In 2009, Congress Convened the Financial Crisis Inquiry Commission to investigate the causes of the crisis and recommend remedies. Around mid-year, the CEOs of major banks gave testimony on these topics. The comments of Goldman’s Lloyd Blankfein, J.P. Morgan’s Jamie Dimon, Morgan Stanley’s John Mack and Bank of America’s Brian Moynihan shed some light on the causes of the crisis. They also shed “inadvertent” light on Wall Street’s role in creating the debacle.

The word inadvertent is used because of the topics which the bank CEOs tiptoed around or avoided altogether. These evasions constitute important clues regarding the banks’ critical failures. The CEOs clearly felt exposed, legally and politically, and could not risk a candid discussion. For us their evasions are like bread crumbs, marking a path toward the deeper causes of the crisis. This path will also help inform us whether remedies such as Dodd-Frank have adequately fixed the problems.

Broadly speaking, the CEOs painted the following picture of the financial crisis. There was a housing “bubble.” This bubble came about because of public policy favoring expanded home ownership, historically low interest rates, and deteriorating mortgage underwriting standards. The banks made errors in risk management. There was also excessive use of leverage and over-reliance on short-term funding. When housing prices fell in 2007, mortgage securities dropped in value. Lenders became worried about the value of loan collateral and curtailed credit. A “run on the banks” ensued, necessitating widespread bailouts.

By and large, all bank CEOs hewed to a line that their industry was victimized by macro-economic developments they didn’t anticipate, and that their mistakes were honest errors of judgment. Occasionally Jamie Dimon mentioned something more revealing, such as the widespread use of off-balance-sheet Structured Investment Vehicles (SIVs) to disguise banks’ leverage and subprime exposures. Dimon described this use of SIVs as surprisingly huge and irresponsible. He could say these things because J.P. Morgan had refrained from these more egregious forms of misconduct.

What is missing from the CEOs’ depiction and what topics were too hot to discuss? For starters, the word fraud never got mentioned. The closest anyone got to citing fraud was an anodyne mention of “deteriorating underwriting standards.” But fraud, in the form of subprime mortgages with no basis for repayment, was at the core of the crisis. It was fraud that created large volumes of securities which were hugely mispriced. Without vast amounts of securities that once were worth par but, upon colder examination, were possibly worthless, interbank lending would not have shut down. Without the sudden concern that banks’ capital might be wiped out by plummeting securities prices, the “run on the banks” would not have occurred. It takes a valuation error of monumental proportions to trigger a contagion. That error would not have been possible without years of toxic mortgage origination.

This brings up the second topic the CEOs were loath to discuss—honest disclosure. Put simply, the ultimate buyers of these fraudulent instruments did not have key information. Pension funds and money managers did not know that the subprime Residential Mortgage-Backed Securities and CDOs offered them contained “liar loans,” “no-doc loans” and “option ARMs” doomed to fail.

There is no clearer proof of this than Goldman’s Abacus 2007 AC-1 deal. This originated when John Paulson, a big hedge fund player, figured out that large amounts of subprime securities were doomed to fail. He asked Goldman to build a Synthetic CDO (SCDO) composed of such securities and they obliged. Goldman then sold this $2 billion security to institutional buyers without disclosing Paulson’s role or their own knowledge that the referenced securities were chosen for their toxic qualities. When the underlying CDOs became worthless, it cost the investors much of their position. Goldman would later pay an SEC fine of over $500 M for failing to disclose Paulson’s role in creating the SCDO and betting against it. A record fine at the time, it paled in comparison with the tens of billions later paid by other banks. In almost all of these later settlements, inadequate disclosure was the legal basis for bank liability.

Fraud + inadequate disclosure are two legs of the causation chain for the crisis. The third element was structural complexity. Its eventual consequence was to disguise the true quality of subprime securities from analysts and investors. This complexity arrived in two forms: the securitization process and the nature of the securities themselves.

The process for turning individual mortgages into mortgage-backed securities had been around for decades. The vast expansion of subprime mortgages turned the securitization process into a fraud conveyer. Mortgage brokers suddenly were freed from having to live with the consequences of dubious underwriting. They could originate liar loans and pass them on down the chain. Their buyers, usually the investment banks, also had few incentives to question the mortgages’ quality. So long as they could package the loans into securities where the underlying collateral would go uninspected, their incentives were to keep the conveyer belt filled and moving.

Here is where the complex nature of the securities entered. The investment banks had to get their new creations past the Rating Agencies. This they were able to do by convincing the Agencies that when evaluating securities of such complexity, statistical methods were both adequate and efficient. The Agencies were complicit in this decision; their managements had their own reasons for going along with this approach. What is distressingly clear is that neither the investment bank proponents nor the Agencies ever sampled the underlying subprime collateral. This basic technique for dealing with pools of asset-backed securities was used by commercial banks but ignored by the Rating Agencies. Unfortunately, it was the ratings from the Agencies that most investors used when considering whether to buy what the investment banks were selling. Little did they realize they were purchasing fraudulent assets stamped “Grade A” by Agencies who had been persuaded not to inspect the property.

The financial crisis thus resembles a traffic accident where many moving pieces have to align in such a way that a disaster comes to pass. This complex chain of causation enables many participants and commentators to point the finger where it is most convenient for them to point. The banks can point to a housing bubble fueled by abundant credit and low interest rates. Opponents of the Democratic administration or of Dodd-Frank can point to the Community Housing Act or other “Affordable Housing” legislation as original catalysts of disaster. What is also clear, however, is that unethical and illegal behavior by the Wall Street banks was the essential link tying together this chain of causation.

