What We Learned In the Meltdown

Financial journalists saw some trees but not the forest. Now what?

One day in June 2005, my colleague Nell Henderson and I hiked over to the Bond Market Association to get ourselves educated on collateralized debt obligations and related products. I was editing The Washington Post’s Wall Street coverage, and Nell was covering the Federal Reserve, and we both had a feeling this might be a corner of the market in which troubles could occur. A couple of hours later our heads were spinning, but at least we felt like we had a better sense of how some of these increasingly complicated financial instruments that were flooding the markets worked.

What we didn’t have was a story to write, or so we thought. What would we have said? That there is a rapidly growing, unregulated market in these things that might turn out to be pretty risky? We had been assured repeatedly all afternoon that the people who dealt in these products were constantly on guard, looking for risks and figuring out how to defuse them. But more than that, we both knew that there isn’t much appetite for speculative stories about complicated issues in most newsrooms. Once the crisis occurs, once you can quote government officials referring to credit-derivative obligations and credit-default swaps as “toxic assets,” it gets easier.

Still, I wish I had gone further and considered other options. I wish I had walked downstairs to where the Real Estate section was segregated from the rest of the business staff to find out more about the connection between the subprime loans they were writing about and these new types of securities. I wish I had learned back then, instead of in the course of writing this story, that the market for asset-backed securities, loans secured by mortgages or other debt, had grown by 45 percent the previous year, mostly because of loans backed by housing, and had surpassed the market for corporate debt for the first time in history. And I wish I had suggested a meeting of the real-estate staff, the reporters who covered the economy, and those who covered regulatory agencies, markets, and banks to explore the connections.

The retrospective me also would have wondered more about other areas of the economy that were unregulated. And I would have been more intellectually curious about why such a creature of Wall Street as Securities and Exchange Commissioner William H. Donaldson would feel so strongly that hedge funds needed to be registered, and would pursue doing so at his own political risk.

But even in hindsight, I think it would have taken a miracle for business journalists to have foreseen the current crisis in its magnitude and depth. Beat reporters saw the pieces of it, and columnists who took a broader view warned about the buildup of risk. But even those who predicted disaster, I think it’s fair to say, didn’t know how widespread it would become or how unprecedented the government’s reaction would be. A New York Times editorial warning in September 2006 that “in a market so vast and dynamic, everyone knows that if mortgage defaults should rise, damage could reverberate throughout the financial system,” probably didn’t leave many readers thinking seriously that two years later we might be talking about a second Great Depression.

Nonetheless, there are certainly lessons to be learned about how to change some structural and cultural biases that might have gotten in the way—including the segregated silos we sometimes fall into in our beats, and a bias against speculative “this trend could be dangerous” stories. It’s not as sexy to prevent disasters as it is to cover them, but maybe we should rethink that, and learn to view warnings and prevention as one of the most important parts of our jobs.

One of the biggest obstacles to understanding, however, was out of our control: it was the decision to let major financial markets full of new types of housing-related investments expand with little or no federal oversight. No regulation means no transparency. Reporters and investors alike were kept from seeing what was going on behind the curtain.

What happened? In short, mortgage lenders began to pool and sell mortgages to raise more money to lend. Then those pools morphed into more complex products, which transferred the risk further and further away from the original lender. The original mortgage pools got packaged with others into collateralized debt obligations (CDOs) or collateralized mortgage obligations (CMOs) and sliced into different levels of risk, graded by rating agencies as safer than they turned out to be. Financial institutions like aig then issued credit-default swaps as a way for players to insure against losses. At each stage, investors borrowed, piling more debt on a slender reed of equity.

The quest for more mortgages to package led to the subprime market, which helped keep the housing bubble expanding—until it burst. Warnings of risks were met by assurances from Alan Greenspan, then the Federal Reserve chairman, and others that the smart, self-interested people would keep risks at bay. They didn’t, and here we are.

