How to Prevent Another Great Recession

ALEX WOODSON: Good evening and welcome to Carnegie Council. This is the first Carnegie New Leaders event of the fall. My name is Alex Woodson. I am the program coordinator for Carnegie New Leaders.

This is the Carnegie Council's Centennial year, and one of the core themes of this year's programming is corruption and trust, which is very relevant to this evening's discussion on the global financial crisis and how to move forward.

I just want to introduce our moderator for the evening, Niovi Christopoulou. She is assistant general counsel of Libra Capital. She has worked as a corporate lawyer at international law firms in New York, London, and Washington, DC. She is also a Carnegie New Leader.

With that, Niovi, the floor is yours.

NIOVI CHRISTOPOULOU: Thank you, Alex.

We have Ms. Asli Ay with us to discuss her experience with the Great Recession and how we could possibly prevent a new one. Asli is the managing partner of US Policy Metrics, a policy analysis and research firm serving leading hedge funds and private equity companies. She dedicates currently most of her time to Lone Star Global Acquisitions, supporting the company's origination efforts around the world.

Before US Policy Metrics, she worked as a deputy to the UBS vice chairman, working all over the world and focusing on financial institutions and policymaking.

I won't go over her résumé in detail, because it's going to take a lot of time, but it's worth noting that she has been selected as a Young Leader by the World Economic Forum. She holds a Harvard MBA. She's originally from Turkey, and she's the mother of two young kids.

Thanks to her extensive background in banking and her expertise in policymaking, she's a great person to discuss the recession and the regulatory response to the recession.

Before diving into this conversation, Asli, if you could please give us a historical recap of how things happened back in 2007 and also your personal experience as you were working at UBS at the time.

ASLI AY: Thank you, Niovi. I will. I have to give one disclaimer before we start. This is a very lofty title, "How to Prevent Another Great Recession." We were just joking about it before we started. I'm convinced that there will be another great recession, by the way. Once all the bankers who have lived through this have died, our kids will have another great recession, because as long as people make free economic decisions, some mistakes will be done and they will have to be undone.

So with that disclaimer, I would like to start.

Thank you for that question. I think it's very important to talk about the reasons for this crisis before you go into the triggers. Because of the traumatic experience in the financial markets, we keep talking about what triggered the recession rather than the fundamental reasons why it started in the first place.

This idea came to me when I was having a meeting somewhere in London. I realized that in Europe everybody talks about this crisis that we had in the United States as a subprime crisis, but in America we call it the financial crisis. It dawned on me in the middle of the meeting—I'm like, hold on a second. It's very interesting. The way we actually even name it tells us how little we understand the fundamental reasons behind it.

It was a subprime crisis caused mostly by government policy that basically required the banks to make loans to people who wouldn't or couldn't pay them back. It was essentially what the crisis was about. It's very interesting. At the moment, we always talk about the dysfunction in Washington, DC. The two parties can never agree on any issue. But it seems to me, looking back, that both parties pretty much agreed on the idea that government should actually promote subprime lending.

Here are the examples. This is basically for both parties. I'm not making a political statement here, although I have strong political convictions.

Back in the Clinton administration, they increased the quota on the government-sponsored enterprises, the GSEs, so that 20 percent of their portfolio—basically, the amount of mortgage-backed securities that they hold on their own balance sheet—had to be subprime. The Democrats at that time basically wanted to pretty much give away all this affordable housing to people. There was this thinking that you would be doing a good public service to the people if you were giving them money or you were subsidizing their housing. I will come back to the intent and how it ended up ruining people's lives later. These quotas have been expanded up to 54 percent later. In fact, the Bush administration increased it to 30 percent first and then, when the wheels came off and when the crisis hit, it was actually 54 percent.

Now, what does that mean? At the time GSEs had about $5 trillion on their balance sheet. It means the government actually required the financial system to create about $2.5 trillion of subprime mortgages. The gentleman who used to run Countrywide now is demonized. People mock him for his sun tan or whatever. He was being given awards in Washington, DC, for providing the most lax standards of lending in United States history.

Let me stop there for a second, because I think that's quite dramatic. Why have tens of millions of subprime loans been given in this country? How could this happen? But let's go back for one second. I think there is this typical example, if I could just kind of distill it to its simplest idea, between causality and correlation in terms of how people behave in the society. There is this thinking that once people own their houses, they become good citizens. Let me stop there for a second. Or is it because people are responsible and good citizens, and therefore they own their houses?

It's a profound difference. The policy approaches, if you think one way or the other, are completely different in terms of how you think about homeownership in the society.

NIOVI CHRISTOPOULOU: Especially in this country. It's such a pillar of American culture.

ASLI AY: Exactly.

