Sunday, April 18, 2010

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.


  1. GERMAINE ANTHONY AUSTINApril 18, 2010 at 10:58 PM

    Well, where should we begin? I think wow, is the expression that comes to mind. Where is the accountability? Investors look towards the help of the International Accounting Standards Board (IASB) and the SEC for protection from predatory lending practices. So why are such frivolous claims, found in the gray areas of respectable standards, strong enough to hold them back? It's sad that we are seeing this situation repeat itself time and time again and the same excuse is used over and over, “it’s allowable under the Generally Accepted Accounting Standards.”

    Why isn't there a rush to make amendments to the Principles to prevent this sort of thing? The same defense used by the Lehman brothers is the similar defense being used in this situation. This article made me reminisce about the first concept taught to me by my Business Association's professor, Professor Clark. "Why does someone own a business or interest in a business? To make a profit, for some it's that simple. However, are we so concerned about making a profit that we forgot about honest business ownership: offering value; helping people; valuing investors; economic responsibility and; responsible lending?

    Why should we remember, right, when there are organizations in place to remember those things for us (IASB, SEC, among others)? Personally, I think it's cowardly, irresponsible and selfish for big lending companies to use the people that keep them in business, when facing down the throat of competition. After all, when their reckless practices are exposed there are only a few results, the company fails, the lives of their investors, shareholders and customers fail and even the economy fails. I didn’t see any adequate justifications for doing the things that Washington Mutual did. It was all wrong, intentional, deliberate, misrepresented, and fraudulent practices. So the excuse is, “it’s allowable under GAAP.”

    Maybe it is allowable, after reading in between the small printed lines right after the words, warning may cause economic failure and other retarded effects. This is a problem that is yet to be fixed, so should we blame GAAP or those who use GAAP as a shady defense. One more thing, when is it too early to start the accountability process.

  2. "Failure of capitalism...." This title has me questioning what "capitalism" really means to people. I pulled a definition for capitalism from Webster online:

    "an economic system characterized by private or corporate ownership of capital goods, by investments that are determined by private decision, and by prices, production, and the distribution of goods that are determined mainly by competition in a free market"

    Call me crazy, but it sounds to me after reading Mr. Austin's post that these banks did just that and while following the GAAP. I'm not saying that their actions are excusable but I'm wondering why we should trust the government over the business men of this country. I don't think they are any different. Their motives may not necessarily be wealth but of course reelection. As always, I'm apprehensive.

  3. What I feel is most disturbing is the information in the congressional report about the tens and thousands of high risk home loans that contained fraudulent errors. Owning a home is the very essence of the American Dream. Clearly, that dream does not include foreclosure, which is what banks are setting many home buyers up for by giving them loans that they cannot afford.

    I don't believe they were even interested in whether these people could really afford these loans. I don't understand those that are against any and all regulation and oversight of these money-hungry banks. Look at what they do when left to their own devices. Its just like a parent child-relationship. When your child is behaving well, you give them more freedom. when they behave poorly, you take away more freedom. All of wall-street should be on punishment.

  4. I think that what Washington Mutual and other banks did was nothing less than toxic dumping into the financial markets. They knew what they were doing would destroy the environment they work in and they recklessly dumped their toxic products into the market. There needs to be accountability for the poison that the banks dumped into the financial markets.

    Not only did the financial institutions dump the risk into the markets, but they then tried to cover it up? Come on - there needs to be immediate repercussions for the industry and someone needs to regulate to make sure this is avoided in the future.

  5. I agree with this article whole-heartedly. However, the only issue I have with this and other articles that deal with these current economic issues is the tone that is taken when discussing "capitalism". I fear that capitalism will soon become a dirty word and this is unfortunate. Most of the issues we are dealing with now are not the result of capitalism, but the result of pure greed and corruption. As some one who has many family members who have dealt firsthand with communism and socialism, I can honestly say that capitalism is by far the most most fair and efficiently ran economic system.

  6. I agree with the article above, however I find it disturbing that capitalism is slowly becoming a dirty word. Having had many relatives live under communist and socialist regimes, I can easily say that capitalism is by far the most fair and efficient economic system. The problem currently is caused by rampant greed and government corruption not a free market system.

  7. 4/18/10 “A Failure of Capitalism”

    The Greenspan model in which there is an assumption that the market will regulate itself may have worked in the 90s when there was massive surplus and the housing market boom followed the Internet boom which followed the technology/computer boom of the 90s. With so much success in the market being upheld by different fields and spectra of American economy, it seemed as though there would never be a bust that would last long enough to curtail massive gains by these companies.
    This recession is not only due to the subprime markets or a regression of the housing market boom; it was coupled with deregulation. Deregulation that occurred as a result of greed. Many felt that the money would never stop flowing so they risked the future of their companies (and shareholders) for the present of making what seemed to be plentiful and boundless gains.
    This wasn't really noticed until this current recession. And now financial like Greenspan have realized that no regulations for large corporations is not helpful to shareholders of these corporations because most shareholders do not have enough money to effectuate change or to elect those who do control their capital. While this may seem like a small procedural problem at first, it becomes a larger hole when you look at how many large corporations have found ways to abuse shareholder capital to profit themselves or the board; and not to profit the shareholders.

  8. I agree with many of the other postings. I do not believe that we are dealing with a failure of capitalism. Instead, it is a manipulation of the economic system by Wall Street. Capitalism is not set up to fail for many, while greatly profiting few. The current financial situation has arisen due to corporate boards pushing the limits of the law and making reckless business decisions. If the government would work to instill the necessary regulations, many of the issues in the financial sector would come to an end.

  9. oversight requires insight. That is a daunting task for any private or public org. We need harsh criminal penalties for these type infractions until we can get a sufficient program. Like stoning or caning or water boarding.