impact would be limited because it appeared after Congress enacted major financial services reform (Dodd-Frank).

But these assessments ignored a fundamental agreement among nine of the 10 members — a source of the report’s continuing importance. The bipartisan commissioners emphatically concluded that one of the primary causes of the meltdown was massive failure of private sector decision-making, especially in major financial institutions.

This consensus highlights an enduring question even in a new era of increased regulation. Given the nearly catastrophic mistakes of many major financial institutions, how can they govern themselves in the future to achieve necessary safety and soundness, to balance properly economic innovation and risk management — to avoid the next self-induced disaster? But the Report is not very acute or cogent or comprehensive on this question of the organizational, motivational, accountability, ethical and cultural failures of the major institutions. Such a sophisticated understanding of internal corporate failures is necessary to devising effective corporate change in the future.

The Commission’s Democratic majority describes in narrative detail the serial failure of homeowners, mortgage originators, mortgage brokers, speculators — then, ultimately and most consequentially, the failure of major financial institutions which created toxic mortgage backed securities and unsecured credit default insurance. These majors failed to see warning signs of a housing market bubble and ignored risk by creating too many unsound assets and assuming too much leverage with too little liquidity. They, not the government, drove us to edge of another Great Depression. The conclusion about massive private sector failure is summed up in a quote from JP Morgan’s CEO Jamie Dimon who, when reflecting on the causes of the crisis, told the Commission: “I blame the management teams 100% and no one else.”

This conclusion about the signal failure of many of our nation’s major financial institutions is also highlighted by three Republican members in their separate statement (Bill Thomas, former chairman of the House Ways and Means Committee; Douglas Holtz-Eakin, former head of the Congressional Budget Office and Keith Hennessey, former economic advisor to President George W. Bush). In assessing the “essential causes” of the crisis, they note a number of private sector failures along the chain from origination to securitization, including the following:

An essential cause of the financial and economic crisis was appallingly bad risk management by the leaders of some of the largest financial institutions in the United States and Europe. Each firm that the Commission examined failed in part because its leaders poorly managed risk.

And they, too, cite the toxic combination in major institutions of overly concentrated assets in one industry (housing); too much leverage; too little liquidity; and poor risk management systems.

The bipartisan consensus of nine of 10 Commission members — after using its subpoena power, reviewing testimony of 700 witness, holding 19 days of public hearing and reviewing millions of documents — puts an important exclamation point on this critical cause. This is so because of the welter of prior views — you will get a list 27 titles (!) if you search Google for “Books on the Financial Crisis.”

Whatever one’s views on the failures of Federal Reserve, the ineffectiveness of other regulators, the poor performance of the credit rating agencies, the mindless cheerleading of business media and certain short-term shareholders or the promotion of affordable housing as national policy, no one made the boards and business leaders of the major private institutions — Merrill Lynch, Citigroup, Bear Stearns, Lehman Brothers, AIG, Goldman Sachs, Morgan Stanley, Bank of America, Washington Mutual, Countrywide et al — take a self-destructive course on the most fundamental decision businesses make: how to allocate capital and under what conditions. Why didn’t leaders ask, critically and skeptically, basic — not esoteric — questions about exposure to one sector, degree of downside risk, amount of leverage and adequacy of liquidity?

Whatever one’s views on the effectiveness of the major provisions of Dodd-Frank, among other things, to assess systemic risk in the financial system, increase capital and liquidity requirements, protect taxpayers from major institutional failure, require more transparency on complex products and give shareholders an advisory voice on executive pay — especially after the numerous and voluminous regulations to implement these provisions are written—-a basic reality remains.

The fundamental capital allocation, risk management and integrity promoting decisions which will dictate whether a firm succumbs to a financial crisis are taken by its board of directors and its business leaders. Unfortunately, the Financial Crisis Inquiry Commission did not go beyond its broad agreement on major institutional failure to analyze cogently and coherently why these major corporations failed, in part because of its narrative style (all 400 plus pages of it).

  • It did not explain how the various levels of checks and balances inside corporations failed to work: operational leadership, the risk function, the finance function, the audits function, the legal function and top leadership and the board of directors. Understanding the dynamics of private firms is essential to understanding the ultimate private sector failure.
  • It did not provide a coherent assessment of whether the problems, at various levels, were due to mistake, negligence, recklessness or intentional acts.
  • It did not seek to untangle the dominant characteristics of key decision-makers and corporate culture which require future attention: hubris, competitiveness, greed, lack of understanding and training, short-termism or misperception of corporate purpose. Greed is an important part of the story, but hardly the whole story in highly complex organizations.
  • It did not, therefore, accomplish its stated goal of explaining the causes of this financial sector failure — for all its extraordinary detail on the development and failure of financial instruments — so that private sector lessons can be learned.

