The close call of 2008 exposed deep and widespread risks in the financial sector that took the most seasoned industry leaders and federal regulators by surprise. Two years after the government bailout of Bear Stearns set off the first shock wave, the Bulletin checked in with HLS faculty and alumni committed to figuring out what went wrong, for their takes on where the greatest dangers remain in our financial system and what to do about them.

Too interconnected to fail?

“We were on the precipice,” said Professor Hal Scott, director of HLS’s Program on International Financial Systems, referring to the high-wire weeks when federal regulators and Wall Street leaders held nonstop emergency meetings to stave off collapse and decide the fate of Lehman Brothers, AIG and other tottering industry giants. Fast-forward to the present, and Scott said the greatest systemic risk of all “remains the possibility that if a major financial institution fails, others will follow. So far, we have not licked this problem.”

Since AIG’s rescue, and the creation of the TARP safety net, the phrase “Too Big to Fail” (aka “TBTF”) has become the mantra justifying the Wall Street bailouts. Scott considers TBTF misleading. The real question, he said, is, Are there institutions too interconnected to fail? As regulatory reform efforts press forward, “we’re trying to design a modern financial system without knowing the most important, basic facts,” Scott contended. For example, if a major bank failed, “how exposed would another bank be as a result? What percentage of its capital would be at risk? We have no idea.”

According to Professor Hal Scott, the greatest risk is still the possibility that if one institution fails, others will follow. “We have not licked this,” he says.

As he wrote in a December op-ed for The Wall Street Journal, and testified in February before the Senate Committee on Banking, Housing, and Urban Affairs, “We clearly need to know far more about the facts of interconnectedness.” For one thing, Scott would like Congress to demand full accounting with documentation, including details of any counterparty exposure, “of why the Fed and Treasury decided they had to rescue AIG to the tune of $85 billion. They have yet to tell us.” If AIG had indeed failed, he said, given that Goldman Sachs claimed adequate cash collateral, the two entities’ interconnectedness did not mean Goldman Sachs too was doomed; it was an issue of capital exposure. If in fact there are no “adverse consequences from interconnectedness, then the TBTF problem becomes much more manageable”: Instead of “after-the-fact taxpayer-funded bailouts,” as Scott put it, the private sector can bear its losses, with public money injected only after that if there is no other recourse.

Somebody needs to have the big picture

“Nobody likes ‘Too Big to Fail,’” said Professor Howell Jackson ’82. “Everyone thinks there should be consequences when a financial institution becomes insolvent. It’s modestly ironic and counterintuitive that to prevent the Too Big to Fail policy, you have to regulate large institutions in advance.”

Historically, the U.S. regulatory system has been “highly fragmented,” with lots of different agencies overseeing different aspects of the financial system, and divisions between the federal and state governments. This built-in divisiveness, Jackson noted, is “one of the elements of risk we’ve generated for ourselves.” No single regulatory agency has had an industrywide perspective. This has allowed businesses to “take advantage of regulatory gaps and play regulators off one another.” Since the meltdown, Jackson has recommended in publications and talks that the Federal Reserve Board’s authority be expanded to cover all sources of systemic risk in the financial services industry, with better coordination with other regulatory agencies. He supports formation of a financial services oversight council, composed of regulators with frontline responsibilities, “as a step toward more consolidated supervision.” (At publication, Congress was moving in this direction.)

According to Jackson, another unresolved risk that Wall Street’s woes made plain is how hard it is to monitor the financial health of international firms. For example, when now-bankrupt Lehman Brothers got into trouble, the status of its assets outside the United States could not be determined. “We need to harmonize, to coordinate with other national regulatory systems. The problem is, who should do this?” A supranational regulatory body isn’t feasible, he said. “So far, it’s done through informal agreements among coordinators—a slow process.” For now, the Obama administration “is attempting to address cross-border regulatory variations with the G-20 and its Financial Stability Board,” the new regulatory body established post-crisis.

Rely on markets, not regulators

Byron Georgiou ’74 is head of Georgiou Enterprises, is of counsel to Coughlin Stoia Geller Rudman & Robbins and serves on the advisory board of HLS’s Program on Corporate Governance. Based on 10 years of experience investigating and prosecuting financial fraud at Enron, WorldCom, Dynegy and AOL Time Warner, he observed, “Many of the behaviors leading to the crisis were lawful but had unforeseen multiplier effects which regulators missed.” He added, “Of course, to the extent the crisis was caused by criminally fraudulent behavior, we expect that public prosecutors at the federal, state and local levels will enforce applicable laws.”

