I just returned to the office after a few days off for a service project my church does every year, and with about five weeks of my project remaining, four of which will be spent at the GAO, things are really beginning to come into focus.

When I began this project, I had only a general idea of what I would be researching. I knew that by auditing the FDIC, I’d be looking at the way the FDIC handles bank failures, and I knew I was interested in Dodd-Frank implementation and learning about the causes and aftermath of the financial crisis, but I wasn’t really sure how what I learned about the FDIC would relate to the financial crisis and Dodd-Frank.

However, some of the goals of Dodd-Frank are to “end ‘too-big-to fail’” and to end bailouts in the event that a large, “systemically important” firm is on the brink of failure. Dodd-Frank attempts to accomplish this by giving the FDIC the authority to seize and liquidate any “systemically important” financial institution, whether bank or nonbank, if it is on the brink of failure. The resolution method would be very similar to the method the FDIC uses for the hundreds of banks that have failed since 2007, though any FDIC expenditures that resulted would be recovered from the financial industry as a whole in the event that the FDIC could not recover them through the liquidation process rather than the amount resulting in a loss to the FDIC’s Deposit Insurance Fund. (In the office right now actually, I’m working with a team on creating a document that fully details the bank resolution process and all the internal controls that govern it. I’m looking at sample items from last year’s audit to trace each step of the process and document our understanding. I’m also trying to find a way the FDIC could illustrate its yearly change in gross receivables based on the amount of deposits it insures at failed banks, the value of the assets the FDIC transfers from failed to healthy banks, the actual amount the FDIC disburses to fund deposits; and dividends the FDIC receives. I thought I had a handle on it, but due to “tri-party” transactions that involve discounts and premiums between the FDIC, failed banks, and healthy banks, it is proving to be very challenging, but maybe in the process of documenting our understanding of the FDIC’s accounting practices, things will fall into place. A team and I are doing a “desk walkthrough” Monday where we’ll call the FDIC and they’ll help us understand what went into a transaction and explain the elements of the documentation that resulted).

There is some debate though as to whether Dodd-Frank’s method of ending “too big to fail” will be effective or is the best solution. David Skeel, a noted authority on bankruptcy, criticizes the plan heavily in The New Financial Deal: Understanding the Dodd-Frank Act and Its (Unintended) Consequences. I’ve read the first few chapters of Skeel’s book, and I will finish it before the summer is out. My understanding of the FDIC should help me determine whether his assessment is fair.

Before I finish Skeel’s book though, I’m seeking to gain a thorough understanding of the perceived causes of the financial crisis and the way it was handled. An understanding of the perceptions surrounding the crisis and its handling, even if many differ, is important, because perception played a large role in the crafting of Dodd-Frank and continues to play a large role in its implementation. For example, according to an article I read about Sheila Bair, who just concluded her five-year term as chair of the FDIC, the FDIC’s new authority to seize and liquidate large, failing financial institutions resulted in large part from a conversation she had with Obama. Obama was lamenting the benefits AIG’s shareholders reaped from the government bailout of the irresponsible firm; Bair pointed out to him that the FDIC’s resolution method wipes out shareholders, eliminating the problem Obama was discussing. Obama helped bring about the Dodd-Frank provisions that give the FDIC its new authority.

At GAO, I’ve had the opportunity to watch Inside Job, a documentary about the financial crisis, and watch a GAO panel discussion on the film and on Dodd-Frank implementation. Inside Job, first screened in May 2010, places heavy blame on Wall Street firms and on US regulators for causing the 2008 financial crisis, and its conclusion bemoans the fact that Wall Street firms continued to profit even during the recession that followed the crisis, none of the firms had been prosecuted for the role it played, and efforts at reform were, to that point, largely ineffective. Interestingly enough, HBO aired the premiere of Too Big To Fail, based on a book with the same title by Andrew Sorkin, on Monday, May 23, just a few days after the GAO screening of Inside Job and panel discussion.

