Sheila Bair, chairperson of the FDIC from 2006 to 2011, spoke at AIER’s annual trustees meeting last October at its headquarters in Great Barrington, Mass., which coincided with AIER’s 80th anniversary. Here is an abridged version of her speech.

Five Mistakes Washington Made

If the financial crisis taught us anything, it’s that we need some basic regulations in the financial system—not a lot of bureaucracy, just baseline rules. I find that the most effective rules are the ones that align economic incentives with financial stability, versus the nanny-state variety that try to micromanage behavior and tell you what you can do and can’t do.

The mistakes that Washington made leading up to this crisis are all related to a lack of basic regulation. But the government didn’t cause the crisis. Let’s be clear: Greed and shortsightedness caused it.

There’s this myth that somehow the crisis was all about the government wanting poor people to have mortgages. I think this is a really dangerous assumption because it hides what the true underlying causes were. That’s not to let government off the hook. Here are my top five of things that the government did wrong.

1. Failing to discourage Too Big to Fail

The too-big-to-fail institutions go out and take risks with a lot of leverage, make a lot of money and get to keep all the profits—until things go wrong and we taxpayers have to bail them out. That’s actually “Heads they win, tails we taxpayers lose.”

Government-sponsored enterprises (GSEs) like Fanny Mae and Freddie Mac were the quintessential too-big-to-fail institutions. Even though they were not guaranteed by the government, the market clearly thought that they were. They played that up big time. They wanted the market to view them as such, so they could issue a lot of cheap debt.

What did Fanny Mae and Freddie Mac do with all that cheap debt that they issued? They reinvested it in so-called private label subprime mortgage-backed securities. The mortgages that they bought and securitized themselves actually were of reasonably good credit quality. They deteriorated a little bit in credit quality, but for the most part, those didn’t perform too badly. Where they got into trouble was buying of the private-label mortgage-backed securitization, which had these huge yields.

At this point, Fanny May and Freddie Mac essentially became hedge funds; they were almost completely levered. It worked until it didn’t. They had no ability to absorb what became huge losses, which is why they went into conservatorship, where they still are.

They weren’t the only ones. A lot of the big banks were also benefiting from the perception of too big to fail—that they were essentially GSEs, since the government would in all likelihood bail them out, too. At the top of my list is Citigroup.

Citi today is much better managed, but back then that was not the case. If you looked at their board and who they hired, you could see that they really had a business model tied to government connections. The market viewed them as kind of a favored government entity. If you want to look at a list of all the stupid things that people did, Citi pretty much did every single one of them.

The market, particularly bondholders and derivative counterparties, would have never let Citi get away with that if they didn’t think there was some implied government support. They weren’t asking the questions they should. They weren’t challenging the management. They weren’t trying to figure out what kind of risks were going on in these institutions, because they assumed they would be bailed out. And they were essentially right.

While shareholders took some losses, the bondholders and derivative counterparties were basically protected at par. Once again, too big to fail skewed the market incentives and market discipline. That would be the top of my list of government policies that were just stupid.

2. Dropping the ball on mortgage securitization

The second big mistake the government made was how we encouraged securitization of mortgages without really thinking through how securitization might also skew economic incentives. At first, the Freddie Mac-Fanny Mae securitization model worked, because they—with implicit government backing—were guaranteeing the credit risk 100-percent and thus took some measures to insure good loan quality. It went terribly awry later, when the government actively encouraged “private-label securitizations” by big financial institutions, primarily Wall Street firms, who bought up these mortgages, packaged them, and turned them into securities that were sold off to institutional investors without retaining any of the risk.

But when you sever the ownership of the mortgage—severing the risk that the loan would default from the decision to fund and originate the loan to begin with—you get some very skewed economic incentives. Pretty soon you have a volume-driven business because mortgage originators weren’t worried about whether people could afford the mortgages they were signing up for. It wasn’t their problem; they were selling them off as fast as they could get them.

A lot of mortgage originators figured out they could make even more money when people had to refinance a mortgage they couldn’t afford. They got a fee every time somebody financed and refinanced. They were incentivized to sell unaffordable payment resets. So it became a volume driven business. The government didn’t stay on top of that. It was happening right under our noses, and we kept encouraging it.