If you go back and read stories written over the past decade, you will find plenty of good reporting that pointed to emerging problems. The Economist warned in 2002, for instance, that “a housing bubble is more dangerous than a stockmarket bubble, because it is associated with more debt. A steep fall in house prices would harm the global economy far more than a slump in share prices.” And there were stories dating back to 1998 in The Wall Street Journal about Commodity Futures Trading Commissioner Brooksley Born’s warnings about risk in the unregulated over-the-counter derivatives markets and how her quest to regulate them was steamrolled.

Now that the economy is unraveling, there has been terrific forensic reporting, including This American Life’s brilliant radio segment “The Giant Pool of Money,” which took listeners through all the steps, from a U.S. marine facing foreclosure (his mortgage broker stated his income as $195,000 when it was actually about $37,000) to one of the companies that created CDOs. The New York Times contributed “The Reckoning,” a great explanatory series of articles that looked at pivotal events and players in the financial crisis.

Even if we couldn’t have nailed this story of a lifetime, many of us can think now of steps we wish we had taken. So the questions are: What can financial journalists learn from this, and what can we do better? What didn’t we see, and why didn’t we see it? And where should we have been looking?

First, some mitigating factors: while the problems that led to the current crisis were building, financial journalists had their hands full with other major stories. We were incredibly busy covering the fallout from the previous scandals, many of which involved cooking the books. There were trials and pleas all over the place: Enron, WorldCom, Tyco, HealthSouth, Adelphia, and Martha Stewart, just to name some of the more heavily covered legal proceedings. There were also stories to be done on the end of the tech bubble, the mutual-fund scandals, Richard Grasso’s departure from the New York Stock Exchange, fights between the regulators and Fannie Mae and Freddie Mac over accounting problems, concerns about the growth in consumer debt and leverage in the markets, and the growing role of sovereign wealth funds. The “Maestro,” Alan Greenspan, was handing over leadership of the Fed to Ben Bernanke. And then came rising interest rates. In Washington, we also had the downfall of the city’s oldest and most respected bank, the Riggs, which turned out to be cozying up to money-laundering dictators. On the regulatory front, there was the Sarbanes-Oxley Act, a law designed to make sure corporate financial reports were more reliable in the wake of so much accounting fraud, and the transfer of the chairmanship of the Securities and Exchange Commission from Donaldson to the more hands-off Christopher Cox.

We were also personally busy refinancing and buying houses. I don’t want to overstate this, but the same housing boom and lower interest rates that helped create the heavy demand for more exotic, risky investments enticed us as consumers. At one point, four or five of us in the Business section at The Washington Post were using the same broker to refinance and reduce our mortgage rates, while other colleagues were rushing to buy houses before prices went up even more.

It may not come as a surprise that business journalists point to examples of things they got right. “I don’t think this is a case of financial journalists falling asleep at the switch,” says Jill Drew, who oversaw business coverage at the Post until 2006. “People were doing stories all around it,” she says, noting a three-part series by Alec Klein, a Post reporter, in 2004 about the conflicts of interest in rating agencies, as well as other stories about elements of the current crisis.

Among those in the media who raised alarms about the new debt market and rising levels of borrowing were columnists Floyd Norris, chief financial correspondent for The New York Times; Steven Pearlstein of The Washington Post; and Allan Sloan, now of Fortune. All three raised questions early and often about risks in the economy. Here’s Norris in August 2005, for instance:
If housing prices fall, will mortgages cushion the downfall, or make it worse? Put another way, will more overstretched homeowners be forced to sell? At issue is whether financial innovations that have made it easier for Americans to buy homes have also made the system less stable and more vulnerable to shocks that could drive many of them from their homes, having lost all they invested in them.

Still, Norris says he wishes he had done more. “I did not take the time to understand the intricacies of collateralized debt obligations,” he says. “What I should have known, and didn’t, was that this amounted to financial alchemy to turn risky assets into risk-free assets, or at least to mostly fund risky assets with risk-free assets.” Norris says that he assumed that the rating agencies were correctly assessing risk, and also that he didn’t understand the extent of fraud going on in mortgage lending, with appraisers being paid to come in with higher assessments. “I would have studied CDOs and CMOs and all those things much earlier than I did, and I would have understood them.” One other point he makes: “I think we were all a little too willing to assume Alan Greenspan knew what he was talking about. It seems pretty clear to me now that Greenspan worshipped free markets but didn’t understand them.”

