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DO THE MATH: "If big institutional investors had worked a little harder at the basic core principles" of economics, "we wouldn't have had the crisis we had," according to former FDIC Chairman Sheila Bair.
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Big Institutional Investors Need Finance 101 Refresher: Sheila Bair

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Sheila Bair has been an advocate of financial education for everyone from homebuyers to kindergartners since she stepped down as Federal Deposit Insurance Corp. chief a few years ago, but it's not just Main Street that needs economic schooling in her mind.

Big institutional investors demonstrated a profound lack of fiscal skill in the run-up to the financial crisis, she says.

Institutional investors' failure to research the risk associated with the mortgage-backed securities they traded left them exposed when the assets turned toxic, Bair said Tuesday in a speech at the Museum of American Finance in New York City.

"Because [institutional investors] didn't do their homework, they lost market discipline and didn't appropriately price for the risk they were taking, and they were surprised" when the wholesale market soured, Bair said. "And that surprise is one of the reasons the market seized up they ended up having a very low risk tolerance for taking any losses."

Bair largely avoided naming names in her critique of private investors, although she singled out Citigroup (NYSE:C) which she has previously argued should have been allowed to fail during the crisis. Financial irresponsibility was pervasive among the majority of institutional investors, she said.

"If big institutional investors had worked a little harder at the basic core principles" of economics such as buyer beware and understanding risk, Bair said, "we wouldn't have had the crisis we had, because the market wouldn't have funded it. You wouldn't have gotten the investment and this kind of excessive risk-taking."

Moreover, Bair said, if investors had followed the lead of Warren Buffet an investor with a reputation for careful risk management who managed to make money during the crisis "they would have been in a better position to absorb the losses when the market turned."

While Bair reserved her harshest words for institutional investors, the former FDIC chairman who currently serves as a senior advisor to the nonprofit Pew Charitable Trusts noted a few other areas in need of improvement.

Banks should face higher capital requirements, Bair said, which would force them "to put more skin in the game."

"We need to force banks to fund [their activities] with more common equity, which will give their shareholders more of an incentive to monitor risk" and provide banks with a cushion for potential losses, Bair said.

In response to the argument that higher capital requirements could make banks less profitable, Bair pointed to out that Wells Fargo (WFC) the highest-earning U.S. bank in 2013 also has one of the highest capital levels. It had a Tier 1 common equity ratio of 11.36% under Basel III in the first quarter.

"Capital is a competitive strength, not a competitive weakness," Bair said.

The financial industry must also face up to the cultural issues that contributed to the crisis, Bair said. She argued that traders who work in large institutions frequently feel disconnected from the effect their actions might have on everyday people.

"Their environment is a blinking screen, their thought process is in algorithms," she said. "They don't interact with real people, but what they do has real-life ramifications."

"Maybe when people go into financial services, they should have to live with a homeless family for a while or stand in the unemployment line for a few weeks," Bair said, noting that her tongue was only partially in cheek.

The idea may not be too far-fetched. Referring to the idea that Wall Street workers should wait in unemployment lines, one audience member spurred a round of laughter with the observation: "I think we've done that in the last few years."

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Comments (4)
Amid all the loose talk about setting new bank capital levels I have yet to see a good analysis of how much capital a bank can be required to hold and still attract investors. I haven't even heard any policy maker acknowledge the need to know that before setting new capital requirements. I am not arguing against higher capital levels if the business remains viable, but we know what the upper limits of viability are from the standpoint of competition and marketability in order to set workable standards. Assessing access to capital seems to be missing from most aspects of regulatory policymaking. Instead, policymakers have adopted multiple new standards that impede investment. That may not have been the intent but it is the result and no one seems to notice or care. The proof is the fact that virtually no new banks have been formed in the US in the past several years. That oversight largely accounts for the anemic growth of credit, and hence the economy.
Posted by gsutton | Friday, April 18 2014 at 12:47PM ET
The real lesson is that managers were compensated handsomely for playing within the rules, perverted by agencies such as Bair's FDIC that was focused more on CRA than safety and soundness - and were subsequently bailed out rather than being held to account.
Posted by kvillani | Friday, April 18 2014 at 1:20PM ET
Lets see Congress mandated in the early 1990s that the GSEs through HUD must support at least of third of mortgage borrowers at or below the medium income to let more people share in real estate ownership gains, setting up the standard for 3% and no down payments loans while the rating agencies offered top ratings to mortgaged backed securities, her bank examiners failed to sound any alarms from their bank examinations, and many non-regulated originators were permitted to jump into the market. But her solution is to have the big institutional investors work harder to understand the basic core principals of economics or perhaps spend time with a homeless family to change their psyche and understand the impact of their action.....OMG.... just keep it up, keep pounding, offer no solutions other than putting up more capital for I'm not sure what....or perhaps in the end she might propose to just nationalize the banks because we can't trust capitalism anymore.
Posted by Rhsmith999 | Friday, April 18 2014 at 4:19PM ET
So here's the person that presided over the biggest real estate meltdown in history, and "Teflon" Bair is out pointing fingers again. She's a political hack that has run out of usefulness. The FDIC did nothing to help prevent the crisis, and she takes no blame what-so-ever. Her severe criticisms of the banking industry continues to have a huge impact on the FDIC as it attempts to crush our business. When will the legislators wake up and see this?
Posted by Mr Drysdale123 | Monday, April 21 2014 at 4:34PM ET
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