What We Need to Know About the Crash

Eliot Spitzer says the report from the Angelides Commission, or Financial Crisis Inquiry Commission, must investigate four broad areas of failure if it seeks the same legitimacy as the Pecora commission, which in the Great Depression helped produce the FDIC and SEC. They are:

1) What did the banks' corporate boards know, when did they know it, and what did they divulge to their shareholders?

2) What did compensation committees do wrong?

3) Why did the ratings agencies fail?

4) Why didn't the New York Fed stop this from happening?

I'd like to add two more. First the commission has to look into the way that Fannie Mae and Freddie Mac conducted themselves during the boom-years of the housing bubble. Wrapped up in the question of whether the housing burst was the fault of Fannie and Freddie, or Congressional regulators, or low interest rates, is the broader issue of whether it makes sense to allow government-sponsored entities to operate as the nation's largest home loan clearinghouse.

Second I'd like to see some metanarrative for how the crash happened in the first place. What we know now are the basic steps: the sub-prime mortgage collapse, the toxic assets, the gargantuan writedowns, the snowball effect of the Lehman bankruptcy, and so on. But there is also a lot we don't know. How did a sub-prime rupture turn into a worldwide financial earthquake? How did a series of seemingly rational business decisions contribute to the near collapse of the world economy?

Recommended Reading

My favorite grand unifying theory of the financial collapse right now is this column by Jonathan Rauch, in which he sums up the complex and fascinating theories of Yale's Gary Gorton. Here's Rauch's nutshell, in my even smaller nutshell:

Financial innovation produced a vast network of complicated asset-backed securities traded among what insiders call "shadow banks," or unregulated banks. Shadow banks looking to park cash where it would hold value and earn interest created a short-term securities market -- much like a checking account. But unlike a regular FDIC-insured checking accounts, these deposits would not be guaranteed by the government. So investors borrowing from this shadow depository system had to put up collateral. And they chose ... their asset backed securities.

Why is that dangerous? Because in the shadow banking industry, these deposits, backed by sub-prime mortgages instead of the FDIC, acted as money. Banks relied on them for transactions. "Subprime mortgage debt had entered the money supply." But then the housing bubble burst. Depositors dumped their assets to raise cash and tried to withdraw their money, raiding the shadow depository market, and the money supply crashed.

But really, just read his piece.