Another question mark I would like to put in one's mind—once people have the minimum amount of wealth, the first advice you get from your financial advisor, if you are lucky to have one, is that you have to diversify. Are we doing a good service to low-income people by basically disabling them from diversification? They don't have much wealth anyway, and we're tying all their wealth to their houses.

Let me give you another example. I'm just asking some questions for all of us to think about.

Subprime borrowers tend to have erratic incomes. They do not have stable incomes. Generally speaking, they do not hold one job for a very long time. Once they lose a job, they have to move to another place to actually find another one. Once they own their houses, they cannot move. So are we really doing a good service to these people by basically subsidizing them with loans and basically condoning, promoting this, that they own their houses? Is that the best financial decision for these people? Probably not.

NIOVI CHRISTOPOULOU: One could argue that, irrespective of whether people agree with it or not, promoting homeownership is one thing. The way it was handled and the securitization of those loans was a different thing, thus making that potentially into a financial crisis, as opposed to a technically narrow definition of a subprime crisis.

ASLI AY: Yes.

NIOVI CHRISTOPOULOU: The incentives were not properly aligned. As many people have discussed before, institutions were too big to fail and handled everything. As Professor Stiglitz has argued—and I know you don't agree with that—if Glass-Steagall was still in place, this crisis would not have happened, because we had, at the same time, players handling commercial investment banking and insurance.

So I would separate the issue of homeownership from the way the financial system handled everything and fed into its own greed in a way, getting too big and too complex. Many people will say that maybe there was too much finance in this situation, instead of sticking to the basics and the fundamentals and handling this in a simpler and clearer way.

ASLI AY: There are four questions in that. Let me try to handle them one after another.

I think I made my argument that the government basically enforces that these subprime loans—to be created, the financial system would have to come up with many ideas, some good, some not so good, of basically providing the supply of loans. So that's what happened.

Let's go to securitization and Glass-Steagall and so-called deregulation and all that. It's obvious that there are many facets of this issue.

Securitization, I believe—I don't believe; it's actually a fact—it is actually quite an innovative way of providing extra liquidity to any financial market. In fact, it is still being very successfully and quite safely used in Europe. Europe has done securitization for a very long time also on mortgages. There were some problems in the securitization system that became apparent during the crisis—the fact that those instruments were designed to be sold, but not to be unbound, and there was not loan-level transparency. There were some issues with it.

But essentially the securitization as a mechanism is not the problem. Once you actually securitize prime loans, when people actually perform on it, there's nothing wrong with securitization. But the problem is, once you securitize subprime loans with huge amounts of default rates that are associated with it, then you have the problem.

But, of course, I think once the regulation is now being rewritten on the securitization and once you basically can say, "You can do all sorts of subprime lending, but you just cannot securitize it. You have to keep it on your balance sheet, and therefore are responsible for the risk that you're taking," I think the problem will be much more easily solved.

On the Glass-Steagall/Gramm-Leach-Bliley law, to my surprise, there is still this argument being perpetuated with people who think that the subprime crisis happened because of deregulation. I don't see any evidence of that. In fact, Glass-Steagall was a law that passed in the Great Depression that separated securities and insurance companies and retail banks from each other. Gramm-Leach-Bliley, which passed in early 1990s—with overwhelming majorities in the Senate, by the way, needless to say, almost consensus—it basically allowed insurance firms, securities firms, and banks to be affiliated through a financial holding company. It did not change one word about the bank's ability to provide mortgages, securitize mortgages, hold them on their balance sheet—nothing related to that. Even today, all of the banks can actually do this. Nothing has been changed.

The Dodd-Frank law, with its thousands of pages and hundreds of rules, does not even mention Freddie and Fannie as a player in this market. It strains credulity that people actually can make this argument, that it has anything to do with Gramm-Leach-Bliley.

I would even make the argument that during the crisis, when the government had to intervene in the financial markets and try to provide stability, they used Gramm-Leach-Bliley by allowing companies like Goldman Sachs and Merrill Lynch to basically get financing from the Fed through becoming a financial holding company. So I see no evidence of that.

Another argument I would make—I can talk about this until I turn blue in the face—another argument is that if you look at which banks have actually gone down in the crisis versus which ones stood up—if you look at it, those financial institutions which had different channels of revenue were actually in better shape than those institutions, like Lehman and Bear, who had single-line businesses, pretty much, very strong in mortgages and subprime mortgages. Guys like J. P. Morgan and others were actually in much better shape.

So I don't see any evidence. People, I think, have decided that deregulation was the problem, and then they forgot to look at the evidence.

NIOVI CHRISTOPOULOU: Maybe some evidence would be that while the act was in place, it was probably the longest period of financial stability in the United States post the Great Depression, which makes you wonder what went wrong after it and why it was repealed and why the events that led to the Great Recession happened.

