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Originally published Tuesday, May 26, 2009 at 4:02 PM

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Looking back at an economic model that failed

Bill Longbrake, former chief financial officer of Washington Mutual Savings Bank, reflects on the economic crash, the free market and the limitations of economic models.

Seattle Times editorial columnist

If anyone in Seattle understands America's economic mess, it ought to be Bill Longbrake. He has a doctorate in finance; he has been chief financial officer of the FDIC, which insures bank deposits, and for many years he was chief financial officer of Washington Mutual Savings Bank.

Longbrake, 66, left senior management in 2004. "I should have left sooner," he said, in reference to Washington Mutual's collapse in 2008. He is now a director of a small thrift in Renton, First Savings Bank Northwest.

In late 2005, Longbrake saw trouble coming, and began selling his Washington Mutual stock. But the trouble he saw was in mortgage lending only. The much bigger trouble was a systemwide crisis of credit.

Doubters had pointed out for years that Americans had been taking on far more debt than their parents or grandparents ever had. Some — financial observer James Grant, for example — said this was dangerous, and there would be a reckoning. But year after year they had been proven wrong. Our markets were deep and resilient. Our economic models said markets were self-correcting. Our portfolio models said more risk was all right.

"We were fooling ourselves," Longbrake said. "The market, by itself, does not regulate itself."

Often, in fact, it does, given some assumptions. One is that decision makers know what their interests are. But in complicated decisions, like choosing a home mortgage, ordinary people fail in predictable ways. In the late boom, people took on mortgages with low initial payments, ignoring the increased risk.

An industry grew to feed on and promote people's bad decisions. Industry also ignored risk — and the regulators allowed it. They also allowed investment bankers to sell mortgage-backed securities that were too complex to unravel, and insurance companies to sell default insurance with no reserves.

All these things were supported by models of one kind or another — economic models, computer models, castles of theory.

Blame is not in one place. "We all drank the Kool-Aid," Longbrake said.

Institutions have to be designed for the people that are, not the people that ought to be. Longbrake suggests that limits be placed on systemwide risk. One way is to break up the biggest banks so that the failure of one won't take down the system. But what if many fail? And many did.

Another idea is to require more capital at the biggest banks. Openly discriminate against bigness. "The bigger banks are, the more risk they pose to the system as a whole," Longbrake said.

Elsewhere, the answer may be less intervention. Government might let ordinary recessions take their course instead of rushing in with economic medicine, Longbrake said. He likens past federal policy to the Forest Service's old policy of putting out every forest fire, which let the brush build up for the really big ones.

Whatever is done to the system, he said, debt has to come down. And that will take a while.

"This is not like an ordinary recession," Longbrake said. "This is a collapse of the old order, and the consequences are not laid out yet."

The stock market is suggesting the worst is over. Almost always when the market goes down hard, it comes back strong. But that, too, is a kind of maxim, a rule of thumb, a model.

Longbrake has learned to be wary of models. Life is complex. Reality changes. Your model can be wrong.

Bruce Ramsey's column appears regularly on editorial pages of The Times. His e-mail address is bramsey@seattletimes.com

Copyright © 2009 The Seattle Times Company

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