Now that we can learn from looking backward, here are some suggestions for going forward:

Pay more attention to the credit and derivatives markets. Financial journalists focus too much on the equities markets—after all, they are easy to understand, and stock prices often tell you about the relative health of companies or industries. It may be that the equities markets are the financial equivalent of political journalists covering the horse race.

But here’s one fact to keep in mind: compared to the credit markets, the equities markets are puny. At the end of 2007, the global stock-market capitalization was $64.6 trillion, compared to the global bond-market outstanding of $79.8 trillion—or more than 350 times its size in 1990, according to the Securities Industry and Financial Markets Association.

Convincing reporters to become experts on debt markets, or even convincing them just to read trade publications such as Inside Mortgage Finance and the Asset Securitization Report can be a hard sell. It’s just not sexy. “Credit markets tower over the equity markets in dollar value,” says James Grant, of Grant’s Interest Rate Observer and the author of Mr. Market Miscalculates. But he adds, “Credit markets, except for propeller heads, have very little entertainment value.”

Yet unregulated derivatives, including most recently credit derivatives, have been associated with financial disasters, including the bankruptcy of Orange County, California in 1984; the failure of Long-Term Capital in 1998; the problems at Enron culminating in 2001; and now the Big One. So it might be a good idea to cover them more consistently and less episodically.

Question what will happen when there are fundamental shifts in the rules of doing business, whether it’s Wall Street suddenly taking public tech companies with no track record or lenders giving up the concept of underwriting—i.e., looking at whether a borrower can make the payments—in favor of a belief that housing prices can go no place but up.

Don’t rely on self-interested experts. In the case of the unregulated collateralized debt obligations, derivatives, and swaps markets and the growing hedge-fund industry, most of the experts were also players. Though there are academics knowledgeable about these markets, too many reporters didn’t push for answers from anyone beyond the International Swaps and Derivatives Association, the rating agencies, or other self-interested participants.
Put me on this list, since my quest to know more started and stopped with the Bond Market Association.

When a huge new industry springs up, make sure you understand everything you can about it. It’s true that, with respect to the collateralized securities and derivatives markets and the hedge-fund industry, they were growing in the shadows, so it was harder to know what you didn’t know.
Grant describes his Interest Rate Observer as “focused pretty much single-mindedly on these mortgage contraptions.” But he says there “was not so much the general press could have known about. So much of the mortgage crisis was cooked up behind doors that were either closed by interested parties or doors that were closed except to the adepts and cognoscenti by virtue of the complexity of the structures.”

If AIG, whose business was assessing risk, couldn’t correctly calculate the risk of insuring in this market, says Grant, figuring it out in advance of a crisis may be “asking a lot of people who might have had an economics course on the way to a degree in journalism or social work.”

It’s not that the growth in these markets went unnoticed. There were multiple stories over the years remarking on their growth, the lack of regulation, and the possible risk. One Post story in 2000 noted that the market for over-the-counter derivatives had “grown 400 percent from a decade ago, 50 percent from five years ago.”

But most of us probably didn’t try as diligently as we should have to understand why they were growing and what the risks were. “To my mind, the beau ideal of a financial journalist would be modeled after the slouching and ill-dressed police lieutenant who kept saying, ‘Can you say that one more time? Because I’m not very smart,’ ” says Grant.

Look forward. It’s hard to do, especially when you’re still deep in the wreckage of the previous disaster. And it will be harder given the shrunken ranks of reporters and editors. One thing that might help is systematically discussing whether and how developments on one beat might relate to something happening on another beat. For example, in many newspapers, the real-estate section is considered separate from the main business section and more frequently viewed in terms of the local rather than the national economy. Maybe the real-estate reporters and the reporters covering national economic news should have been having lunch together, discussing what was happening at either end of the housing bubble.