ASLI AY: It was not repealed. In fact, Glass-Steagall was not repealed, in the sense that the firms, once they can affiliate themselves to a financial holding firm—you cannot double-count your capital and you cannot go through your financial holding company and use your capital for the other ones. The idea that firms actually gambled with the taxpayers' money—it's a misunderstanding. That is not what Gramm-Leach-Bliley said. Gramm-Leach-Bliley was a very short law that allowed them—I know I'm repeating myself—to affiliate themselves with each other. In fact, it turns out that insurance firms and banks did not really want to be affiliated with each other. It was not good business for them and it didn't really work.

Again, going back, this Gramm-Leach-Bliley did not change a word about banks' ability to make subprime loans, to hold them, or to securitize them. Nothing has changed. This had nothing to do with the crisis, in my opinion.

I want to talk a little bit about how this thing unfolded because I think it's important to go through the narrative and to think about an unconventional—I would say unfortunately unconventional—evaluation of what actually happened.

You go to the 2008 elections. It is a very difficult time. The bubble burst. One year house prices were going up 14 percent a year. No one could make a bad loan. The regulators are asleep on the Hill and, of course, the government is promoting subprime ownership. What were they going to do, argue with the Congress? Of course they were not going to do that. The banks are providing this. Then the bubble bursts. Then the rhetoric—everything becomes politicized during the presidential election. Then the story comes that it was because of the greedy bankers.

I am sure, like in any other industry, there are some bad apples in this industry. I believe that with all my heart, because humans—there's a fair distribution of bad apples in any single industry. If you look back into it, I cannot explain 47 million subprime loans being packaged and created in this industry by just a couple of fat-cat greedy bankers.

But, of course, with that kind of rhetoric in place, it has some consequences in a democracy like this. Public opinion gets inflamed, because you are looking for a scapegoat. Then you end up having something like Dodd-Frank, which does not address most of the issues that we had in the crisis. I think it is not only a law of errors of omission and commission, but also there are a lot of unintended consequences that come with it that are genuinely hurting the financial markets at this point in time.

NIOVI CHRISTOPOULOU: Greediness is generated by incentives, right?

ASLI AY: Yes, I think so.

NIOVI CHRISTOPOULOU: And incentives have to relate to the primary participants in the market, like the bankers, for example, and the auxiliary participants, like the credit-rating agencies. So what's your opinion on what should change to create the proper incentives and to avoid this mess a second time around?

ASLI AY: Thank you for asking that question, because I forgot to mention that. Clearly credit-rating agencies played a role in this. The thing is, in the system that we are in—if someone landed from Mars today, we would find it very difficult to explain to them why we came up with the system in the first place, but we have this system—we actually kind of give a special license to a bunch of institutions. We tell them they are the arbiter of risk, and everybody needs to follow their advice. When they make a bad decision, we demonize them.

But the thing is, why do we give them that license in the first place? Investors need to know what they are investing in without regard to any credit-rating agencies. Whatever those people think, if it is my money, I am responsible for evaluating the risk within a portfolio. If I do not have, as a mortgage-backed security investor, loan-level visibility, which was the case in most of these securitizations, by the way, then I see that, because I think transparency is key. But the idea that we are requiring investors to buy double- or triple-A-rated assets is one of the big problems.

With credit-rating agencies, I want to address another topic. Clearly there are a lot of angles here, and I don't want to miss anything. There's another problem here, which is still in place, and we have not done anything to address that.

Basel II, the banking regulations have this concept—I will try to articulate it as simply as possible, because it's going to sound crazy, but this is the system we have—it assumes that risk can be known beforehand. Basel II literally tells the banks—and this is still the case, by the way; it's now getting more sophisticated—it tells the banks, if you are holding triple-A-rated mortgage-backed securities, you do not have to have any capital against it. If you are holding government securities—and some governments are obviously more risky than others; Greece versus Germany, a perfect example—you don't have to hold capital against them. But if you are holding corporate risk, you have to have a certain capital risk, as if the people actually know what the risks are going to be like.

This is interesting. What happens is that Basel II creates systemic risk, in a way, by basically aligning everybody and requiring them to take the same positions. I worked for a bank, UBS at the time, which lost $50 billion after all was said and done. Before the crisis, we had $250 billion in mortgage-backed securities. We couldn't sell them fast enough. We took 20 percent losses on them. The reason was not because UBS was gambling with anybody's money; it was the safest instrument we could find in the market, with triple-A-rated securities.

What I'm trying to say is, once you assume that the regulators can know where the risk is and align everybody in the market to take the same positions, you're essentially creating systemic risk. My take on it is, look, anyone can be in any business they want to do, as long as they have capital against it. If you want to be a bank that only does subprime lending, you might as well; be my guest. But you have to hold to a certain amount of capital and you have to hold against it. That's it. You cannot know all these risks.

