The Queen and Mr. Sarbanes

From every corners of the globe the headlines are screaming “Financial Meltdown” that it might be hard even for a hermit to escape hearing about it. The Meltdown elicits shocked disbelief from everyone, including the Queen of England. At a function, the queen met professor Luis Garicano of the London School of Economics (LSE), and asked him “If these things were so large, how come everyone missed them?” The professor’s answer was: “At every stage, someone was relying on somebody else and everyone thought they were doing the right thing.”

To which, Her Majesty the Queen said a single word, “Awful!”

Her Majesty’s question is of the type that we are familiar as an “elephant in the room”: If there was an elephant in the room, why did nobody notice the elephant? No logical answer would suffice to explain the conundrum inherent in such a question.

No heads were put on the block.

However at the Committee Hearings of the U.S. House of Representatives on the subject of the Financial Crisis and the Role of Federal Regulators, the heads of former FED Chairman Alan Greenspan, former Treasury Secretary John Snow, and former SEC Chairman Christopher Cox were put -- so to speak – on the block. Take, for instance, the statement made by Representative Sarbanes:

“We have been talking a lot about this metaphor, the blind man and the elephant. I don’t really buy that, because I think what – I certainly don’t buy it as an explanation for what happened. I think it’s been used as a kind of excuse to pass the buck and sort of say, well, nobody could see the whole picture, so we were each compromised in our ability to take action that would have mattered and made a difference, but the hearing testimony today just confirms to me that in each part of the world that you each had a clear perspective on, you had tools that you could have used, which if you had used them, might have averted the situation, or certainly lessened its impact.”

I have selected a subset of the answers and explanations from the former FED Chairman Alan Greenspan’s.

1. In 2005, I raised concerns that the protracted period of underpricing of risk, if history was any guide, would have dire consequences. This crisis, however, has turned out to be much broader than anything I could have imagined.

2. What went wrong with global economic policies that had worked so effectively for nearly four decades?

3. To the most sophisticated investors in the world, they [the derivatives?] were wrongly viewed as a “steal.”

4. A Nobel Prize was awarded for the discovery of the pricing model that underpins much of the advance in derivates markets. This modern risk management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year because the data inputted into the risk management models generally covered only the past two decades, a period of euphoria.

5. Had instead the models been fitted more appropriately to historic periods of stress, capital requirements would have been much higher and the financial world would be in far better shape today, in my judgment.

For the contexts of these statements, the readers can go to the original sources of unedited transcripts of the hearings: http://oversight.house.gov/story.asp?ID=2256.