To be sure, there were have been calls for a wide variety of private sector changes since the 2008: elevating the stature and pay of the risk function, better education and training of business leaders on risk management, greater internal transparency on total firm exposure to certain risks, improved risk processes at CEO and board level, restructured executive compensation. (For my own attempt, see the policy brief, Restoring Trust in Corporate Governance: Six Essential Tasks for Boards of Directors and Business Leaders.) And, many financial institutions have made changes in systems and processes, including executive compensation, although not enough has been written about whether these are paper changes or real changes in culture.

But, because of its potential stature, because, in fact, there was agreement among nine of 10 members and because the issue remains critical even after Dodd-Frank, the Commission could have had a greater future impact on this vital subject had its analysis been deeper and more acute.

And this issue of balanced and disciplined private sector decision-making remains significant because, despite the swinging of the regulatory pendulum, it will always be difficult for regulators to keep up with the creativity and dynamism of the private sector due to lack of knowledge and to the difficulty of securing public sector experts at a fraction of private sector compensation. (As Lord Turner, head of the UK’s Financial Services Authority said, the “poachers are better paid then the game keepers.”)

The initial reaction to the Financial Crisis Commission did not, in my view, stress enough its solid consensus on massive private sector failures as a central (in my view the “primary”) cause of the financial and economic melt-down. But the report itself did not, unfortunately, delve deeply enough into why this happened — from operating leaders to risk, finance, audit and legal functions to CEOs and boards — in some of the largest and most important corporations in America.

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  1. Ian Stock
    Posted Tuesday, February 1, 2011 at 9:52 am | Permalink

    Why did the management teams of these elite financial institutions fail? That’s easy: lack of character. Manifest how? Brown-nosing to a pathetic degree, by toeing the party line in an unquestioning manner for fear of earning someone’s displeasure. Leaping on the runaway train which was the housing bubble so that no short-term profit being made by a competitor was not copied, even if the competitor’s behavior made no sense under any basic financial analysis. Where has all the character gone? It’s not just greed, it’s weakness.

  2. aparna more
    Posted Wednesday, February 2, 2011 at 3:35 am | Permalink

    why did rating agencies were not made accountable for their lax ratings? why did no one inquired into unethical profits of CRAs? when whole world was into crisis & facing severe liquidity problems, the only organization that was benefiting was rating agencies, how? CRAs had misused both their powers & position for personal profits & gains at the cost of huge investors, other stakeholders, issuers across the world.they should be made liable and accountable for faulty ratings.