Now we have Basel III. Again, we are treating different government sovereign bonds in Europe the same. You can hold Greek government bonds and you do not have to have any capital against it. It's a joke, but it's the way that the system is.

So I find there are fundamental issues here that we have not even started addressing, let alone talking about them.

NIOVI CHRISTOPOULOU: What was your experience while you were at UBS and while these events were unfolding? Can you give us a bit of an insider perspective and what it felt like?

Actually, one of the last big deals I worked on during the time was Korea Development Bank's tender offer for Lehman Brothers. I remember we started working on it in May and then by September, Lehman was under. I remember how things were really convoluted. It was a time of craziness.

Can you give us a bit of a personal perspective, what it felt like and how the leadership handled everything, to the extent you can disclose, of course?

ASLI AY: Yes, of course. One disclaimer first. I don't know how I timed it, but I delivered my first baby a week after Lehman went bankrupt. So when the world was going to hell, I was basically sleepless, sleep-deprived, taking care of a baby 24/7. It really grounded me, I have to tell you.

Having said that, it was very interesting to work at an institution that was basically going through the convulsions of the crisis. I'll tell you first the things that everybody knows: The fact that UBS was one of the large banks who had admitted losses; UBS was one of the first banks who went out and actually raised substantial amounts of equity to actually cover ourselves against those losses.

What is less known—and I think I can honestly say, because all the leadership is now gone at the bank—is that there was genuine panic at the bank, genuine panic at the time, at the highest levels, the chairman level. The bank did things that were unheard of at the time, basically calling every single central bank in the world and securing liquidity lines before we went out to the world and said that. I think our first announcement was about $17 billion. I lost track. It eventually ended up being $51 billion losses. I don't remember the first announcement, but it was significant amounts of money.

It was very interesting. Another interesting fact was how a Swiss bank—I think it's partly cultural, but mostly because of the regulatory framework that they are used to—how they approached the problem. The problem was that there was an internal hedge fund in the bank and there was also the bank's own balance sheet. The losses were coming from both sides. I think the bank has done a very good job and, I think, acted very decisively about cutting the hedge fund off, immediately shutting it down—we were just going to get to the bottom of this. I thought that was the right decision. It was not an easy decision, but I have a lot of respect for that leadership at the time for doing that—and then basically restructuring right away. Before any European bank started admitting even the problems, UBS was already done and over with.

I'm working with a lot of European banks at this moment. Although the subprime crisis—I call it the subprime crisis—has been over in the United States and the bank balance sheets have been cleaned up a long time ago, the European banks have barely started this process.

I think UBS at that time did a good job, but my goodness, it was traumatic.

NIOVI CHRISTOPOULOU: It sounds like a great case study in crisis management, the way they handled it.

ASLI AY: I would think so, yes. I guess a lot can be said about other banks as well. But yes, I would agree with that.

NIOVI CHRISTOPOULOU: Going back to the regulatory response to this whole mess, let's put it into historical perspective. First was TARP [Troubled Asset Relief Program].

What's your take on TARP, by the way, and how it resulted in a situation where the big banks were bailed out immediately, whereas some smaller players have to still be bailed out? What do you think about the inconsistencies and the response? Could there have been a better response? Do you think it helped? Do you think it was really just a political reaction?

ASLI AY: I have two points of view on this issue. Maybe the narrative at the moment is that we injected all that money through TARP to all of these banks because some big banks were too big to fail. But if you actually look at what happened, I think the reality was a little bit different than that perception.

What happened was that when Hank Paulson went to Congress and asked for the bazooka—as he spoke, I thought it was a very apt term—he said, basically, "Give me the bazooka, so that I have credibility." I think the whole intention—I don't think; I know—that the whole intention was to basically go to the banks and buy the assets from the banks and create a bad bank, like many other nations have done, in the Swedish crisis—a very successful crisis in the sense that it became very successful in the way that it was handled. That was the idea.

But it became very obvious to the Treasury secretary at the time and other leaders that it was not going to be possible to do this over a weekend and basically they would not be able to go through massive amounts of information through a weekend and make such decisions. It became obvious to them that they were not going to pull this off. In order to kind of create a sense of confidence in the market, they injected capital at 824 or whatever—830—banks in the United States.

Obviously we don't have 826 too-big-to-fail banks in the United States. That was not the idea. The idea was that the financial system was too big to fail. And I agree with that.

I want to make one more point. The point I'm trying to make is it's not that they had many alternatives. I think they have done the best that they could.