The other thing that we didn’t figure out was what would happen when the housing market turned. If all of a sudden the mortgage you needed to refinance is higher than the value of your home, you couldn’t get financing anymore. So we had a lot of people who couldn’t refinance, and they defaulted.

With portfolio lending you have a bank that actually makes the mortgage and holds it, there’s always an incentive to do loan workouts for troubled borrowers to minimize steep losses from foreclosures. That is the standard business practice. Foreclosure is an ugly process to go through for most banks because they are distressed sales with very steep losses. If a portfolio lender has a borrower that’s troubled, they try to work with them, get the loan restructured, get the payment down to something affordable, maybe for a temporary period of time, until the borrowers get back on their feet.  Lenders do this to try to minimize those losses because foreclosure losses are usually going to be a lot greater.

The servicers’ incentives were actually skewed towards foreclosure, because they were paid a flat rate to service each loan regardless of whether it was a troubled loan or a performing loan. The investors would take the hit. The servicers were paid the same, so they had no economic incentive to service a loan. And it’s hard to service a loan—to get the borrower on the phone and go through their financials and figure out what kind of mortgage is affordable, what kind of restructuring needs to be done—that takes a lot of staff time and resources, and they weren’t being paid for it.

Not only that, most contracts required the servicers to advance principal and interest payments to the mortgage investors, and they only got repaid once the house went into foreclosure. Until then, they had to keep paying out-of-pocket. And there were other expenses that they could only recoup once they went into foreclosure. So they didn’t have any interest in mitigating losses. The losses ultimately would be there for the investors.

It was completely messed up. It’s still messed up. Which is unfortunate, because I actually like securitization. I think finding a way to move mortgages off lenders’ balance sheets to other investors who have longer investment horizons is a great thing. But we don’t want to bring it back in the way that we had it before.

I think one of the important things about the Dodd-Frank bill was the requirement that securitizers had to keep some skin in the game. They said it was only 5 percent, but I think 5 percent would be enough to change behavior. Yet, regulators have completely backed off that by proposing rules that basically say we don’t need to align economic incentives if we have mortgage-lending standards. That’s very misguided, because prescriptive rules are never as effective as rules that align economic incentives.

If we forced securitizers to eat five cents for every dollar of loss in that securitization—  they could never get away from it—that will change their behavior in the kinds of loans they originate. It will change their behavior and motivations when they have a troubled borrower and it comes time to try to work with them to mitigate losses. At this point, it doesn’t look like we’re going in that direction. The government firmly encouraged securitization—and it’s still not fixing it. 

3. Relaxing capital requirements

Another really dumb thing that the government did that contributed to this crisis involved relaxing bank capital requirements.

Capital regulation is a key component of financial services regulation. Financial institutions operate on a highly leveraged basis. That’s their business model. And again, the too-big-to-fail institutions had the equivalent of puts on the government. If they got into trouble, they could fall back on insured deposits, access the Federal Reserve’s discount window—and—as we saw with the 2008 and 2009 bailouts, they put a lot of the risk on the government when they got into trouble, and ultimately, the taxpayers. So it’s critically important for bank regulators to have tough capital requirements for banks that can fall back on the safety net.

After the savings-and-loan crisis, we put in place some pretty good rules in capital regulation for FDIC insured banks. Then in the late 90s, a bunch of international regulators, called the Basel Committee, decided on a new framework that basically let big banks set their own capital requirements. The idea was that these big banks had a lot of really sophisticated risk-management tools and models and that they would know better than regulators what their true risk was. Therefore, they should be in charge of how much capital they needed to hold.

This is part of the idea that markets can always self-correct, which maybe in a pure world they could. But when a bank is viewed as too big to fail or has hundreds of billions of dollars of insured deposits, you cannot rely on them to do the right thing. They can put a lot of those losses back on the government.

Regulators have to come in and make sure that the banks are funding their risk with lots of shareholder common equity, which is loss absorbing. Debt they have to pay back; common equity can go up or down. It’s an important distinction.

But the regulators decided to allow banks to set their own capital requirements. Fortunately, the FDIC fought it off for the commercial banks that they insured. The commercial banks ran into some problems, but their leverage was nothing like what you saw with the investment banks.