  3. Ami de Chapeaurouge
    Posted Thursday, February 3, 2011 at 5:59 am | Permalink

    Attempt at a Response to Heinemann
    Thanks for your interpretive sketch of where the FCIC, in your mind, is correct and where it didn’t complete its analysis. To my mind, you’ve simply cut the onion in two halves, focusing on one half while neglecting the other. Let me attempt to peel the onion as a whole and look into it in its entirety. One of my intellectual forbears, Alexis de Tocqueville, observed about Harvard University in the early 1830s that it was not a place of vibrant debate, but astonishing uniformity of argument and thought. When I attended Harvard Law School, this was different. As it had lost out to the Realist debate mostly led at the Yale and Columbia Law Schools in the 30s and 40s of the last century, Dean Vorenberg made sure that this time in the form of Critical Legal Studies vibrant debate was implanted in the faculty and there to stay. It is my guess that under the guidance of Martha Minow, such diversity and heterogeneity will persist, at least on the faculty.
    There is no such diversity in this Blog, there is virtually no debate. Whatever attempt is being made at moderate controversy is silenced over although there is not only the divide between activist (Bebchuk and Ackman) and status-quo adherents as far as Governance issues are concerned (the Wachtell partnership); but the gulf between practicing lawyers and academics, between essayists and bloggers, between a domestic audience and people from abroad looking in.
    I’d like to defend the work of the FCIC in that the process by which they arrived at their conclusions was, at times, fabulous. I was sometimes spellbound by the hearings and the timeline and summaries of the Bear Stearns and Lehman controversies were one-of-a-kind works of detail, almost works of art – akin to the impressive level of exhaustive evaluation found otherwise in the Valukas Report on Lehman. As someone who did represent Bear and Lehman as an attorney, I am inclined to side with their senior management rather than dismiss them as ignorant of modern risk management or greedy do-no goods who’ve been sidelined by their extracurricular passions or outsized egos. I am also siding with Peter Wallison and Alan Ferrell. The first succinctly delineated that a distinction between regulated financial institutions and far less regulated shadow banking system market participants was rendered meaningless by virtue of the fact that both got hammered by the markets. I side with Ferrell because he is the author of one of the best quotes:
    In defense of former executives such as Thain and Fuld [but also Cayne and Schwartz], it is well to remember that the short-term funding and refinancing strategy employed by Bear Stearns, Lehman and Merrill was embraced by an entire industry for many years and copied world-wide. As Jennifer E. Bethel, Allen Ferrell, and Gang Hu state: “Even more surprising [than the run on Bear Stearns, my addition] was the funding run on Goldman Sachs, which had minimal asset writedowns and issues with bad MBS and CDOs. Rather than be acquired to mitigate funding issues, it was forced to convert to a commercial bank holding company…… Ultimately it sought access to a commercial bank’s insured deposits and the Federal Reserve’s expansive discount window as an alternative to secured borrowing as a basis for its funding model.” (Legal and Economic Issues in Litigation Arising from the 2007-2008 Credit Crisis, The Harvard John M. Olin Paper Series, November 17, 2008, on p. 30)
    It seems to me that you are taking aim at the modern broker-dealer business model as such, particularly its reliance on overnight repo refinancings and roll-overs. Here, following the rich description of what went awry in the particular instances of Bear and Lehman, I am relying on Darrell Duffie’s rendition in “How Big Banks Fail” (Princeton University Press 2010), but particularly the searching criticism of Mark J. Roe, ‘The Derivatives Market’s Payment Priorities as Financial Crisis Accelerator’ (October 20, 2010 Current version available at
    Stanford Law Review, forthcoming) as to how some of it could have been avoided.
    In this vein: While I believe that plenty of mistakes were committed by Bear’s and Lehman’s respective leadership and bankers through-out the boom-years in various disciplines – the worst mistakes were presumably to run these institutions like military top-down command structures with too little respect and receptivity for constructive dissent as ably described in Michael Lewis’ depiction (in Vanity Fair) of the developments engulfing AIG Financial Products, the London-based subsidiary – it came ultimately down to failures on part of the Federal regulators that brought down the house, compounded by selfish aggressiveness on the part of some market-leaders and competitors in the industry.
    The status change of Goldman and Morgan Stanley still conjures up the question why Richard Fuld’s polite inquiry as to Lehman’s possible change-of-status from broker-dealer to Fed supervised bank holding company was denied in mid-July, whereas Goldman’s and Morgan Stanley’s pertinent requests were granted in September? There seemed a two-way street of unequal treatment or so it appears. It’s the same story with Bear Stearns: access to the Fed’s discount window as of Sunday eve March 16, 2008 was denied, whereas Goldman, Lehman, Morgan Stanley and Merrill were given unhindered access. Treasury, Fed and NY Fed could and should have done better than that. However, this is a story of inconsistent public policy-making in many more ways than just these exhibitions of unequal treatment of bailing out Bear while letting Lehman falter, of denying the discount window to Bear while opening it as of Sunday March 16, 2008 to Merrill, Lehman, Goldman and Morgan Stanley; and of denying Lehman that very change of status from broker-dealer to Fed supervised bank holding company, a move that – as cited above in the Harvard study – saved the existence of Goldman [and Morgan Stanley] while Lehman perished.
    The consequences of these inconsistent public policy moves were aggravated by aggressive trading practices aimed at Bear and Lehman by a whole host of different actors on Wall Street, hedge funds and several travellers from the same industry alike on an institutional plateau. The level on which this fight was carried out was not a personal one. This is so since we have observed very aggressive behavioral pattern on part of some market leaders at the expense of those market participants hit the hardest by the tsunami. It seems as though they had something to do with shortening the latters’ life-span. We witness clearly fratricidal tenets and carnage associated more strongly with images from the Old Testatment than we would view them as some unavoidable rough’n tumble of intense competition.
    I still believe that if Treasury, Fed and NY Fed had a choice, from today’s perspective they would have sold Bear Stearns in an orderly auction at full and fair market value and preservation of most of its job base (to a foreign bidder that would have been given a couple extra days due diligence time), keeping their powder dry for an intervention where the private sector alone couldn’t handle a rescue as proved to be the case in connection with Lehman Brothers. Among academic and public policy makers, only Vincent Reinhart of the AEI has come out consistently on this point over time since his speech in late April 2008 during an AEI seminar when and where he asked repeatedly why there were no auction proceedings for Bear Stearns put in place. It is my conviction that, if given a choice and being allowed to rethink and do it all over again, today Treasury, Fed and NY Fed would have stepped up to the plate and supported Lehman’s survival via a loan structure similar to the one extended to AIG; at least, with the benefit of hindsight, I reckon, they would have found a way to ensure an orderly bankruptcy unwinding of Lehman preserving considerably more value for bondholders and creditors; and taken some heat off the stove for the benefit of all of us inside and outside the United States.
    If anything, the FCC hearings and final Report bring about similar conclusions as to the fate of Lehman and particularly the NY Fed’s truncated analysis of a possible fall-out of a Lehman failulre; on the score of interpreting the Bear rut, I guess I will always be a lonely voice in the desert.

