A Failure of Capitalism?

In 2008 testimony to the House Committee on Oversight and Government Reform in the days following the failure of Lehman Brothers, former Federal Bank chair Alan Greenspan told Congress, “Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief.” Law and economics icon Judge Richard Posner wrote in his 2009 book entitled “The Failure of Capitalism” that “we are learning from [the crisis] that we need a more active and intelligent government to keep our model of a capitalist economy from running off the rails.”

How did the economy run off the rails in 2008? New revelations have just surfaced that should add additional “shocked disbelief” to Greenspan’s admittedly flawed worldview. Last Wednesday, news from Congressional interrogation shows that Washington Mutual, once the nation’s largest savings and loan association, was deliberately packaging mortgages they knew were delinquent or strongly believed would become delinquent, and securitized them as CDOs to pass the risk of known or sure default on to investors. The bank admittedly and purposefully "used shoddy lending practices . . . to make tens of thousands of high-risk home loans that too often contained excessive risk, fraudulent information or errors” according to the congressional report. The bank, in its reckless pursuit of profits, in the face of competition that had materially minimized its returns resorted to innovative new financial instruments that instead of freeing up capital caused a financial collapse.

In light of this purported failure of capitalism, have Wall Street investment banks and national commercial banks changed their practices—reined in the reckless pursuit of profits at the expense of consumers and shareholders? It appears that the answer is no. Eighteen banks, including Goldman Sachs, JP Morgan and Citigroup, "understated their debt levels used to fund securities trades by lowering them an average of 42% at the end of each of the past five quarterly periods." The very banks that needed bailout money from the U.S. taxpayers in 2008, have for the past five quarters in 2009 and 2010 manipulated their balance sheets by hiding their true risk exposure directly before required quarterly disclosures are due to investors. While these banks argue that this manipulation of balance sheets falls within GAAP (generally accepted accounting principles), that is also the argument that Lehman Brothers makes in response to its “repo 105” practice that has been slammed in the recent Valukas Report.

The incentives inherent in a deregulated market, the private market discipline mantra of Alan Greenspan and the insatiable greed exhibited by Wall Street bank executives clearly do not promote the public welfare. Un-regulated markets that incentivize failure for profit rather than sustainable growth are not beneficial no matter how “free.”

Cross-posted on the SALT Law Blog.