An Interview of William Isaac by Derek Parker for In the Black magazine.
Author Bill Isaac talks to Derek Parker about what he thinks caused the global meltdown – and what lessons still need to be learned.
Ill-considered attempts to address financial problems often do more harm than good, and the response of United States policymakers to the crisis of 2007-08 was a painful example, according to Bill Isaac, who headed the Federal Deposit Insurance Corporation (FDIC) during similarly troubled times – the banking crisis of the 1980s.
Isaac is the author of Senseless Panic: How Washington Failed America, which details how credit problems in the financial system were turned into a much larger economic crisis in 2007 and 2008.
He pins the blame on inconsistent crisis management policies, as well as faulty regulatory and accounting policies that were put into place during the two decades following the 1980s banking crisis.
Isaac is also the chairman of LECG Global Financial Services, which provides high-level analysis, testimony and consulting services.
“In 2007-08, there was a loss of public confidence in political leaders that was not seen in the crisis of the 1980s,” he says. “The 1980s began with shockingly high interest rates of 21.5 per cent, designed to break the back of inflation. It resulted in a very serious and protracted recession, with unemployment reaching 11 per cent.
“The entire savings and loans sector was on the verge of insolvency, the agricultural sector fell into depression, a bubble in the energy sector collapsed, there was a serious real estate recession, and the major banks were bloated with poor-quality debt from developing countries.
“In 2007, the economy was in pretty good shape by all measures, yet the problems in the financial system were not contained and worldwide panic ensued.”
The role of the FDIC was to organise mergers of banks and thrifts, and to help others restructure themselves. In some cases, toxic assets were acquired by the FDIC. Altogether, the FDIC handled about 3000 bank and savings-and-loan failures, including many of the largest banks in the country. Isaac’s key point is that dealing with the 1980s crisis took place according to a clear plan, with careful attention paid to consistency, transparency and maintaining public confidence.
“In comparison, it was very hard to tell who was in charge in 2008 and whether they had a coherent strategy,” says Isaac. “When Bear Stearns was on the brink, the government arranged for JP Morgan Chase to purchase it with considerable assistance from the Fed. Then Lehman Brothers was allowed to go into bankruptcy.
“Next AIG was bailed out. Senior government officials repeatedly stated that mortgage giants Fannie Mae and Freddie Mac were sound and did not need government assistance – right up to the point that they were nationalised. The markets could not determine who would fail next or how they would be handled. It created a severe financial panic.
“The situation was further inflamed by the language used by key players. When the secretary of the US Treasury, Henry Paulson, went to Congress to argue in favour of the Troubled Asset Relief Program (TARP) legislation, he talked about ‘financial Armageddon’. Not the sort of thing to build public confidence.”
Isaac argued against the TARP legislation before Congress, saying it would be a huge waste of public funds. He notes that it was never used for its intended purpose of removing toxic assets from the balance sheets of struggling banks, but instead became a fund to quasi-nationalise auto companies and large financial institutions. It scared the public and created a severe political backlash, which has yet to run its course.
“When you look back at the crisis of 2008, the US Treasury did much to create the atmosphere of panic,” Isaac says. “It is a political agency not designed for crisis management or for bank supervision.
“It was dominated by people from investment banks who see the world through that prism, when what was needed was a non-political approach by people with a deep understanding of prudential supervision and crisis management.”
Isaac’s views have been criticised by some commentators and participants who saw derivative products – such as the collateral debt swaps that tied financial institutions together and increased their vulnerability – as the main reason for the 2007-08 crisis.
Isaac counters that banks have long been connected through crossholdings, and that securitisation has existed for decades, albeit under different names. “In any event, and irrespective of the causes of the crisis,” he says, “the government failed to take care of priority number one: maintaining public confidence in the financial system.”
Isaac takes the view that policymakers did not draw the right lessons from the 1980s. He is particularly critical of the shift to mark-to-market accounting, rigid rules and reliance on mathematical models, arguing that they have tended to accentuate the boom/bust cycle.
Likewise, he believes that changes to regulatory agencies moved in the wrong direction. The FDIC lost its crisis-resolution power around 1991, and much of its independence; it now has to work through the Treasury. Moreover, the financial reform bill pending in Congress would largely strip the Federal Reserve of its ability to contain a crisis.
Plans for a new independent banking supervisory body were put forward in late 2009 but were abandoned when the key figure advocating them, Senator Chris Dodd, announced his retirement.
The creation of a systemic risk council was another good idea that ran foul of Washington politics, says Isaac. The original concept was that the council would have an overview of the whole financial system, but the legislation setting it up makes it subservient to the agencies it is supposed to be overseeing.
Isaac accepts that there is a tension, at the international level, between the globalisation of financial markets and the national nature of regulation. However, he sees little prospect of a global super-regulator and would not welcome the creation of one. He would prefer increased cross-border co-operation among regulatory agencies and governments.
“There is the larger question about the compatibility of democracy and effective financial regulation,” he says. “One aspect of the inconsistency that turned a problem into a panic was over-sensitivity to criticism from the media and from political opponents.”
Certainly, everyone who works in a public-service role has to be aware of the supremacy of those who are elected to represent the people, but the other side of that coin is that elected representatives have to be willing to let regulators do their job. The bills pending in Congress are campaign documents, not serious financial reform measures.”
The US might be through the worst of the crisis but Isaac has deep worries about the long term.
“There is a lot of truth in the saying that those who fail to remember the past are condemned to repeat it,” he says. “I wish I could say that the right lessons have been learned in the US. But I have experienced three major banking crises in my professional lifetime and I fear I will live through a fourth if Congress passes the legislation currently before it.”
Bill Isaac will speak at the 2010 CPA Congress in Sydney and Melbourne. For more information, visit: www.cpacongress.com.au.