  4. Stephen R. Ganns
    Posted Monday, March 7, 2011 at 1:07 pm | Permalink

    “…it came ultimately down to failures on the part of the Federal regulators that brought down the house…” Ami de Chapeaurouge

    Behaviour will never be regulated; the ability to monitor the holistic system or “connect
    the dots” is again being discussed by various parties–most recently in the report–Enhancing Financial Stability and Resilience: Macroprudential Tools and Systems for the Future. It was a faillure of the system as a whole. Non-existent regulation, abysmal legislation with no forethought of unintended consequences, a former “sophist” Fed Chairman, who didn’t see the whole picture and CEO’s who didn’t fully understand their businesses (isn’t that what a CEO is supposed to do?).

    From a writing of mine:

    “There is inherent value in being a student of history applying heuristic and analytic methods to the research of core phenomena in pursuit of solutions that have the highest probability of success. Below is a program that, importantly, contemplates reviewing a hierarchy of causes of the current financial turmoil to determine which were most contributive. This would be inclusive of recommendations developed from an understanding of the historical events of the past 25 years coupled with a pragmatic understanding of what occurs in the daily world of this strata of various financial transactions. The financial upheaval that is with us today and will continue for an indeterminate amount of time—needs to truly be understood. However, re-tracing specific events leading up to a complex series of problems is especially important to fully grasping the situation before devising a strategy.

    Restoring confidence would mean embracing very
    determined and decisive action. Moving to the beginning of these evolutionary processes one might consider,‘‘What policy actions could have been instituted that might have created systemic regulatory and prudential (supervisory) framework control?’’ These regulatory frameworks are still capable of acting positively today. The categories contained in the frameworks could be carefully defined and enumerated. Embracing these concepts, the program would contain the following attributes and components:

    a. A concise historical timeline of causal events that led up to this severe economic crisis inclusive of the dismantling of earlier safeguards that had been put into place.
    b. An analysis of capitalism by breaking it down to its component parts viz., a) free market theory and b)‘‘financial capitalism’’ (banking and financial services).
    These two concepts, although complementary, in the main have some mutual exclusivity and need not necessarily be synthesized as one theory. Too often, ‘‘capitalism’’and ‘‘free enterprise’’ are used interchangeably although
    they refer to different concepts. One element to
    be reviewed could be the growth of the financial services sector from 15 percent to 25 percent of GDP and the its effect on employment.
    Regulatory anomalies that have occurred over the past 25 years or so which portray a confusing system of financial regulatory frameworks and legislation that have generated an array of unintended consequences through poor coordination. Included would be legislation
    of the late 1990’s.
    c. A review of derivatives, especially the unregulated swaps or OTC markets, and how their existence and use has acted to magnify the bursting of an otherwise severe but manageable series of ‘‘asset bubbles’’ into a complexity at a higher ‘‘order of magnitude’’ than has
    been contemplated in modern times—which has virtually frozen or stalled the capital markets. As a note, these instruments are termed by some as ‘‘welfare enhancing’’
    credit risk transfer instruments—which create
    diversification and liquidity. However, the speculative nature and sheer volume of these unregulated instruments have been daunting to the international financial system and hard on real economies.
    d. The adverse effects of unplanned international support systems in terms of credit, interest rate, and foreign currency derivatives and the roles played by various dealers and other participants.
    e. A view of the inherent flaws of the credit rating agency system.
    f. The concept of ‘‘super anti-efficient’’ or shadow markets and the evolution of special purpose entities (SPEs) as they relate to the current dilemma’s offbalance-sheet transactions and their effects.
    g. Overview of the existing inventory and potential default severity of credit instruments (by asset class)still held by financial institutions (especially housing)
    along with relevant Financial Accounting Standards Board (FASB) accounting procedures.
    s Recommendations for applied remedial actions in an effort to address the current turmoil at its core, and to restore a sense of normalcy to the United States economy, and to the global markets.

    Obviously, other elements would need to be analyzed and solved for, such as residential and commercial real estate valuation and their financings. But the key to any program would be to have one overarching purpose: to allow the markets to clear, reset and move forward. Reinstatement or the creation of new frameworks would provide of new frameworks would provide boundaries to keep the economy on a smooth road.”

  5. Don Cline
    Posted Friday, March 9, 2012 at 3:58 pm | Permalink

    The regulators greased their own palms with money from the specials interests to capitalize on the fake boom from 2002-2005. I would daresay its a failure of both government and private sector. Many officials with oversight of Fannie and Freddi Mac had quoted that the institution was sound. Don’t believe them for a second. They all rode this gravy train until it crashed.

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