The Bankenstein Fiends
October 5, 2011 § 1 Comment
I have just finished reading a book, published last year, that changed my understanding of and reaction to the financial debacle in the U.S. that precipitated the present worldwide recession: “13 Bankers”; subtitled, “The Wall Street Takeover and the Next Financial Meltdown” The authors are Simon Johnson, a professor of “Entrepreneurship” at MIT’s Sloan School of Management and a Senior Fellow at the Peterson Institute of International Economics; and James Kwak, described as having “had a successful career as a consultant for McKinsey & Company and as a software entrepreneur”.
This carefully documented and well written book has convinced me that the United States government is more blameworthy than Wall Street for the poverty, pain and financial calamity that has occurred as a result of the debacle that began in 2008.
I don’t mean to excuse or ignore the reckless greed of the Wall Street banks. They behaved as creatures of capitalism are designed to behave. They marketed and sold trillions of dollars worth of risky and grossly overpriced securities, mislabeled as safe investments by complicit corrupt rating agencies. They made tons of money betting against the securities they were marketing. And, when their schemes imploded and they were facing insolvency, they successfully bargained with agents of the federal government for billions of dollars worth of taxpayer money to bail themselves out. They kept all their winnings, suffered no consequences for their fraud and, after a few months, returned to their previous practices, lobbied hard to prevent any serious regulatory reaction designed to prevent a repetition of the financial train wreck they caused and are rewarding themselves with multimillion dollar bonuses for their success.
After reading this book, I have had to ask myself: “When harm results from market practices, which is more blameworthy, corporate pirates whose business is outsmarting others in the market in order to reap profits; or agents of the government, whose obligation is to guard and protect the welfare of citizens, who have re-written the rules to allow the harmful practices?” If cars collide at a busy intersection, who is to blame? The motorists or the government that repealed the speed limits and ordered the traffic signals removed?
The title of this effort is based on Mary Shelley’s novel, “Frankenstein”. She did not call of Victor Frankenstein’s creation a “monster”. She referred to him as a “fiend”, a term borrowed from Coleridge’s Ancient Mariner:
“Like one who, on a lonely road,
Doth walk in fear and dread;
And, having once turned round, walks on,
And turns no more his head;
Because he knows a frightful fiend
Doth close behind him tread.”
I have become convinced that our government, like Frankenstein, created a frightful fiend.
A Brief History
“13 Bankers” opens with a history of American banking and American equity markets. It begins with George Washington’s efforts to handle the fledgling nation’s debts, a description of Hamilton’s support of a federal bank and Jefferson’s bitter opposition it. The story moves on to Andy Jackson’s epic battle with the Second National bank. Both Jefferson and Jackson perceived federal banks as threats to democracy because of their ability to control wealth and influence government.
Between 1890 and 1920, the rapid growth of industry, led by the railroads, was financed by huge and powerful financial trusts that attracted both domestic and European investment. These were the days of the “Robber Barons” like J.P. Morgan, Andrew Carnegie and Jacob Astor, whose power evoked the “trust busting” efforts of Teddy Roosevelt and the warnings of Louis Brandeis, whose phrase “the curse of bigness” presciently anticipated “too big to fail”, used to explain federal policy decades later.
Widespread bank failures precipitated the Great Depression and the New Deal reacted with the Glass-Steagall Act which required the separation of commercial and investment banking. Commercial banks accepted money from ordinary depositors and small businesses, paid interest on savings accounts at rates fixed by the government and lent money at higher rates, also based on decisions by federal regulatory agencies. The safety of deposits in commercial banks was guaranteed by the FDIC, which was able to regulate strictly the practices of the insured banks.
Investment banks provided money for companies and traded securities. They used shareholder money and investor money, not deposits from ordinary households and businesses.