The bankers were the vital middle link. They possessed the best information. They knew that the subprime mortgages increasingly met no reasonable credit tests. They also knew that ultimate investors were being fooled by the ratings given to the complex securities they constructed. In plain terms, the banks knew they were peddling highly risky and in many cases fraudulent assets and they were quite happy to do this. Strikingly, as bank awareness of subprime fraud grew, it only intensified their commitment to push securities through the Rating Agencies and into the market. By late 2006, there was general awareness that the 2006 subprime vintage was highly toxic; the volume of subprime mortgage securities going to the Agencies then reached record levels in 1H’07.

It is interesting that no Wall Street CEO sounded the alarm on subprime fraud before the crisis hit. In 2004 there was already an FBI warning that fraud was rampant—this fact was cited by Inquiry Commission Chairman Angelides during the CEOs’ testimony. Yet, none of Wall Street’s investment banks went to Washington seeking corrective legislation or regulator interventions. There is scant evidence of internal credit and risk committees carefully discriminating among quality and toxic subprime assets. Goldman’s Mortgage Capital Committee reviewed the Abacus 2007 AC-1 deal, signed off on the disclosure and saw no issues. Citigroup’s Residential Lending Group continued to ignore warnings from their internal underwriters that the mortgages they were packaging didn’t meet bank credit standards. Citigroup sold them to Fannie Mae, Freddie Mac and Ginnie Mae anyway, while representing that the mortgages did meet bank standards. The prevailing spirit of the time was perhaps best captured by Citigroup CEO Charles Prince III who famously commented: “as long as the music keeps playing, you’ve got to get up and dance.”

This brings us to the last of the topics the CEOs wished to avoid—their banking business models and the compensation associated with those models. One might ask—What accounts for this systematic failure of moral and ethical leadership at the banks? The answer would be—Astounding levels of compensation rooted in business models comfortable with manipulating markets. Consider first these results:

What can be seen here is that the prelude to the Financial Crisis involved extraordinary performance by the leading investment banks. This in turn was reflected in the compensation paid to its leaders. These rich pay packages set the tone for compensation throughout the firms. It was not uncommon for individual traders and bankers to see annual bonuses of $10 M, $20 M or more. For these individuals, legacy wealth could be achieved by simply delivering a good year in their area.

The business model underpinning these compensation levels grew increasingly dependent on trading and proprietary investing. Investment banks were no longer primarily intermediaries. They were principals putting their own money at risk and looking after its performance. This posture inherently conflicts with their legacy banking roles. Wearing their advisory, fiduciary, or broker hats, banks gain access to a wide range of proprietary information. Although such information supposedly was segregated behind “Chinese walls,” there is little doubt it seeped out to the firm’s traders and partner private equity funds.

In short, the performance depicted above was rooted in a business model that embraced conflicts of interest, harvesting proprietary information, and viewing clients as “counterparties” to be bested whenever possible. Within such a culture and with so much wealth available for the taking, who was going to blow the whistle on excessive risk or unethical conduct? Analysts looking for reasons why risk committees didn’t raise red flags or in-house controls failed to function should look no further than the fact that bank leaders didn’t want to look closely or meddle in the business model producing results. For most of this period, the conveyer belt of subprime mortgage securitization and the subsequent trading, hedging and shorting of its products was a big part of that model.

Bigness itself is the final piece of this model. With size comes more markets to trade in and more contact points yielding information. With size also came balance sheets capable of supporting large bets and yielding great returns when they went right. Unfortunately, with size also came moral hazards. These typically are cited as a “Too Big to Fail” issue. There is, however, a second moral hazard—Too Big to Manage. There is more than a little history suggesting that CEOs at behemoth firms like Citi, BofA, and Merrill had little idea of how employees on the shop floor were generating the results they demanded.

These issues have not just surfaced in discussions of Wall Street ethics. They have emerged in a larger discussion labeled ‘The Financialization of the American Economy’. This perspective highlights how the financial sector has evolved from an enabler of firms producing goods and services to one emphasizing trading and speculation as ends in themselves. In the process, the financial sector has become larger, even outsized in relation to the overall economy. This view questions whether banks’ increasing commitment to trading-driven models is supportive of real growth and productivity. It also raises the possibility that its shaky ethical foundation plus addictions to leverage and risk may be structurally value destructive.

This assessment raises fundamental questions about the banking sector. Do the Big Trading models have to be reined in to provide a firmer foundation for Wall Street ethical conduct? Do banks have to shrink to become more manageable? Do banks need to be shepherded back towards their traditional roles as advisors and capital raisers for the real economy? Banks have extracted large rents from financial markets which they’ve redistributed as compensation across the firm. Do these rents need to be curtailed and trading rendered less remunerative? Does the structure of compensation need to be altered such that risk taking by individuals is no longer a “heads I win, tails the shareholders lose” proposition? Do internal controls need to be a higher priority within firm management systems? Do CEOs who fail to lead on these issues need to be replaced and, depending upon their conduct, prosecuted for legal violations?

These are the issues which the bank CEOs didn’t want to discuss with the Inquiry Commission and they are the issues we now focus on in the post-Crisis case studies. As with the Enron debacle, a legislative fix has been put in place. Then it was Sarbanes-Oxley; now post-Crisis it is Dodd-Frank. As a prelude to the post-Crisis cases, we provide an overview of Dodd-Frank’s provisions and their subsequent implementation by regulators.

In the meantime, here is the link for the CEOs testimony before the Commission. Pay particular attention to the questions asked Lloyd Blankfein by Chairman Angelides and the Goldman CEOs difficulty in providing clear answers. https://www.c-span.org/video/?291292-1/causes-2008-financial-collapse-financial-institution-representatives