1 Boring Old Man

Back when the financial crisis was first becoming apparent and I was poring over the Internet trying to understand what was happening, I ran across Dr. Robert Shiller – the expert on financial "bubbles." At the time, I didn’t really get the full concept. In several of his articles, he mused on the question, something like, "Why don’t people see that the escalating prices are ‘a bubble’ until it crashes?" Then he goes off on various psychological theories that might explain why.

At the time, I didn’t understand "bubbles" very well, and I thought his formulations of the psychology were naive. I apologize for my own naivity. Shiller’s question is not only the best question around, his version of it isn’t big enough. The current series in the Washington Post on the financial crisis is chilling, but throughout it, Shiller’s question fills the spaces between the paragraphs, "Why didn’t these people see what they were doing?" They were building a house that could not stand. Here’s a guide to the first part of the Washington Post series:

• Part I: Risk and Regulation
  How did the world’s markets come to the brink of collapse? Some say regulators failed. Others claim deregulation left them handcuffed. Who’s right? Both are. This is the story of how Washington never caught up to Wall Street.

  Key Players in Market Regulation
• Part II: Banking Regulator Played Advocate
  The Office of Thrift Supervision let lenders grow out of control, then fail, including IndyMac Bancorp, Washington Mutual, and Downey Savings and Loan.

  Regulator Let IndyMac Bank Falsify Report
• Part III: The Frenzy
  When the housing market began to tank in 2005, Wall Street ran through the yellow light of caution and created even riskier investments — and Washington had no mechanism for finding out what was going on.

  Graphic: How Mortgages Became Part of the Mess

First, it’s Pulitzer Prize level Journalism [it’s just a shame it wasn’t investigated and published several years ago when it might have helped]. Anyone who reads this series and still doesn’t see this crisis as the result of regulatory failure should simply read it again. That is what it says. But the first series doesn’t hold a candle to current one on A.I.G. – another Pulitzer in the making. But as good as the Journalism is, it’s very hard to read without screaming Shiller’s question out loud, "Why didn’t these people see what they were doing?":

• The Beautiful Machine
  Part 1 of 3 | Greed on Wall Street and blindness in Washington certainly helped cause the financial system’s crash. But a deeper explanation begins 20 years ago with a bold experiment to master the variable that has defeated so many visionaries: Risk.
• A Crack in the System
  "…it was a logical extension of what the firm had been doing all along: discovering gaps in regulations and markets."
  Part 2 of 3 | By 1998, AIG Financial Products had made hundreds of millions of dollars and had captured Wall Street’s attention with its precise, finely balanced system for managing risk. Then it subtly turned in a dangerous direction.
• Downgrades And Downfall
  Part 3 of 3 | How could a single unit of AIG cause the giant company’s near-ruin and become a fulcrum of the global financial crisis? By straying from its own rules for managing risk and then failing to anticipate the consequences.

In October, SEC chairman  Christopher Cox appeared at a roundtable discussion that the agency was hosting at its Washington headquarters. He delivered a tough, grim message: The federal government had failed taxpayers by not regulating the swaps market.

"The regulatory blackhole for credit-default swaps is one of the most significant issues we are confronting in the current credit crisis," Cox said, "and it requires immediate legislative action."

He tried to put the regulatory failure into context. "The market for CDS is barely 10 years old. It has doubled in size since just two years ago," he said. "It has grown between the gaps and seams of the current regulatory system, where neither the commission nor any other government agency can reach it. No one has regulatory authority over credit-default swaps — not even to require basic reporting or disclosure."

He went on: "The over-the-counter credit-default swaps market has drawn the world’s major financial institutions and others into a tangled web of interconnections where the failure of any one institution might jeopardize the entire financial system. This is an unacceptable situation for a free-market economy."