The scramble over how to regulate financial markets is already under way. There will certainly be a major realignment. All players in the financial industry will be fighting tooth and nail to protect themselves as much as possible from regulation. That will include hedge funds, banks, and the rating agencies that decreed some of today’s toxic assets as reasonably safe. Huge sums of money are at stake and will be spent. That’s an obvious place to watch. The financial press should be all over that story, and should be putting teams of well-sourced reporters in place to cover the battle and the new regulatory agencies.

But even as the current crisis unfolds, something else, in some corner we aren’t watching, will be gathering.

“By their nature, crises surprise us,” says Greg Ip, now of The Economist, formerly of The Wall Street Journal. “But we should still try to report on risks even if the risks we choose to investigate aren’t the source of the next crisis. They might still be dangerous, and our reporting on them can mitigate that danger.”

Ip has a good idea about how to encourage such reporting. Noting that Pulitzers are awarded for work done in the previous year, he suggests a prize for prescience that would look back even further.

Just because something is unregulated or deregulated doesn’t mean that journalists should stop paying attention. Regulation is good for journalists because it guarantees that someone other than self-interested players will be watching and, even better, will have the ability to pry loose records that we don’t. In the twenty-five years after the Reagan Revolution, journalists got so accustomed to deregulation that we didn’t look hard enough at all the issues and problems it obscured.

We used to joke in the newsroom that we didn’t need an antitrust reporter anymore because there was no such thing as antitrust. In fact, we might have done better to ask ourselves whether any of the ills that antitrust regulation was supposed to prevent were occurring. For instance, were more and more companies “getting too big to fail”?

Even where there was regulation, there wasn’t always enough attention paid when it was relaxed.
In an excellent piece in “The Reckoning,” the New York Times series I noted earlier, Stephen Labaton took a backward look at an sec decision to loosen requirements on how much capital the brokerage units of investment banks needed to protect against risk. The banks wanted the money cut loose in order to invest in “the fast-growing but opaque world of mortgage-backed securities; credit derivatives, a form of insurance for bond holders; and other exotic instruments.” In return for loosening the rules and agreeing to use the banks’ computer models to monitor how risky investments were, the sec was supposed to get a stronger supervisory role and more insight into investments in mortgage-backed securities, although “the agency never took true advantage of that part of the bargain.”

In 2004, however, the press paid little attention to the meeting in which that decision was made. “The proceeding was sparsely attended,” wrote Labaton. “None of the major media outlets, including The New York Times, covered it.”

We probably should have shone the spotlight more brightly on de facto deregulation, such as cuts in spending for enforcement. And we certainly should have tried harder to keep tabs on industries created completely outside the regulatory framework.

Kudos, by the way, to Bloomberg News for filing suit in early November in federal court arguing that the Fed is required under the U.S. Freedom of Information Act to reveal more details about how it is spending the bailout money.

Some state watchdogs were able to step into the regulatory void during the past decade, as then New York Attorney General Elliot Spitzer did, uncovering unsavory practices by stock analysts and in the mutual-fund industry. And when they did pick up the regulatory slack, we remembered how wonderful it is for reporters (and for readers and investors) to have regulation.

I’ve had occasion to regret sunshine-meeting laws, forced to sit through some staggeringly dull committee meetings, when, in earlier times, I would have been outside the door joking and gossiping with other excluded reporters. But, by and large, sunshine laws are good for the press and the public—and so is regulation.

As someone who spent years watching airline bankruptcies, I can attest that the transition to deregulation has its own fun and excitement. But thoughtful regulation is good for industries, which sometimes are not the best judges of the consequence of certain practices. And it’s good for consumers and investors.

It’s as American as the Freedom of Information Act and the First Amendment. 

Has America ever needed a media watchdog more than now? Help us by joining CJR today.

Martha M. Hamilton , CJR's Audit Arbiter, explores complaints about fairness, accuracy, and other issues arising from business-news stories. Send possible story ideas her way at the link on her name. A former reporter, editor, and columnist at The Washington Post, she is a writer and editor for PolitiFact.com.