American banking became safe and quiet, described by the authors as “boring banking”. “Regulation Q”, part of the Banking Act of 1933, limited the interest rate commercial banks could offer on savings accounts. This prevented any spirited and reckless competition between banks for depositor money. A “3-6-3 rule” prevailed: Borrow money at 3%; lend it at 6%; and get to the golf course by 3 pm. Bankers did not allow employees to work overtime because they did not want anyone to notice the lights on after hours and become nervous about problems at the bank. Memories of bank closings were fresh and no one wanted an encore.
Wall Street’s Fifty-Year coup d’etat
This “boring banking” period began to unravel in 1970, when economists at American universities began to use mathematical models to find maximal debt/equity ratios and ways to evaluate complicated relationships between different classes of assets, thus enabling arbitrage investing. [Traders could identify small price discrepancies based on theoretical “true” values, then bet that the market would “correct” the discrepancy resulting (theoretically) in no-risk investing.] Several Nobel Prizes were awarded for this work and it influenced investor behavior in America and throughout the world. A trio of economists designed a formula for valuing a derivative security thereby enabling vast marketing of derivatives that later capsized the financial system. [Derivatives are securities whose value is based on combinations of, or comparative values of, other securities or commodities. Derivatives can be designed to be extremely complex.] This work was facilitated by the advent of computer technology that made possible access to real-time information about millions of individual trades being made electronically and programing powerful computers to react instantly without any human intervention to slow things down.
Most of this research and analysis was based on the the “Efficient Market Hypothesis”. There were three flavors of this theory: “Weak”, “Semi-strong” and “Strong”. The weak hypothesis taught that future prices cannot be predicted from past prices. The semi-strong hypothesis taught that prices adjust quickly to all available public information. The strong flavor taught that no one ever has information that can predict market prices, so the price set by the market is always the right price. Eugene Fama, an economist, described these theories in an article in 1970. His research established that the semi-strong hypothesis was most often true.
The ideologues in politics and government ignored Fama’s research and seized on the “market is always right” to justify their opposition to any government interference with the market. By the time Reagan became President in 1981, this had become gospel for anti-government politics.
Reagan waged war on government. He appointed the CEO o f Merrill Lynch, Donald Regan, to be treasury secretary. Regan announced that his priority would be “the deregulation of financial institutions. . . .” The first target was S&L’s. The Garn-St. Germain Act enabled S&L’s to invest in bonds, including junk bonds. It removed restrictions on banks’ offering adjustable rate mortgages. It allowed interstate mergers of S&L’s and banks. This was followed by the Secondary Mortgage Enhancement Act of 1984, that allowed the marketing of mortgage-backed securities by private investment firms. The Tax Reform Act of 1986 created the Real Estate Mortgage Investment Conduit which offered tax advantages for mortgage-backed securities.
All of this deregulation was done in the name of “home ownership”. The fraud it facilitated resulted in the failure of over 2,000 banks between 1985 and 1992. Over 1,000 people were indicted for fraud. The bill to the taxpayers was over 54 billion dollars.
That was only the beginning. Alan Greenspan, chairman of the federal reserve from 1987 to 2006, relentlessly preached the free market philosophy of Ayn Rand and he was elevated to guru status. He believed that the market needed little regulation because the market would regulate itself through the choices made by the participants. He told Congress that complicated securities like derivatives needed no legal supervision because “. . . these derivative transactions are transactions amongst professionals. . . ”
It would unduly lengthen this essay to list the step-by-step process by which the Reagan, Daddy Bush and Clinton administrations presided over Wall Street’s takeover of the United States Government. Part of it was done through legislation. Part was accomplished by establishing a revolving door between Wall Street and the half-dozen or so federal agencies that were supposed to regulate banks and protect the rest of us from economic ruin. Part of it involved old-fashioned bribery in the form of blank-check campaign finance money. We have two examples of how difficult it is for government to control an enterprise with unlimited money: Wall Street and illegal drug traffic.
I will cite a couple of examples of how it was done.
The regulatory agencies responsible for controlling financial practices are funded by the fees they charge the objects of their supervision. Their jurisdictions overlap. The financial entities are allowed to choose which agency by which they prefer to be regulated. So, there is desperate competition between agencies to attract financial entities. If an agency is reputed to be “tough” on banks, the banks avoid that agency in favor of another agency whose staff is more “friendly”. The net result is that the agency that tries to do its job is starved for money and the one that nods and winks is bloated with money.