Europe implemented loosened capital requirements in 2004, and you could just see the leverage increasing. Before the new rules, there was about 12-to-1 or 14-to-1 at the investment banks—in other words, $12 of debt for every one dollar of equity they used to fund their balance sheet. Then it shot up to $30 or $40 and even $50. That’s $50 of debt for every $1 of common equity. This was the direct outcome from some very misguided rules, which still haven’t been fixed. Instead of admitting it was a mistake and getting rid of it, regulators keep adding more layers of rules on top of it trying to fix it.

But there is some good news on this horizon because the Federal Reserve, the FDIC, and the Office of the Comptroller of the Currency (OCC) recently proposed a much stronger leverage ratio, which is a simple measure of tangible common equity to total assets. The ratio is 6 percent, which doesn’t sound high, but for the big banks, it actually is pretty high. It would require banks to raise another $100 billion at least. I’d like to see it at 8 percent or 10 percent, but it’s a good start. I think this requirement could give us a far-more stable system by getting more common equity into these banks. 

4. Allowing money market funds to behave like banks

Relaxing regulations on money market funds is another dumb thing the government did. Banks have a lot of regulation if they’ve got insured deposits; they have to pay premiums for it, and they have to have examiners. There’s a very harsh resolution process if they fail. So there’s a lot of cost and expense that goes with being an FDIC-insured bank.

But in the mid-1980s, the SEC decided to let our money market funds act like banks—but not have to mess around with deposit insurance or anything else. The SEC and the markets thought this would be a great thing for money markets because they could offer higher yields without having to deal with all sorts of regulatory costs. The SEC wrote a regulation that basically said that money market funds, just like banks, could promise investors a stable value. A dollar in is a dollar out just like it is with the bank. You could say that even if the securities where you’ve invested are not worth a dollar.

So that worked, until it didn’t. And it really didn’t during the Lehman Brothers bankruptcy. A money market fund called the Reserve Fund had invested in Lehman Brothers’ debt. You might ask why a money market fund would invest in Lehman Brothers debt. Why are they buying commercial paper? Well, they were betting on a bailout. Too big to fail, right?

Well, the government let that one go into bankruptcy, so the Reserve Fund had a loss after all. They “broke the buck” and had to tell their investors that a dollar in didn’t mean a dollar out. This precipitated a run with a lot of other money funds, and the government had to come in with a very significant bailout package. Fortunately, it didn’t lose money. But the end result was taxpayers guaranteeing trillions of dollars on an ad hoc basis for these money funds to stabilize the system.

There is an effort afoot to have money funds act just like any other mutual fund. It’s a securities product, not a bank product. They take investors’ money and invest it in securities, just like any other mutual fund, and investors get out what the fund is worth. But again, there’s tremendous industry opposition. I fear the SEC will back down.

I was testifying on the Hill this fall, and there was a lobbyist for the fund industry there, and I couldn’t believe it. This guy had the chutzpah to say “What’s the big deal; only one fund broke the buck?” But why did only one fund break the buck? Oh yeah, because of that massive government bailout. Amnesia is sitting in big time in Washington, and that is just another example.

5. Lack of derivatives oversight

The fifth area where I think the government really fell down on the job was with regard to derivatives oversight.

Financial regulations are usually centered around institutional regulation, so regulators look at specific institutions. That’s the bank regulation model. Banks that provide financial products and services on a bilateral basis are typically regulated on an institutional level.

Then you have market regulation of securities and bonds and other products where you have deeper markets. They tend to gravitate towards centralized trading and clearing—that is, if the markets are working appropriately. With this kind of regulation, there’s a very different kind of framework: You want a lot of good price transparency with market trading. If you own shares of a public company, you want public pricing of the value of your securities investment. So regulators have a whole host of rules designed to make sure that markets are transparent and liquid and functioning well.

So this new product came up back in the 1980s called the derivative, and big banks were selling them on a bilateral basis. The market started to grow. And as these products became more commoditized, there was some thinking that maybe there should be a centralized market for better price transparency.

Typically, when products become more commoditized and standardized and moved into a centralized trading, the cost comes down due to transparency. These greater market efficiencies produce lower transaction costs. But the banks didn’t want that because they were making tons of money the way things were, selling them on their own.