But looking back, a lot of things that could have happened—one of the reasons why Lehman created such convulsions in the market was, of course, the fact that Lehman was big. I give that to any person who followed the issue. But it was also another, much more important factor—the fact that nobody knew what would have happened and what kind of claim one had to Lehman, created all that confusion.

When Washington Mutual went bankrupt and got acquired by Wells Fargo, everybody took their cups and went home. It was a massive bank, but everybody knew whose claim was what, because we have a very clear system, with FDIC [Federal Deposit Insurance Corporation] taking over. We have an established bankruptcy law. Everybody knows. I was not a Washington Mutual customer or bondholder or equity holder, but if I were, I knew exactly what my claim would have been and I would have gone home and played with my kids and gone to sleep.

But with Lehman, nobody knew, because there was no legal framework. That was the problem. It was not that it was the biggest, but it was the most unknown. I think that is one thing that is less understood.

That brings us to the regulatory response again. They have this idea that the banks have to have living wills—another crazy idea. The idea is this. Let me rephrase this. This is very funny if you think about it.

You are going to tell the management of a bank how the bank would be on the ground if they got into trouble. But hold on a second. Aren't those the guys that actually drove the bank to the ground? So why would we ask them? The first thing you would do is fire all of them. You have legal procedures, just like we have in the bankruptcy law and the takeover of a retail bank. You first fire them and then have legal procedures that are not dependent on management, that everybody understands beforehand, before getting into that situation, so that you can unfold the bank, undo the bank, unwind the bank, and do whatever you have to do with it.

So the whole idea of this living will disturbs me. I'm one of those people who like to understand what the rules are. Financial markets cannot operate without clear rules that you know will be enforced without any interference from politicians or from humans that are not constrained by the rule of law. You do not want to have judgments on this. It scares financial markets.

Again, thanks for asking the question. How would I have responded at that time, with that kind of legal framework? I would have probably done the same thing that the Treasury secretary did. They have done the best they could. But what is very sad and, in a way, terrifying is that eight years after the financial crisis, we still do not have a legal framework of how we will be unwinding an institution like Lehman if it went bankrupt. It has been seven years. And the best idea we came up with is living wills.

NIOVI CHRISTOPOULOU: So what do we have in place? We have Dodd-Frank, which does not thrill you, I know, the Volcker Rule. How do you feel about that?

ASLI AY: I don't know where to start.

NIOVI CHRISTOPOULOU: If we can get some background on the rule, first of all.

ASLI AY: The Volcker Rule was an idea that was first floated by former governor of the central bank, Paul Volcker, a very distinguished central banker, an historical figure, in my opinion, who stated that if the banks did not "gamble with depositors' money that is backed by the taxpayers, every problem in the world would have been solved."

The problem with this approach is that first of all, it prohibits the banks from investing in private equity companies or leveraged finance or active investment managers like hedge funds, and all of those restrictions on their balance sheets and whatnot.

There are many problems with this. That's why the rule still has not been made. Every time the regulators come up with questions to the market, there are about 400 new questions that are being raised, because it goes against the way the financial markets work.

So here is the problem with this thinking. First of all, banks did not get into trouble in the subprime crisis because they had investments in hedge funds or private equity or they had exposure in leverage. They got burned because of subprime mortgages. So all these prohibitions—

NIOVI CHRISTOPOULOU: Those mortgages were traded by whom?

ASLI AY: The trading of the bank was going with the banks. They were selling it to the GSEs. The subprime mortgages, they were securitized and sold all over the world. German banks went under—

NIOVI CHRISTOPOULOU: There was proprietary trading involved. That's what I'm saying.

ASLI AY: Yes. But what I'm trying to say is that the Volcker Rule prohibits banks from investing in all sorts of assets. That has nothing to do with the crisis.

NIOVI CHRISTOPOULOU: I think it does, to the extent that it prohibits prop trading [proprietary trading].

ASLI AY: Prop trading in private equity funds, in hedge funds, and all sorts of unrelated vehicles to the subprime crisis. See what I mean? It does not prohibit them from trading for mortgage-backed securities. It does not, which is another stunning factor. We had a subprime crisis and the law almost does not even touch the subprime issue.

The other thing is with the Volcker Rule—and I think it's going to take literally years to really figure out how it's going to impact the markets—it is very difficult to figure out whether the bank was acting on behalf of a client or on behalf of itself. It's like going apple picking and then getting a whole bunch of apples, bushels of apples, and trying to separate the ones you're going to use for apple pie and the ones you're going to use for apple cider. You have all these baskets of things together. It's extremely difficult to do this.

So it remains to be seen. I do not think that it's going to be applied the way that at least it's written. We don't even know how the rule is written yet.