Byron Georgiou ’74, who serves on the Financial Crisis Inquiry Commission, says “market mechanisms” must be developed to maintain the stability of the financial system.

Georgiou is one of the 10 appointees to the new bipartisan Financial Crisis Inquiry Commission charged with evaluating the prime causes of the financial crisis, in 22 areas ranging from the impact of the housing crisis to the repeal of the Glass-Steagall Act of 1933, originally passed to prevent banks from speculating with depositors’ money. The commission will examine “major financial institutions that failed or would likely have failed without infusion of exceptional taxpayer assistance,” Georgiou said, and will present its report to President Barack Obama ’91 and Congress on Dec. 15.

Georgiou emphasized the need to develop “market mechanisms” to enforce behaviors that can help maintain stability of the financial system and prevent over-reliance on regulation. “One must always assume that financial innovators will come out with new products ahead of regulators” having the tools to regulate them, he explained. In the securitization market, all participants in the creation of mortgage-backed securities—including lawyers, accountants, underwriters, mortgage brokers and rating agencies—were compensated in cash, often with higher percentages for riskier, high-interest products. But once the security was issued, “none of the creators retained an interest in how it performed.” One solution is to require that a significant portion of participants’ fees be paid not in cash but in a long-term retained ownership of the securities they create, “so that their financial interests are aligned with [those of the] investors to whom they sell,” thereby encouraging responsible due diligence at the front and reducing the likelihood of nonperformance.

In the wake of the subprime lending collapse and credit crisis, the number of federal class-action securities filings has surged. Writing with co-authors Jennifer Bethel and Gang Hu (both Babson College faculty members), HLS Professor Allen Ferrell ’95 has suggested that securities class-action litigation either could expose “weak links” in the chain of participants in the process of issuing securities—from origination to underwriting to rating and sale—or could serve “to highlight where the market may have underappreciated certain risks or failed to anticipate particular circumstances.” It remains to be seen whether such litigation can help tamp down future unreasonable risk-taking in the securities markets.

Trouble from the top

Bonuses paid to CEOs of bailed-out companies earlier last year elicited public wrath and brought the topic into public view, but Professors Jesse Fried ’92 and Lucian Bebchuk LL.M. ’80 S.J.D. ’84 have long been studying the corrosive role of unmodulated executive pay. “The boards of investment banks paid executives and traders for short-term performance,” said Fried. “Not surprisingly, the boards got what they paid for. Many of these banks did not make it to the long term.” Some banks that survived are taking steps to improve pay structures, such as lengthening holding periods for the equity executives receive in their compensation packages. Fried thinks holding periods should be longer, and cash bonuses based on short-term results should be smaller. Getting boards to follow suit won’t be easy, however, “because executives and traders will resist.”

The harsh term “clawback” is becoming familiar as the public fumes over bonuses paid to bailed-out AIG executives while legislators and legal experts debate how to rein in excessive compensation. Fried believes that current laws and arrangements impede taking back pay that executives and traders received before their firms are bailed out. At present, “it is difficult to find authority to recover pre-bailout bonuses,” he said. “Compensation contracts rarely require executives to return already-paid bonuses, even if the decisions made while ‘earning’ these payments ruin the firm.” The Sarbanes-Oxley Act permits the government to recover certain bonus payments, but only under very narrow circumstances, and while provisions of the federal Bankruptcy Code and state insolvency statutes could be used to recover payments to executives if the firm becomes insolvent, “the bailout itself prevents the use of these insolvency-triggering clawback provisions.”

Fried would like Congress to adopt a law that allows the government, when it bails out a firm, to claw back cash bonuses paid out to executives and traders in the previous year or two—bonuses that can’t currently be reached. “Right now, too much of the cost of cleaning up a financial firm’s mess falls on the taxpayers’ shoulders; a bailout clawback would force those who profited from the risk-taking to chip in more,” he said, ideally impelling future decision-makers to “think twice before taking financial gambles.”

Security from the SEC?