The banks convinced Congress to pass a law called the Commodity Futures Modernization Act, which basically said that over-the-counter (OTC) derivatives are not futures, which we regulate, and they are not securities, which we regulate. Therefore, nobody gets to regulate them. Hundreds of trillions of dollars of derivatives, and nobody was regulating them. That was considered okay because the big dealers were regulated by the bank regulators, and the reasoning was that nobody else needed to look over their shoulders.

Well, that was just wrong. Bank regulators don’t regulate markets; they look at safety and soundness. And even on safety and soundness grounds, they were letting banks take these huge derivatives positions, because they figured that if the banks were doing a mirror transaction on the other side, they were perfectly hedged.

Well, a lot of those hedges were held by a little institution called AIG, which was left holding the bag. Let’s be clear: There is no perfect hedge. At some point, it has to end, right? Somebody is holding it, and we found out that somebody was AIG. But the market completely lacked transparency—no dealer registrations, no trade reporting—so it was very difficult to know exactly what we were dealing with.

A particular kind of derivative called credit default swaps was really what was driving a lot of the problem. At core, credit default swaps are a form of insurance. You can do derivatives on interest rates and currencies and lots of things, but those are different. Credit default swaps really are insurance. So, if you own a bond that IBM has issued, and you want to hedge against IBM defaulting on that bond—highly unlikely, but let’s say you are unusually cautious—you can go to a big bank and buy credit default swap protection, which basically that means if your bond defaults, J.P. Morgan Chase or some other big bank is going to make good on your losses.

But unlike traditional insurance products, there’s no insurable interest requirement. You can buy credit default protection on IBM bonds whether you own IBM bonds or not. That’s what was going on—you could buy credit default swap protection on just about anything, including mortgages, whether you owned them or not. So a lot of hedge funds were short the housing market by shorting something called the ABX index. If the housing market got into trouble, if folks started defaulting on their mortgages, these hedge funds were going to make a lot of money. They wanted you to default on your mortgage.

Early on, in 2007, we were out there saying we’ve got a problem, that we’ve got to get these loans restructured before too many of them end up in foreclosure. And some of these hedge funds came after us.

Then it was reported in the paper that they were short housing, and they became quiet. But the whole credit default swap situation, with its total lack of insurable interest requirements, created upside-down incentives. It’s like when you buy fire insurance on your house. Your insurance company is going to ask you if you own the house. If you don’t own the house, you have an incentive to burn it down, because that’s how you’ll get paid. It’s kind of the same thing.

On derivatives we’ve actually made some progress. The Commodity Futures Modernization Act has basically been undone. A lot of this is now being moved on to centralized clearing and trading, which I think is positive. But the market still uses speculation. I really think we need an insurable interest requirement for credit default swaps, because its absence creates terribly upside-down economic incentives. The banks hate this. They will probably fight to the death to make sure it will never happen. But I really think this would be a huge change in how that business is conducted.

In conclusion, I believe that rules work best when they align with economic incentives, instead of trying to tell people what to do. We just need to make sure that if they make a mistake, they’re going to take the loss, not somebody else—especially taxpayers. And if we’ve got bad rules, get rid of them. Don’t try to rationalize them, don’t try to tinker with them and change them and add 200 more pages to them. Just get rid of them.

I really worry that not only are the rules getting more complicated, but the regulators, having frankly been so badly embarrassed by this, they are going from a very hands-off approach to more of a command-and-control approach. So you’ve got thousands of examiners going in, and the banks are hiring thousands of compliance staffers who are in there all the time. But it is foolish to think that they can tell the banks how to run their businesses. They cannot. That is destined to failure. That is not a realistic regulatory approach.

And that’s even as we don’t do things like really toughen the capital requirements against the times when banks do make inevitable mistakes—and I don’t care how many thousands of examiners you have, banks are going to make mistakes. To some extent, that’s healthy, so long as the costs aren’t externalized to the rest of us. Having thick cushions of capital could make sure that the rest of us aren’t hurt when banks make mistakes.

These are very real issues. We did not, we did not protect our economy and our society from a lot of very bad behavior in the financial sector, and we need to make sure that that doesn’t happen again.
 

After her presentation, Sheila Bair invited questions. The following reflects that exchange.