NIOVI CHRISTOPOULOU: There's a lot of uncertainty, a lot of complexity. Where do you think we stand now? What do you think we're headed towards? What's your feel for the situation right now? What have we achieved, first of all? We achieved some stability, right?

ASLI AY: Yes, we did.

NIOVI CHRISTOPOULOU: There was some crisis management, and confidence, I think.

ASLI AY: The things that we have achieved: The list is short. We have achieved stability because of extraordinary central bank policies of very cheap money. We are in uncharted territory, and we do not know where this is going. The central banks really do not know how they're going to unwind all of this quantitative easing that they have done.

So have we achieved stability? Yes.

Have we achieved a little bit of growth? Yes. But the growth is extremely disappointing. After a recession like this—if you look at the post-World War II recoveries, we should have been growing 4.5 percent every year. We would have had probably 13 million, 14 million more people working. So it's very disappointing. Have we had growth? Yes. Is it satisfactory? Absolutely not.

In terms of subprime lending, where are we? Again the news is not very good. We are now unwinding GSEs in the sense that we are winding down their portfolios, and their lending standards are much higher right now. But we have put another $1 trillion of subprime loans on FHA right now, the Federal Housing Administration—the same loans, with zero percent down payment. It's now on the other side of the balance sheet. So we took it from one part of the government and put it over here. It's right there. Nobody wants to talk about it, but it is there.

So the policies that put us into this mess are in place. Not much has changed there.

Dodd-Frank: I think, frankly, we will be rewriting Dodd-Frank for the next 20 years. We are going to be tweaking it, rewriting it, and we're going to have to deal with all of the unintended consequences created in the financial markets. I do not know where it's going to go, but I think it's going to be a long, arduous process.

NIOVI CHRISTOPOULOU: Thank you very much, Asli.

ASLI AY: Thank you. Thank you for listening to me.

QUESTION: James Starkman. Thank you very much for a very interesting talk.

I'm not sure that we can avoid the next recession or great recession, but you would do the financial community a great favor by publishing the results of your next pregnancy test so that we can liquidate our portfolios in a timely fashion.

Just for something a little bit different, every recession and depression tends to have a different cause and character. You go back to 1907, 1929, right down the line. How would you quantify—very difficult to do this—the intersection of geopolitical events, which have just proliferated recently, as a probable cause of the next severe contraction?

ASLI AY: That's a tough question, sir. It's a very tough question.

If we're talking about economic recessions in the United States—and I'm just talking about the United States; clearly you can talk about Europe, China—very different dynamics—if you're talking about the United States, I do not know what the next recession is going to be triggered by. I do not know. My guess, my strong hunch, is that it will be caused primarily by the unwinding of the Fed policies. I do not see an easy way of getting out of this problem that we have.

By the way, this is the same in Europe and also in Japan; zero interest rates, incredible quantitative easing everywhere—once growth picks up, how do you deal with the interest rates? If you start increasing the interest rates too much, if you do not do it very fast, then the banks would basically take all of the reserves that they are holding at the Fed and then basically start lending. It would create—and you will have to really put it hard and drive the economic growth to pretty much zero pretty fast. It's unclear.

Geopolitically, how could this be impacted? Clearly there are huge security issues in the world right now—huge—most of them our own making because of us losing credibility, in my opinion. Could there be an oil price shock because of the Middle Eastern situation? There's no evidence of that happening because of, thank goodness, the fracking revolution in the United States we have. It can get so much better if we actually allowed it to happen. So far it has happened because of private ownership of underground resources. On federal lands it's effectively prohibited. Nothing can be done.

So we can do a lot on that front. Oil shock I do not see. That is related to geopolitics.

In terms of a confrontation in Europe with Russia, I don't see this happening in the current situation. But we will have to face that reality at some point. I hope that it's going to be at a situation where America feels more confident about itself so that it can put its game face on, because there's no solution in hiding from the reality. I hope that's the case.

Another geopolitical factor could be a severe contraction in China. It is possible. The Chinese government is doing basically economic stimulus, now the third round of doing this. Sotto voce ("quietly"), they just injected $81 billion into Chinese banks. It is possible.

The funny thing about the Chinese economy is that so much of it is not under the control of the government. My guess is that if things get really difficult there, they will basically try to tweak the capital controls and still kind of control the situation, because they still have a lot of levers, unlike our free economy, that they can pull on.

So a severe Chinese slowdown—yes, that might be a problem.

Security issues in the Middle East: I don't see an oil shock or anything that would trigger a recession in the United States.

Another security issue, like a major military confrontation in Europe, I think is in the realm of possibilities, but not any time soon.

I know it's a long-winded answer to your short question, but I think it's a very complicated question, so I tried to address it. I hope it was helpful.

QUESTION: Allen Young.