The differences between Inside Job and Too Big To Fail are prime illustrations of the different stances being taken. Too Big To Fail told a very different story than Inside Job; it was a docu-drama rather than a documentary, so it focused more on the human nature of the regulators and bankers during the crisis and the decisions they faced. Even the director’s casting decisions indicated he had a different agenda than the director of Inside Job. For example, in Too Big To Fail, William Hurt plays Henry Paulson, who was Treasury Secretary during the crisis. Paulson’s features are rather intimidating; he is bald and gaunt, so the director of Inside Job had absolutely no challenge in choosing news clips that made him appear sinister, as was his intention. William Hurt, on the other hand, is slightly pudgier and has generally softer features; casting him as Paulson helped Too Big To Fail portray him as a hero during the crisis rather than the villain Inside Job attempts to make him. There’s been a lot of finger-pointing in the aftermath of the crisis; Inside Job blamed virtually everybody for the crisis but foreign officials and Eliot Spitzer (New York’s attorney general who prosecuted several Wall Street firms in the early 2000s; he was forced to resign as governor of New York in 2008 following allegations that he utilized a prostitution service). In Too Big To Fail though, if there’s any finger-pointing, it appears to be at British regulators for preventing Barclay’s from purchasing Lehman Brothers before the US firm’s collapse.

While Inside Job bemoans the high executive compensation for Wall Street executives and other workers even after the crisis, Too Big To Fail suggests that the reason for those levels of compensation was to avoid a “brain drain,” or a loss of intellectual capital; if Wall Street firms hadn’t kept compensation high, key workers (supposedly) would have left the firms, potentially resulting in failures that the government was trying so desperately to avert. Since the government invested money in investment banks through TARP, the banks remained healthy and were able to continue paying out high levels of compensation. Fortunately, were a large firm to be at such risk in the future, there are provisions in the Dodd/Frank financial overhaul bill that hopefully would prevent the need for a government bailout (though the FDIC, the Federal Reserve, and other regulators are currently under a lot of pressure in regard to what firms they would identify as being subject to these provisions and in regard to what new limits and regulations they will place on these firms). The reason TARP was necessary, according to some, was that certain banks had become “too big to fail;” this means that they were so important to the US financial system that if they were to fail, the effects on the economy would be catastrophic because so many people would lose money and because the concepts of “credit” and “debt” would become meaningless, making it impossible to conduct business or to finance projects.

The panel discussion of Inside Job was interesting to see. The panel began by pointing out that though Inside Job was given the Academy Award, the criteria for this was creativity, not objectivity. Though the panel acknowledged that the movie was fairly accurate, they definitely agreed that there was a significant bias that, in many ways, made the movie unfair. One panelist especially took issue with the movie’s conclusion; he believes that the Dodd/Frank law will be largely effective, but we won’t know its full impact for three to five years from now.

The panel pointed out that, as early as 1990, the GAO began identifying many of the risks Inside Job says were ignored. These risks included derivatives; large, relatively unregulated institutions and hedge funds; the use of interest-only loans; and adjustable-rate mortgages. However, the GAO’s findings were ignored, and people argued that the GAO simply didn’t understand markets. The panel also pointed to the problems posed by the US’s “patchwork quilt” of regulation: the financial regulatory system had been developed over the course of many, many years, and consisted of many agencies. In some cases there was overlap between agencies, and in other cases there were loopholes in the regulatory structure that limited the power of agencies to do anything. Later, during discussion of the Dodd/Frank Law and its effectiveness, the panel noted that Dodd/Frank, rather than solving the issue of the fragmentation of regulation and supervision by consolidating agencies, left the issue unresolved since, though the Office of the Comptroller of the Currency would assume the responsibilities of the Office of Thrift Supervision, two more agencies were being created elsewhere, for a net effect of one additional agency.

One panelist emphasized the role that lack of caution and lack of foresight at the regulatory level and at the firm level played, as well as the role delusion, particularly the self-delusion that housing prices would never fall, played. He believes that regulators will always be one step behind firms, so they need to take greater action and discontinue what he referred to as “light touch” regulation. He also pointed out the irony that Goldman Sachs, one of the largest investment banks, was actually competent and foresaw much of the crisis, and now the bank can’t get out of the press for the actions it took. What he was referring to is the fact that Goldman has been accused of exploiting its clients by entering deals where the firm would profit at the expense of clients due to the downturn in the housing market.

The panel highlighted the role that the emphasis on short-term profits played in the crisis; many Wall Street employees simply couldn’t think past their next bonus check. Personally, I think that Goldman’s case is a prime example of this: though Goldman disputes these allegations, it appears that Goldman was so focused on short-term profits that they profited at the expense of their clients without considering what the consequences would be or the reputational risk.

