Lots of squealing, little wool said the devil, sheared the pig

Regulators

Lots of regulation

Many organizations to control financial market
There are several organizations to control the finance market. Like the Securities and Exchange commission, SEC. The Department of Justice, DoJ. The Office of the Comptroller of the Currency, OCC. What they have in common is a next to complete unwillingness to prosecute for even the most blatant crime. Most of the Fed top executives come from Wall Street, most of the lower executives want to go to Wall Street; it's no wonder most federal investigations find little or nothing to report.

Five fraud investigating groups, total staff one
At the 2012 State of the Union Address, president Obama announced the Residential Mortgage-Backed Securities Working Group to investigate mortgage fraud. It seems this working group does still exist but it does not do very much. Which still is more than five other similar groups since 2009, five groups with a total staff of one (1).

Basel I, II and III
In Basel in 1988, the world's richest countries reached an agreement called Basel I. It was a collection of common standards and rules specifying how much capital a bank must have to cover its risks. Soon Basel I was found insufficient and a new and more detailed agreement was reached in 2004, Basel II. Now they are working on Basel III.

Raising leverage and risk
To protect customers and taxpayers, banks used to have rigid leverage constraints; a certain part of their total capital had to be backed by own assets to keep leverage down. As part of deregulation, in 2004 the rigid restraints were eased and replaced by the banks' own estimates.
In spite of low asset requirements, the banks were not satisfied. A perfectly legal method to increase own capital was selling bad mortgages. Selling to Fannie and Freddie, thus transferring risk to the taxpayers. Selling to investors, thus transferring risk to pension funds and others. Loans were insured, federally by the Federal Housing Administration and privately with Credit Default Swaps (CDSs). As CDSs were not requested to have the same backing as normal insurance, there was a genuine risk they had no value.

Hiding bad assets
Bad own assets showed up in the balance sheet as high leverage. One way to lower leverage was using repos. The bank sold bad securities against a promise to buy them back at a higher price. The sale was made before preparing the balance sheet, so anybody looking there would see ready cash.
The Federal Reserve's Gramm-Leach-Bliley banking reform from 1999 effectively put mortgage lending out of reach of the OCC examiners. The major banks promptly hid their more questionable mortgage operations in nonbank subsidiaries. The Congress essentially halted US supervision of major bank mortgage operations in 1999.

Lehman daily supervised, failed tests
The New York Fed did not neglect its supervising duties. Lehman Brothers was supervised on a daily basis. They gave "full and complete financial information to government agencies" and nothing improper was found. Lehman was subjected to three "stress tests" and it failed them all; then, just before it went bankrupt, Lehman was permitted to construct its own test which it passed. After that, the biggest banks were permitted to run their own "stress tests" which they passed.

Regulation can force crisis
In 2007, accounting rules were changed and assets had to be valued at market value. Before, it was difficult to assess the value of a company because the value of its assets could be computed in obscure and complex ways. With the securities market already weak, this change contributed to market collapse, forcing banks to large write-offs. This started a chain reaction; to cover their losses asset-holders were forced to sell, forcing prices even further down. The situation got so bad, the mark-to-market rules had to be suspended.
If market players are not permitted to hold securities below a certain rating, they all have to sell when those securities are downgraded below that rating; for a popular type of security this could mean a big market slump. If the rules favor certain ways of holding assets, everybody will use these ways and they will be hit by the same types of problems at the same time. If the authorities learn from the problems and start favoring something else, all market players will instead adapt to the new rules and again face new problems at the same time. For a bank to be prudent is not to avoid bad securities. The best prudency is to get the same bad securities as all the others; then it can be sure to get saved by the taxpayers.

© Anders Floderus