You made quite a number of statements which are contrary to the received wisdom. We could argue for hours about it. Let me start with just one point. You said, basically, the real problem was the problem of subprime lending. The problem there was that the U.S. government forced the banks to increase their portfolios of subprime lending. Yet you said you worked for UBS. UBS had $250 billion in subprime. They are not subject to the requirements of the U.S. government.

Why did the European banks put so much money into subprime lending? The European banks had maybe even more difficult problems than the U.S. banks did. Ultimately things were worked out—hopefully. But they weren't subject to the U.S. government's requirements about subprime lending, and they invested in it.

ASLI AY: Let me just restate one thing. The U.S. government put requirements on government-sponsored enterprises, which are Freddie and Fannie, that they hold 54 percent—it started with 20 percent, up to 54 percent when the wheels came off—54 percent of their portfolio in subprime loans. The U.S. government does not require the banks, but through GSEs, they basically promoted creation of all of these subprime loans in the financial system. This was enabled by the banks.

Why did banks put all of this money—trillions in total—in mortgage-backed securities? UBS put in $250 billion. Because you did not have to hold any capital against it and the returns were very good. It was the safest investment you could find. That's why UBS had so many investments in it. It's because we were so conservative that we put all of the money there—because it was essentially riskless and you did not have to hold any capital against it.

That brings my point, the Basel II points—the fact that the regulators deem some instrument riskless. How do they know? That is my point. At this moment they are deeming that—I'm sorry, Niovi, I know you're Greek, and I come back to Greece, because it's a simple point—the Greek government bonds are deemed to be riskless on Greek balance sheets. Who would believe this? That's my argument.

So that is why all of these banks had all of these investments. I think this creates systemic risk more than anything else. I'm less worried about too-big-to-fail.

We didn't talk about that issue, of course. That's another big issue. Before the crisis, there might have been some banks that were too big to fail. Now we have an official list of banks that are too big to fail. Everybody knows the list.

NIOVI CHRISTOPOULOU: And the Fed just reverted to this issue in early September, as you know.

ASLI AY: Yes. Insurance companies are on that list, which is another incredible fact. Nothing to do with subprime crisis, but they are deemed to be too big to fail now in the insurance business, which doesn't even have the characteristics of banking. But anyway, go figure.

QUESTION: Thank you very much for your very refreshing views.

What I find incredible is that your voice is over here, over here—I'm not going right or left—so, in my mind, refreshing and honest compared to everything I've been reading for the last 25 years. My concern is, how do we take your voice and get it so it's a broader voice? I don't know who you work for. How do we get your message out so that more people start to see it? I've been preaching the same thing for many, many years, and I'm just a single voice.

ASLI AY: Thank you. That's very kind of you.. You're honoring me. Thank you.

First of all, the opinions I have just articulated—obviously they belong to me and they are my opinions. But this view on the financial crisis is a view that actually has been written about extensively by some people who actually understand these issues. There are a couple of gentlemen, like Peter Wallison from the American Enterprise Institute, who have written extensively about this issue. I know people who have written op-eds, journals, research reports. I know I'm not alone. But I think you are right in saying that this is a minority view.

So that brings me to the issue of public opinion getting inflamed and then policymakers, who are the politicians, basically losing perspective. That is what happened. That's why I believe Dodd-Frank will have to be rewritten over and over and over again, because once you have a wrong diagnosis of the problem, you cannot write the correct policy solution that would address the problem. This was a subprime crisis before it became a financial crisis. And we have not done anything about that problem.

NIOVI CHRISTOPOULOU: Isn't it funny, though, if I may add, how the Great Depression was very effectively handled by regulation, as opposed to the Great Recession? There's a contrast here. Regulation has reacted before and it saved the country and propelled it into long-term growth and development.

ASLI AY: That is one thesis.

NIOVI CHRISTOPOULOU: Whereas right now, we're kind of spinning our wheels.

That's one comment I would make. The other comment would be that I know how Asli is for free market. You keep stating that policymakers should be leaving banking alone and the market alone. But I'm not really sure that policymakers are that immune from banking interests and the banking industry. They are surely pulled in every way. That may be creating additional confusion, too. It's not like pro-regulation people are only talking to the policymakers.

ASLI AY: I think you're absolutely right. You made two points, one about the Great Depression. Let me make one point and then come to your second point.

On the Great Depression, I am not an economic historian myself, but I recently read a book written by a lady called Amity Shlaes, The Forgotten Man, about the Great Depression and basically, the economic history of the Great Depression. That suggests to me that actually we got out of the Great Depression not because of regulation, but despite the regulation. In fact, some of the policies of the Roosevelt administration probably put us back into the recession, while Europe was actually out of it.

But that's a very different argument. I am not an economic historian, who could credibly argue that.

