Fixing the Financial System: The Fix Is In

The Financial Crisis Inquiry Commission was created by Congress "to examine the causes, domestic and global, of the current financial and economic crisis in the United States." But look at what is off-limits.

Having introduced itself last September, the FCIC has finally started taking testimony. I have two primary concerns. The first is that Congress will rush into financial system reforms without the benefit of a proper inquiry into the nature and causes of the crisis. We know that Senator Dodd in particular is eager to have one last great achievement before he departs.

More importantly, I am concerned that the commission will fail to document some of the true underlying causes of the crisis. In particular, the FCIC charter is focused on all things except government interference in the financial markets, especially the market for home mortgages.

There are 22 specific causes of the crisis that the commission is required to examine and report on:

(A) fraud and abuse in the financial sector, including fraud and abuse towards consumers in the mortgage sector;

(B) federal and state financial regulators, including the extent to which they enforced or failed to enforce statutory, regulatory, or supervisory requirements;

(C) the global imbalance of savings, international capital flows, and fiscal imbalances of various governments;

(D) monetary policy and the availability and terms of credit;

(E) accounting practices, including, mark-to-market and fair value rules, and treatment of off-balance sheet vehicles;

(F) tax treatment of financial products and investments;

(G) capital requirements and regulations on leverage and liquidity, including the capital structures of regulated and non-regulated financial entities;

(H) credit rating agencies in the financial system, including reliance on credit ratings by financial institutions and federal financial regulators, the use of credit ratings in financial regulation, and the use of credit ratings in the securitization markets;

(I) lending practices and securitization, including the originate-to-distribute model for extending credit and transferring risk;

(J) affiliations between insured depository institutions and securities, insurance, and other types of non-banking companies;

(K) the concept that certain institutions are "too big to fail" and its impact on market expectations;

(L) corporate governance, including the impact of company conversions from partnerships to corporations;

(M) compensation structures;

(N) changes in compensation for employees of financial companies, as compared to compensation for others with similar skill sets in the labor market;

(O) the legal and regulatory structure of the United States housing market;

(P) derivatives and unregulated financial products and practices, including credit default swaps;

(Q) short-selling;

(R) financial institution reliance on numerical models, including risk models and credit ratings;

(S) the legal and regulatory structure governing financial institutions, including the extent to which the structure creates the opportunity for financial institutions to engage in regulatory arbitrage;

(T) the legal and regulatory structure governing investor and mortgagor protection;

(U) financial institutions and government-sponsored enterprises; and

(V) the quality of due diligence undertaken by financial institutions.

This laundry list implies that the creators of the commission already know all the causes of the crisis and they need to just flesh out the details. There is no provision that they must examine and report on "all other causes which the commission may identify in the course of its inquiry." Most importantly, nowhere in this list will you find the word "legislation," nor any direction to evaluate negative impacts of government interference in free markets.

This is not surprising, the commission having been created by a Reid-Pelosi Congress and approved by President Obama. Clearly, the Democratic Party expects to leverage the Commission's findings into more government intrusion and not less.

By comparison, consider the stated function of The National Commission on Terrorist Attacks Upon the United States (the 9/11 Commission) established by a Republican-controlled Congress and approved by former President Bush. The events of 9/11 were clearly a government failure, and this was recognized in the charter of the commission.

They were broadly directed to investigate and report on "relevant legislation," "[e]xecutive order[s]," and "facts and circumstances relating to (i) intelligence agencies; (ii) law enforcement agencies; (iii) diplomacy; (iv) immigration, nonimmigrant visas, and border control; (v) the flow of assets to terrorist organizations; (vi) commercial aviation; (vii) the role of congressional oversight and resource allocation; and (viii) other areas of the public and private sectors determined relevant by the Commission for its inquiry[.]" Their investigative mission was left completely open by the inclusion of this last item, a far different approach from the language of the FCIC.

I worry that the FCIC will find a myriad of problems with the financial markets, all seemingly ripe for government solutions. But they will refuse to find that government intrusion in the financial markets was a key underlying cause of the crisis. One saving grace is that by the time the commission is scheduled to issue their report next December, we may be looking forward to a much more conservative Congress.