UCLA's Segregation Problem

Congress has tasked the Financial Crisis Inquiry Commission, which held initial hearings last week, with making sure that the financial system doesn’t blow up again. The commission looks like a reprise of the 1933 hearings, led by former New York Assistant District Attorney Ferdinand Pecora, that led to Wall Street reforms.

But the Pecora hearings succeeded because they helped Washington understand that finance couldn’t regulate itself. We’re far from relearning that lesson.

In grilling four chief executives of the nation’s banks last Wednesday, the commission’s chairman, former California Treasurer Phil Angelides, got his sound bite. Angelides lacerated Goldman Sachs head Lloyd Blankfein over Goldman’s selling of mortgage-related securities to investors even as Goldman bet against the securities.

“It sounds ... like selling a car with faulty brakes and buying an insurance policy on the buyer,” Angelides said.

Angelides made Blankfein look villainous -- just as, 77 years ago, Pecora, charged with the same task by Congress, made J.P. Morgan and other banking giants look villainous. But shaming financiers was not what made the Pecora hearings important; their real contribution was exposing bankers as powerless to prevent the disaster.

Consider the concession that Pecora won from National City Bank chief Charles Mitchell. Mitchell, exhausted after intense questioning, admitted that “there are so many factors over which the men in finance have no control and really have comparatively little knowledge, that it is just as impossible for them to predict a definite future as it is for anybody else. We are human, we are filled with error, and it does not matter how good our intention may be, we are going to make mistakes.”

Back then, policymakers came to understand that they couldn’t rebuild the financial system by shaming bankers into better behavior.

The problem wasn’t that individuals failed through poor judgment or criminal intent. It was that these inevitable failures resulted in systemic economic catastrophe.

Washington realized that it had to create consistent rules to protect the economy from human folly. Starting in 1933, regulators imposed limits on borrowing for speculation, for example.

For the next 50 years, such rules didn’t prevent firms from making bad bets or bankrupting themselves. The rules did prevent such mistakes from blowing up the economy.

In the ’80s, though, new financial instruments began to evade such rules, gradually bringing us back to the ’20s.

Unfortunately, commissioners last week won no epiphanies that illustrated the need to reapply such rules. Rather, the commissioners, and the bankers, too, often seemed focused on the idea that financiers could have prevented the crisis themselves.

When financiers alluded to lack of control, it was, they implied, because nobody had control. Goldman’s Blankfein likened the financial crisis to a hurricane and said that we couldn’t prevent a “100-year storm.”

But people could have prevented the crisis. It wasn’t the bankers, though, who could have done so by being better bankers. It was regulators who could have prevented it, by applying old rules to new markets.

Applying rules to limit borrowing on credit-default swaps would have muted the economic effect of American International Group’s failure, for example.

If commissioners learn instead that the answer is less greedy bankers who conduct better risk management, the nation will be no better off.

Desire for money and prestige is timeless, as is human error. The task, as it was in the ’30s, is to ensure that human impulses can’t imperil the economy.

This piece originally appeared in City Journal

This piece originally appeared in City Journal