JP Morgan Chase 2008 Annual Report Download - page 19

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Clearly, things had changed. In the past, regulators had
focused on preventing a systemic collapse of the main
intermediaries in the financial system; i.e., the banks.
In this new world, however, we need to discuss how to
protect ourselves not only from runs on banks but also
from runs on other critical vehicles in the capital and
financial markets.
D. Regulatory lapses and mistakes
With great hesitation, I would like to point out that
mistakes also were made by the regulatory system.
That said, I do not blame the regulators for what hap-
pened. In each and every circumstance, the responsibili-
ty for a company’s actions rests with us, the CEO and
the company’s management. Just because regulators
let you do something, it does not mean you should do
it. But regulators have a responsibility, too. And if we
are ever to get this right, it is important to examine
what the regulators could have done better. In many
instances, good regulation could have prevented some of
the problems. And had some of these problems not hap-
pened, perhaps things would not have gotten this bad.
Unregulated or lightly regulated parts of the market
contributed to the crisis
I’ve already discussed some of the flaws with money
market funds and hedge funds – the latter were not
regulated, and the former were lightly regulated. In
addition, there are two large segments, among others,
that – had they been regulated – could have helped the
system avoid some problems.
• Much of the mortgage business was largely unregulat-
ed. While the banks in this business were regulated,
most mortgage brokers essentially were not. In fact,
no major commercial bank that was regulated by the
OCC wrote option ARMs (possibly the worst mort-
gage product). A very good argument could be made
that the lower standards of the unregulated parts of
the business put a lot of pressure on those players
in the regulated part of the business to reduce their
standards so they could compete. In this case, bad
regulation trumped good regulation.
• Insurance regulators essentially missed the large
and growing one-sided credit insurance and credit
derivative bets being made by AIG and the monoline
insurers. This allowed these companies to take huge
one-sided bets, in some cases, by insuring various
complex mortgage securities.
Basel II, which was adopted by global banks and U.S.
investment banks, allowed too much leverage
It is quite clear now that the second of the Accords by
the Basel Committee on Banking Supervision (known
as Basel II), published in 2004, was highly flawed. It
was applied differently in different jurisdictions,
allowed too much leverage, had an over-reliance on
published credit ratings and failed to account for how a
company was being funded (i.e., it allowed too much
short-term wholesale funding). In 2004, the five inde-
pendent U.S. investment banks adopted Basel II under
the jurisdiction of the Securities and Exchange
Commission (this was not allowed by the banks regu-
lated by the Federal Reserve or the OCC, which
remained under Basel I). The investment banks jetti-
soned prior conservative net capital requirements and
greatly increased their leverage under Basel II. And the
rest is history.
Perhaps the largest regulatory failure of all time was the
inadequate regulation of Fannie Mae and Freddie Mac
The extraordinary growth and high leverage of Fannie
Mae and Freddie Mac were well-known. Many talked
about these issues, including their use of derivatives.
Surprisingly, they had their own regulator, which clear-
ly was not up to the task. These government-sponsored
entities had grown to become larger than the Federal
Reserve. Both had dramatically increased their leverage
over the last 20 years. And, amazingly, a situation was
allowed to exist where the very fundamental premise
of their credit was implicit, not explicit. This should
never happen again. Their collapse caused damage to
the mortgage markets and the financial system. And,
had the Treasury not stepped in, it would have caused
damage to the credit of the United States itself.