Who Shot John?

I have several objections to the efforts to assign personal responsibility for the financial mess. They all pretty much boil down to asking the wrong question, because the question itself proceeds from a bad premise.

That premise is that things will be all better if the person or persons responsible are “held accountable.” I do not believe that premise holds. We suffered a systemic collapse, and we need systemic solutions. Finding wrong-doers is necessary, but it is not sufficient, and it is not more important than finding systemic causes and fixes.

We build dams to hold back rivers. But what happens when there is a storm upstream, or unprecedented ice melting, or whatever, and the river comes at the dam with unprecedented fury? If the dam breaks, we can, and should ask why it broke. But that answer won’t help us if we have not dealt with the possibility that, if the dam had not broken, it would have been overtopped, causing some flooding anyway, or that the banks would have flooded, hurting the people who live along the river instead of those in the town below the dam. We must deal with the fact that the water had to go somewhere.

Now, we certainly don’t want our towns defended by dams that will not hold, so something must be done about the dam. If we can figure out whose contribution to the dam failed, we need to find a new contributor for that part of the damming process. But we ought not to fool ourselves: the real problem was the river. We need to be asking what we can do to prevent the river from coming down on us like that, and nothing else we ask should be viewed as more important than, or as a substitute for, that inquiry.

And even if we do identify a “culprit” – someone who should have done a better job – we need to find a way to prevent the person who gets that job next from being able to make the same mistakes. Probity and competence are nice, but systemic changes – regulations – are critical to counteract human foibles. To the extent that removing people becomes an obsession, fixing the system that made their bad behavior possible loses its urgency. So, again, actually naming names and lopping heads can be counterproductive, however satisfying it may be.

Consider one domino in the financial mess: the ratings agencies. They were, in my opinion, the guys whose part of the dam cracked. Goldman Sachs is accused of selling short against securities that they created, after “persuading” the ratings agencies to issue those securities high ratings. What if the agencies had said “no.”? What if no subprime-backed paper got AAA ratings? What if the ratings agencies announced that paper backed only by alleged property values (and by none of the usual mortgage underwriting tests) would only be rated AAA if it could withstand a 50% decline in the value of the underlying real estate? What would have been issued, what would have been sold short, what defaults could have been swapped, etc.?

I don’t know the actual numbers associated with the various things that went wrong. I’m quite certain that credit default swaps should have been illegal from Day 1, and that CDS contracts unrelated to mortgage-backed securities could have done enormous harm even without the sub-prime mess. But again, if I were at a ratings agency, I would never issue an AAA-rating to any security that could be backed by a CDS: the moral hazard imposed on the securities by the very existence of CDS contracts would be enough to make the security risky. Indeed, the mere legality or, at least the apparent, and so-far untested, legality of CDS contracts should have been enough to make ratings agencies unwilling to rate any paper as virtually risk-free.

But what are we to do about the ratings agency problem? To the extent that ratings agencies were corrupted or insufficiently vigilant by reason of their business model – issuers paying for ratings – we need a new ratings mechanism, something like the Underwriters Lab, where the people with skin in the game pay for the rating and demand toughness rather than accommodation from the agency. But that may not be enough, because I’m not sure anyone at the ratings agencies should have been able to dope out the moral hazard created by naked CDS contracts, and, especially those situations where naked short selling was used as an accelerant for torching the underlying paper.

To prevent the systemic risks, we need bans on CDS contracts and naked short selling. Those bans, I submit, would be more important than a change in the agencies’ business model. Not because changing the business model wouldn’t be a good idea, but because the business model has been in place for many years, and absent systemic threats like sub-prime lending and naked CDS contracts and naked short-selling, the occasional ratings error wouldn’t bring down the whole house of cards. Because there wouldn’t be a house of cards.

So even blaming the people that I blame the most for the mess – in terms of being the weakest link in the chain – would be a distraction from the systemic changes necessary to keep the dam from breaking. And even those systemic changes would be a distraction from figuring out what caused the flood, and whether shoring up the dam would have prevented the mess, or merely changed its shape.

My earliest posts to this blog were about the water – petro- and sino-dollars, but I have not tried to figure out where those dollars would have gone if we had not created phony AAA-rated paper to receive them. The answer, I think, is to financing the Federal debt, and the consequences of that deserve their own post or two. For now, though, I only want to say about that inquiry is that nothing in the blame game leads us to it – that Mr. Angelides’s lynch mob, charged with “inquiring” into the causes of the financial crisis, doesn’t seem at all interested, and that all this talk about taxing banks and bankers is a further distraction. When the scapegoat has been slaughtered, will we still care - have we ever cared - what really happened?