Q. There’s talk of reforming Fannie Mae and Freddie Mac. Where do you see that going and what might they look like a few years down the road?

A. I’ve got to tell you, I would really just like to get rid of them. Let’s just see if the housing market can function by itself, with a properly aligned securitization market. I think what’s going to happen is something along the lines of the bill that’s introduced by Senators Corker and Warner, which would basically create a government agency like the FDIC except this agency would be guaranteeing mortgages instead of deposits.

So if you’re going to do it, at least have a government agency do this. Don’t have this hybrid thing with Fannie and Freddie where they privatized all the profits with their government support and then put it back on the government when things blew up. If you are going to guarantee the secondary mortgage market, this is at least a better model, ideally with a 10 percent first loss position for the private sector. That means that the agency would only guarantee 90 percent of the unpaid mortgage principal, and the first 10 percent of losses on those mortgages would have to be absorbed by the market instead of taxpayers.

Q. Should money market funds be changed into ultra-short bond funds?

A. Look, money funds work great when times are good. But if people really want their money funds to have a stable value, then I think the answer probably is to have funds that only invest in very short-term federal government securities. Presumably, since we can print our own money, there is no credit risk with very short-term treasuries, and I think very short-term, the interest rate risk is at least contained. The SEC proposal goes in that direction a little bit. So if we had to have something, I guess I could live with that.

But I still think the best thing is just what is called a floating net asset value or “NAV”.   That is just let the value of the fund float with the actual value of its underlying assets. If you just invest in very short-term treasury securities, if that’s all you invest in, in reality the fluctuation will be very small because the change in market value of very short-term treasuries is going to be very small. So I think you can have that kind of product even with a rule that says this is a security product like any other mutual fund and it has to float with market value.

Q. Could you comment on why there have been no criminal indictments?

A. There was a lot of fraud going on. And I don’t have a good feel of how far up the management chain people knew it was going on. People were certainly looking the other way when they shouldn’t have been. I think even if we didn’t have more criminal indictments, we should have had more personal financial accountability. That’s one of the things that drives me crazy about the enforcement cases even now.

It’s still the corporations paying it; it’s the shareholders paying it. How are you going to change behavior if, even when you bring the civil suits, which are much easier to prove than the criminal suits, it’s the corporation that’s paying for it?

One of the things that I like about Dodd-Frank is now if the big institution fails, it has to go through what is called the Title II resolution process. By statute, the top managers lose their jobs, the boards lose their job, and there is an automatic three-year callback of compensation, all of it. If Dick Fuld had known that was going to happen to him, he would’ve sold Lehman while he still had the opportunity and there were interested buyers. It never would’ve failed. But as it was, he thought he was going to get a bailout.

Q. You’ve listed five things that government did wrong. How is it that a lot of these problems are still not fixed?

A. Yes, it’s amazing. They’re still not fixed. I think it’s a lot of different things. I think it’s an unwillingness to admit past mistakes. You can’t fix things until you acknowledge something could have been done differently. And there is a huge industry lobby against it. And I think the regulators can also be too insular in their perspective. And it’s really not corruption. It’s what I call cognitive capture. They start looking at the world the way the banks they regulate look at the world. Even with this terrible crisis, there’s a tremendous amount of resistance to actually getting meaningful changes.

Q. Do we need to fix the incentives of the regulators?

A. I would argue for lifetime bans on the revolving door. You can’t ever work for someone you regulated.  And people hate that. But I think you also need to enhance the status of regulators. You pay them more. You give them better opportunities. You make it like the Foreign Service, a world-class career to aspire to. That’s what I would love to see. But the revolving door is just an accepted way of doing business right now, and I think that even with the best people, that will alter their mindsets in a way that’s just not helpful.

Q. I think it’s very important to align incentives and risk, especially when the asset sides of the balance sheets were so inflated. How might we go about doing that?

A. I think at the end of the day it would be nice if we could get rid of too big to fail so that bond investors in particular understand they are on the hook. If they were, I think you could get market discipline to demand greater transparency and more realistic valuations. Tinkering with the accounting rules is just so hard, and the solution is not clear. I would like to think that the market itself could correct for that again if we can get rid of too-big–to-fail.

