Maybe the Fed never really missed the bubble after all

The news of the secret tapes of Carmen Segarra is out. 47 hours of secret recordings show us how the Federal Reserve has evolved into a captured regulator. It's hard to believe that one of the most powerful regulators in the world could become captured, but work by This American Life and ProPublica offer compelling evidence that is exactly what has happened.

The relevant episode of This American Life discusses the recordings in great detail, which I won't go into here. Suffice it to say, that when someone finally pipes up to ask the hard questions, she is shot down and fired for doing so. The subject of the question? Goldman Sachs, the bank everyone loves to hate (unless you're a senior manager there). The issue? Whether or not Goldman Sachs has a company wide policy concerning conflict of interest. Segarra maintains that Goldman Sachs does not have such a policy. Her supervisors disagreed.

There are some economists who are sure that the Federal Reserve did not see the collapse of the housing bubble coming. Others suspect otherwise. Paul Krugman notes that in 2005, former Federal Reserve Board chairman Alan Greenspan was presented with a paper by an economist warning of the risk taken on by the economy. That economist, Raghuram G. Rajan, warned us of a sort of disconnection between risk and liability. Translation: it might be better if banks could not make risky loans and sell them to an unsuspecting buyer as a security.

Rajan was later proven to be right. The collapse of the housing market was a supreme underestimation of risk. But I suggest here that the risk was underestimated because of a conflict of interest. The role of Goldman Sachs and other investment banks in the financial collapse is well documented and can be fairly summarized as follows: sell securities that are likely to fail, buy insurance to cover the failure of the same securities and collect when failure occurs. The position of Goldman Sachs fit the classic definition of a conflict of interest.

In the case of Carmen Segarra, she identified an instance of a conflict of interest within Goldman Sachs and reported it. During her investigation, she found another conflict of interest in the Fed. On the one hand, the Fed was a regulator, in charge of making sure that one of the biggest investment banks in the world did not take down the economy. On the other hand, her supervisors had become too friendly with management at the bank and sought to protect the bank if it were found to violate any regulations. The Fed, enamored with Goldman Sachs, had become a captured regulator.

Given all of the available information, I think that the Fed saw the housing bubble coming, but due to a conflict of interest, did nothing to prevent the collapse of that bubble. Segarra's recordings show a very definite pattern of a regulator protecting the regulated, a sincere desire on the part of her supervisors, not to offend Goldman Sachs.

How is it that bank examiners at the Federal Reserve can be cowed into submission? Could it be that they are hoping and wishing for a cushy 6-figure job at Goldman Sachs sometime in the hopefully not-too-distant future? I think it's more like a revolving door. This sort of practice may not be possible to eliminate, but it can be greatly reduced. How? I'm not sure, but I suspect there are plenty of suggestions to be found in the suggestion box at the Fed.