WASHINGTON — Bubbles, tsunamis, implosions oh my: The financial world struggles to explain complex concepts to regulators, at times turning to metaphors that would make an English teacher cringe. Former Treasury Secretary Hank Paulson, who led the regulators tackling the brunt of 2008’s financial turmoil, took his turn in front of the Financial Crisis Inquiry Commission on Thursday with an arsenal of his own metaphors. The FCIC is a 10-person bipartisan group looking into the causes of the financial downturn. Here’s a sampling from that exchange.
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Subprime securitizations are E coli: When market participants found out that subprime securitizations were at the heart of the credit crisis, it created fears of all securitizations, even unrelated ones. “People use this E. coli example or mad cow disease,” Paulson said, referring in part to the 2006 E. coli scare that created an aversion to all spinach, even the untainted. Paulson detailed this phenomenon in his recent book. “I do think that it’s a good example because there was so much uncertainty about that. It infected, you know, so many in securitizations in terms of the investors’ concern.”
The authority to backstop Fannie Mae and Freddie Mac was a bazooka: Paulson said that he wanted this authority but hoped to never have to use it, like a bazooka that allays fears of being unprotected lacking protection by its mere presence. Paulson said that he immediately began working on legislation for reform of Fannie and Freddie. “You asked to give a bazooka you would never have to use and then shortly thereafter you used it,” said Douglas Holtz-Eakin, FCIC commissioner. Fannie eventually raised $7 billion. Freddie committed to raise capital, but never did.
Financial crises are toothpaste: When trying to assess whether Paulson could have stopped what led to the financial crisis, FCIC chairman Phil Angelides asked if “the toothpaste was already out of the tube” by the time Paulson took the Treasury’s helm in 2006. “Most of the toothpaste was out of the tube and there really wasn’t the regulatory apparatus to deal with it,” Paulson responded.
Alternative: Financial crises are baked goods. “The situation was already baked” when Paulson arrived.
Financial crises are tsunamis: Angelides insinuated Paulson could have seen something coming. “Even when a tsunami comes you have warnings ahead of time,” he said. Paulson didn’t run with this metaphor, replying that history from World War II onward didn’t predict the wholesale decline in housing prices. He doesn’t know what could have been done with such a warning. Crises happen no matter what, he said, and will continue to happen.
Skin is money: In securitization of mortgages, the process of bundling the debt and selling it off, the originators don’t have a stake in people paying off their mortgages; they don’t have “skin in the game.” Also, market makers, or those who hold enough of a security to provide quick trading, don’t have skin in the game, critics claim. Paulson warned that it’s also important not to have too much skin in the game. “Where the big problems were, were the two or three institutions that not only had skin in the game, they had half their body in the game,” Paulson said.
Complexity is the enemy: Paulson defended the benefit of financial innovation and hedging techniques, but made the point that when they become too complex it’s a problem. For over-the-counter derivatives, the tools firms used to bet against the housing market, he recommends standardization and the use of an exchange, and penalizing complexity with extra charges.
“Complexity just in general I think is our enemy,” he said.
TARP is Big Brother: At the peak of the crisis, Congress enacted a $700 billion bailout bill called the Troubled Asset Relief Program to prop up remaining banks and financial institutions and get them lending. It was eventually used to purchase shares in the banks instead, which cause public outcry because they paid big bonuses to executives and still didn’t lend. The money came with increased oversight and consequently fewer banks participated and lending recovered slower, Paulson said.
“I think if it hadn’t been stigmatized by all those who wanted to put the controls on it, it would have gone much farther,” he said. “How is Big Brother going to step in and help you make these lending decisions?”
Complex derivatives are cookies: Banks that packaged collateralized debt obligations, which are slices of other debt bundles, or other securities involving subprime mortgages wound up suffering from their own creations. They “choked on their own cookie.”
Bear Stearns was a weak animal: FCIC commissioner Keith Hennessey asked if Bear was just the “slowest steer and the lion got it.” Also, Bear was referred to as the “weak deer” that served as food to short sellers, investors that bet on market decline, who were coordinating to bring it down. Paulson said though he did not believe that short sellers were a big cause of the crisis, there were likely coordinated attacks. “It sure looked like to me some kind of coordinated action,” he said.
Unacceptable collateral in the repo market is a Styrofoam tortoise: This one from FCIC vice chairman and former California congressman Bill Thomas elicited equal numbers of smiles and furrowed brows. Because some financial institutions don’t have deposits, sometimes they have to rely on a short-term secured lending market known as the repo market. The court-appointed investigator for Lehman Brothers revealed the failed bank used an “accounting gimmick” to use the repo market to hide losses.
Thomas relayed an anecdote in which he found that tortoises were disappearing rapidly and it was thought it was due to the sheep. Someone offered the solution of using Styrofoam tortoises to track their interaction with the sheep. Thomas replied smartly that they might as well use Styrofoam sheep too, the point being that it wasn’t an acceptable substitution – just as shaky mortgages aren’t a substitute for stable securities.
It turned out, Thomas said, crows were “flipping tortoises in the morning for a warm meal in the evening,” nothing to do with the sheep. Paulson said the participants got sloppy in their decisions, like those who accepted mortgages as the collateral.
The housing market is tinder: Paulson’s responded to Thomas with yet another metaphor. It points out how subprime was only the most flammable part of the problem, “the driest tinder” but that other parts of the housing market were flammable and eventually caught on fire. “The subprime market by itself was relatively smaller compared to the U.S. economy or U.S. capital market. The problem was much bigger,” he said.