The panel also touched briefly on the actions being taken against investment banks and other financial institutions. Inside Job bemoans the fact that no criminal suits have been filed against any firms; a member of the GAO Counsel’s Office pointed out that criminal prosecutors would be chomping at the bit to try the firms criminally if they could, simply because that’s what criminal prosecutors do. However, the burden of proof for a criminal case is guilt beyond a reasonable doubt, which is difficult to prove. I’ve been following closely in the news what actions are being taken against the large financial institutions, and actually back in April it was announced that the SEC was beginning to settle civil suits against many firms (in late June, they actually reached a huge settlement with JPMorgan Chase). The difference though is that a civil suit only requires a preponderance of the evidence, rather than guilt beyond a reasonable doubt. Also, in late May the Justice Department began encouraging federal prosecutors to take greater action. Federal prosecutors have been encouraged to use the Civil War-era False Claims Act, under which the US government is not required in civil suits to prove intent to defraud, but rather “reckless disregard for the truth.” Under New York’s Martin Act, the burden of proof for cases of criminal fraud is less than the burden for federal cases, so prosecutors are considering taking advantage of this. In early June, it was reported that Goldman has received subpoenas from Manhattan’s District Attorney. Meanwhile, it’s been reported that JP Morgan and Bank of America have been adding billions of dollars to their litigation reserves. It should also be noted that as early as November, the FDIC began criminal investigations of about fifty former executives of banks that have failed since the start of the crisis. These of course though are, for the most part, smaller commercial banks that actually failed rather than the large investment banks that almost failed but survived (or, in some cases, were bailed out by TARP) during the crisis.

I’m currently finishing reading former Treasury Secretary Henry Paulson’s account of the crisis, On the Brink: Inside the Race to Stop the Collapse of the Global Financial System. If I have time before further investigating the FDIC’s new authority to liquidate large, failing firms and reading Skeel’s book on Dodd-Frank, I’d also like to read Sorkin’s Too Big to Fail (the book on which the film is based) and Michael Lewis’s The Big Short.

Of course, it feels a bit odd reading about the financial crisis and Dodd-Frank as the nation now confronts a debt crisis. The government is coming dangerously close to reaching the debt ceiling. The US Treasury issues debt to finance the operations of the government for expenditures beyond what tax revenue collected by the IRS can cover. The US’s debt level skyrocketed during World War II, and though it dropped after the war, it has recently returned to World War II levels. Congress has over the years raised the “debt ceiling” which places a maximum amount the Treasury can borrow by issuing debt. The recession truly brought our problems to light: we were already on a fiscally unsustainable course where the government was spending more than it was taking in through tax revenue and making up for the difference by issuing more debt; then, when the recession hit and incomes, and hence tax revenue, dropped, and the government pumped stimulus money into the economy, the spread between revenue and expenses became even greater, plunging us deeper into debt. Though the US is approaching its debt ceiling, there’s a standoff in Congress about whether or not to raise the ceiling. Republicans even conducted a vote in late May for the sole purpose of voting against raising the ceiling, simply because they wanted to illustrate that they would not raise the ceiling unless it were tied to a deficit reduction agreement (i.e., spending cuts and other provisions that would move us to a more sustainable course). Of course, if the US defaults, it would be catastrophic. US Treasury bills, which are short-term debt, have long been perceived as risk-free and are thus used as a benchmark for interest rates. If the US defaults, there is a chance that T-bills will no longer been seen as a risk-free, benchmark rate throughout the world. Also, the value of the dollar would fall, and the US would lose its advantage of having its currency serve as a major reference for global currency valuations. Currently, Republicans and Democrats are trying to reach a deficit-reduction package that includes an acceptable combination of spending cuts and tax increases that both parties will find acceptable. However, there have been many instances of perceived progress followed by setbacks in the negotiations, so tension is mounting. Today (Sunday, July 24) Congress has been racing to try and find a solution so they can deliver the news before Asian markets open for the week.

There’s been a significant amount of talk about the debt ceiling around the office. One measure the government has taken actually to buy additional time is suspending payments into a government pension fund. However, once the issue with the debt ceiling is (hopefully) resolved, the payments that should have occurred will be paid into the fund, including back interest. One of my coworkers actually helps calculate what these payments should be, based on the day’s market rates. I’ll be in the office through August 12 most likely, which is ten days after the potential default date; I sincerely hope that this issue will be resolved by then.