Q. Too-big-to-fail is actually bigger now and you said that markets in a pure world might have taken care of them, but were the markets even given a chance to? A lot of the players who made bad decisions were never held responsible and are still in those same institutions.

A. I couldn’t agree with you more. We could have at least fired some people, or made them take 10 percent haircuts, even cut back on their bonuses. We didn’t even do that.

When Citibank came back for a second helping of bailout money, one of our examiners had a great idea. We were pushing it. He said okay, but if there are any government losses on this bailout, you lose your bonuses. There will be no executive bonuses if the taxpayers lose any money. We could not get any the other regulators to agree even to that. It was unbelievable, the mindset. All they cared about was system stability.

But that’s this cognitive capture again. When you start confusing your job with whether banks are profitable, you’ve got a problem. 

I think at least in 2009 when the system had relatively stabilized, we could have imposed some pain then. The system stability arguments were not even there anymore, and we still couldn’t get it.

We pushed for a proposal, which Tim Geithner actually announced and then didn’t want to follow through on, to force the banks to sell their bad assets into a facility. I think the reason Tim and others ultimately did not want to do it was because the banks would’ve had to take huge losses by selling those assets. Well, yeah, duh. But they thought system stability was showing the banks profitable again. And if you made them take losses, the people wouldn’t have confidence.

That might make a little bit of sense in the short-term, long-term you’re making the system much more unstable because you are not letting the market work the way it should. You are not getting those stressed sales, with really cheap prices where vulture funds can come in, buy the loans, get them restructured, write-down principal. That’s the way the market works. And that’s the way it should work. But by doing that, the banks would’ve had to take big losses, and the government didn’t want to force those losses.

Q. I’m really troubled by having one or two appointed gurus making decisions that change the entire or affect the entire world economy. As someone who lives in a democracy, I like accountable decision-makers. Is there some way that the Fed could be made more accountable to the citizens when they make decisions that are going to affect the entire world economy?

A. I’ve been a huge critic of the Fed’s monetary policy. The Fed has been buying bonds for a long time now, but it’s not working. I think it’s making matters worse. Somebody said it’s like giving the drunk another sip of the bottle.

I like rules-based monetary policy. I think the bond and stock markets are so overvalued right now, it’s going to be very, very difficult for them to get off the stimulus. If it does end badly again, and it could very well, then I don’t know if we have the Fed anymore. Unfortunately, we need something like the Fed, but I think it could really backlash the other way. So I share your frustration.

Q. You talked about something very important for this entire nation and you have the undivided attention of every single person in this room. What thoughts have you had about leveraging the impact of your analyses?

A. That’s a good question. I’m just one person, so I go out, I do the book, give speeches like this, and I write a column for Fortune. I have my individual views and I also head a group called the Systemic Risk Council. We have a website called SystemicRiskCounsel.org. On money-fund reform and bank capital, we’ve weighed in heavily, and if you would like to engage on those two issues, there’s a lot of good information on our website on that.

We should try, as you say, to leverage people who are concerned about this as much as I am. I think Washington just keeps hoping that it will just go away, the big banks just keep hoping all of this will go away—and it’s not. People are angry. They are so upset and concerned, and they rightfully see it’s not getting fixed, and we could be setting ourselves up for another crisis that’s even worse.

Sheila Bair, who served as chairperson of the FDIC from 2006 to 2011, was one of the first regulators in Washington to sound the alarm about the explosive growth in subprime mortgages and related predatory lending practices. Although regarded as something of a bureaucratic backwater, Bair aggressively raised the FDIC’s profile as she worked with Treasury and the Federal Reserve to stem what would soon become a full-blown financial crisis.

A no-nonsense Kansas Republican, with many years of experience navigating Capitol Hill as a top aide to Bob Dole, as well as monitoring the financial markets, Bair became an unlikely hero to those who felt taxpayers were footing the bill for Wall Street’s excesses.

Bair, who has twice been named the second most powerful woman in the world by Forbes magazine (right behind German Chancellor Angela Merkel), has also been the recipient of the John F. Kennedy Profile in Courage Award, among other awards. Her book about the financial crisis, Bull by the Horns: Fighting to Save Main Street from Wall Street and Wall Street from Itself, was published in 2012 by Free Press.