The Securities and Exchange Commission has taken a drubbing since the meltdown for blinkered inaction and worse. Professor Scott would merge the SEC into a new “USFSA” modeled on the United Kingdom’s FSA (Financial Services Authority), the regulator of all U.K. financial service providers. Said Scott, “One major failure of the current reform proposals is [the lack of] any serious reform of the [U.S.] regulatory structure.” The SEC proved incapable of providing financial supervision before the crisis, he said, and is trying to fix this by creating a new division focused on risk. “But I am skeptical that they can overcome their lawyer-dominated culture.”

That brings us to the notorious legacy of one of Wall Street’s biggest manipulators: Bernie Madoff, a former stockbroker and investment adviser. Now serving a 150-year sentence, he sidestepped SEC detection for many years while swindling clients in the largest Ponzi scheme in history. But on a smaller scale, countless investment advisers took liberties with their clients’ money in the fast-and-loose pre-meltdown markets.

From the vantage point of Norm Champ ’89, an associate regional director for the SEC, the ongoing risk post-crisis “is that investment advisers do not treat their clients fairly.”

From the vantage point of Norm Champ ’89, an associate regional director for the SEC, the ongoing risk post-crisis “is that investment advisers do not treat their clients fairly.” Although they are required to manage their clients’ assets as a fiduciary, said Champ, “we continue to uncover instances of advisers” who fail to disclose “material conflicts of interest to clients as required by law. We’re concerned that this behavior harms investors and undermines public confidence in the markets.” (This point was amplified in April when the SEC brought an enforcement action against Goldman Sachs in connection with the firm’s marketing of mortgage securities.) The SEC is ramping up by hiring more agents and intensifying scrutiny of investment advisers based on risk factors the agency has identified. The reviews focus on areas of investment management “where misconduct is most likely to be found”; the SEC’s Enforcement Division is called in when serious rules violations are discovered.

Inevitably, the number of people criminally prosecuted will be small. According to Professor Bill Stuntz, this highlights the limits of using criminal punishment to police financial markets. “The worst problems affect the whole market, not a small number of badly run firms,” said Stuntz. “Criminal punishment works best when it is precisely targeted. Regulators usually need to paint with a broader brush.”

Legislative reform and the financial industry

“Industry is getting ready for a lot of change,” Scott said, as the legislative package to reform the financial sector moves through the Senate; the House version already voted on waits in the wings. Scott has consulted regularly with House and Senate members and their staffs; surprisingly, despite the bipartisan wrangling and industry foot-dragging, he believes “disagreements actually are not great” on how to deal with derivatives and clearinghouses, design resolution procedures for insolvent financial companies, jump-start private-sector securitization and come up with fixes for the rest of the problems crowding the massive bill.

The main sticking point between Congress and industry has been the CFPA, the proposed consumer financial protection agency that would oversee financial products such as mortgage loans and credit cards. Professor Elizabeth Warren, chairwoman of the TARP Congressional Oversight Panel, has said the Credit Card Accountability, Responsibility, and Disclosure Act passed in 2009 is “a good first step” toward fixing the “broken” consumer credit industry. But she contends an independent CFPA is vital to rein in the big banks, which she has bluntly criticized for deceptive tactics that ensnare ill-informed consumers in disastrous financial positions.

“The easiest way to reduce risk in the system,” says Professor Elizabeth Warren, “is to start at the front end by making the credit market safe again.”

“The lack of meaningful rules over the consumer credit market has destabilized families for a generation and also contributed to the collapse of the global economy,” said Warren. “The easiest way to reduce risk in the system is to start at the front end by making the credit market safe again. This can be done by a new agency with the tools to slim down the fine print and eliminate all the tricks and traps buried in incomprehensible contracts.” (At publication, while the House reform bill included an independent CFPA, its fate in the Senate was uncertain, as a plan to fold the agency into the Fed was gaining traction.)

In Scott’s view, the CFPA’s focus on “credit cards and late fees is small potatoes compared to the high percentage of people’s net worth tied up in real estate. Nobody is really protecting investors in this area. But Elizabeth Warren and I are on the same page when it comes to the mortgage problem: We have yet to come up with a convincing solution to the subprime crisis.” And another wave of foreclosures threatens. As Byron Georgiou pointed out, “We haven’t yet seen the collapse in the commercial mortgage-backed securities. Many of those are due in five years” and will need to be refinanced and reset.

By the time his commission issues its consensus report in December, said Georgiou, “the financial crisis will, regrettably, still very much be with us.”