But going to the second point, I think you are making a very important point, which is as follows. The idea that government is omnipotent, that regulators can know where the risks are and can effectively regulate away risk, the idea that financial markets are risk-free, the idea that free individuals who make economic decisions are never going to make mistakes, is not realistic. Government is not a unicorn. When they make policies, there are unintended consequences associated with it.

The idea that just because government does it, it is right, and therefore it is the best for the society—I think it's just not right. I think the subprime lending is a prime example of that. Even the word "subprime," which is a silly name if you think about it. What is "subprime"? "Subprime" is "bad loan." Even the term came from FHA, which is the Federal Housing Administration. They were trying to find kind of a euphemism for giving out loans to people with bad credit, so they came up with the idea of "subprime." Even that is a government term.

So I think everybody goes back to a couple of very simple, timeless ideas. Number one is that—first of all, again—I think I like it—government is not a unicorn. Therefore, it has a lot of problems with incentives, agency problems, execution problems, all sorts of things. Government is not perfect. Government policies are not perfect.

Number two is that although intentions might be great and holy, just like trying to get people to own their houses, it might actually have profoundly disastrous results. It is important to understand how policies actually work in the real world and how it impacts people's lives—not theoretically in some kind of nice conference room atmosphere, but what actually they do to real people in the real world. So that's number two.

I think transparency is extremely important, letting markets work with minimal intrusion if possible—obviously, the right regulatory framework with minimal intrusion. I think that's important.

Again, going back to the crisis, I think it's important to not forget what made American financial markets the best and the deepest in the world—again, rule of law, understanding the rules-based environment, not judgment-based, not ad hoc-based, not dependent on some politician who might be knowledgeable or not at that time, who may or may not be a good Treasury secretary. We were blessed by the fact that we had somebody like Hank Paulson, who knew financial markets, and Ben Bernanke, who was a student of the Great Depression. We got lucky. This might not be the case. Our current Treasury secretary does not seem to have that kind of experience, with all due respect to Mr. Lew. He seems to have different interests, much more kind of micro issues.

What I'm trying to say is that we need to clarify the rules without worrying about the political decision makers who might be making those rules at that time. I think that's what we should work on.

NIOVI CHRISTOPOULOU: And the incentives. It feels like we've been privatizing gains and socializing losses here, be it TARP or be it—

ASLI AY: Yes.

NIOVI CHRISTOPOULOU: And that's probably something that we haven't touched upon that we should, the ethical perspective of this crisis and where do ethics stand in the situation, in terms of the bankers, the regulation. Human nature, of course, can be greedy. Incentives were not properly aligned.

Asli, you argued before that markets should be left alone, but they were left alone and the Great Recession did happen. It didn't really happen, I think, as a result of overregulation, for sure.

ASLI AY: No, not overregulation—

NIOVI CHRISTOPOULOU: Maybe of wrong incentives.

What do you think about ethics? Do they even belong to finance?

ASLI AY: Absolutely.

NIOVI CHRISTOPOULOU: How so? Where's the ethical failure in this situation, in this crisis?

ASLI AY: Clearly ethics belong to every single aspect of our lives, and financial markets are part of it, of course. But I think the difficulty is basically trying to blame individuals for a massive, complex problem that was essentially created by another reason, and to basically act like a couple of bad apples could actually create a problem like this.

There are a lot of problems with that kind of an approach. That's my thing.

There are, of course, ethical considerations for financial markets. Financial markets are one of the most regulated industries in the country, relative to technology or Internet-based businesses. My goodness, virtually they're unregulated. So it's already very regulated. There are ethical factors. But humans are humans. I'm sure financial services firms have some bad apples, like any other industry and any other firm. Clearly that's the case.

But the thing is, once government policy again promotes the creation of bad loans in a financial sector, there is nothing to stop it. There's no power at the moment in our financial markets to actually stop something like that.

Again, it goes back to being honest with ourselves, really going through the policies that we had, really understanding correlation and causality. Homeownership—is it something that we really want to kind of put on steroids? Maybe in a society like America, 60 percent homeownership is good. In Spain it is 80 percent, but everybody buys in cash.

In America we have done this. We have lost hundreds of billions of dollars. We went through this traumatic experience, and the homeownership is exactly the same level as it was before. In Canada homeownership is higher and they do not have any GSEs.

So what are we doing here? Is this the right thing to do?

So there are many questions that need to be answered. I think once we have those incentives right, then we will have the moral standing to actually investigate ethical issues behind all of this. But I think we need to address the bigger issues first, before we get into the more relatively market-level individual ethics. Again, it goes back to being honest with ourselves about how we caused this crisis and what happened.

NIOVI CHRISTOPOULOU: Thank you very much. Thank you very much to our audience as well.