Our home-grown Texas Wall Street advocate, Phil Gramm is an egregious example of the partnership between Congress and Wall Street. His pockets were stuffed with New York campaign money and he waged a campaign to dismantle what was left of the New Deal’s regulation of Wall Street. He succeeded by securing the enactment of the Gramm-Leach-Bliley Act, signed by Bill Clinton, that removed all of the New Deal restrictions and distinctions between commercial and investment banking. His wife, Wendy Gramm, the head of the Commodity Futures Trading Commission, in 1993, issued an order exempting most over-the-counter derivatives from federal regulation. That same year, she was named to Enron’s board of directors, a major beneficiary of that regulation.
As the New Deal regulatory system was dismantled, there was one dissenter: Brooksley Born, the head of the Commodity Futures Trading Commission. She was appointed by Bill Clinton in 1996. She sharply disagreed with Wendy Gramm’s deregulation of derivative securities. She proposed to issue a “concept paper” stating her reasons for strengthening federal regulation of derivative securities. Treasury Secretary Robert Rubin (former chair of Goldman Sachs), Larry Summers, Deputy Treasury Secretary and Alan Greenspan, Federal Reserve chair, all reacted with alarm. Summers called Born and said, “I have thirteen bankers in my office, and they say if you go forward with this you will cause the worst financial crisis since World War II.”
Ms. Born did issue her paper. It did not cause a financial crisis, probably because it was roundly denounced by Rubin, Summers and Greenspan. Just to be sure that it would have no effect, the Clinton administration promoted and secured the enactment of the Commodity Futures Modernization Act, signed by Clinton in December 2000. It exempted all derivatives from federal regulation.
The Debacle and Government Capitulation
The book describes in detail the events leading to the freezing of credit and consequent threatened collapse of the domestic financial system. When the government allowed Lehman Brothers to become insolvent and investors throughout the world, in effect, threatened a “run on the banking system”, the surviving Wall Street banks, like unruly children holding their breaths to get their way, refused to accept any financial losses. They demanded a “blank check” bail out. At that point, the government could have called their bluff, taken them over, fired the CEO’s, wiped out their stockholders and instituted a new set of rules guaranteeing no repetition of their reckless irresponsibility.
The book describes several examples of that kind of reaction by the IMF when other, mostly third-world countries, experienced similar melt-downs. Larry Summers, when he was an IMF official, strongly supported that kind of harsh reaction.
Instead, led by Summers and other financial leaders of, first the Bush Junior administration and, later, of the Obama administration, the government refused even to consider nationalization of the banks. They handed the U.S,. Treasury over to the banks and said, “Take anything you need. We trust you to do the right thing. We need you to make credit available to our struggling businesses.”
The banks took the money, complained bitterly at any suggestion that they cut back on bonuses, imposed harsh restrictions on credit, and accumulated huge piles of sideline cash. They spent lavishly on lobbying opposition to any return to meaningful regulation. They returned to the same kind of marketing practices that caused the debacle.
The banks are stronger than ever. Mergers and acquisitions have created bigger banks than the ones who capsized the financial markets. Their bonuses are larger than before. They successfully prevented any congressional action that called for systemic changes. The minor changes that were included in the regulatory legislation are yet to be implemented with administrative rules and the outcome of that process probably depends on the result of the presidential election, although past history seems predictive of choices between bad and worse, so far as concerns conflicts between bank profits and citizen protection.
We do have one hint of what we can expect: Elizabeth Warren, a woman who led the fight for an agency to protect consumers of financial services, has been declared ineligible to head the new agency. Obama did not even bother to propose her. She is now engaged in a political effort to become a Senator from Massachusetts.
Is There a Solution?
Johnson and Kwak contend that the only practical solution is to return to Teddy Roosevelt’s trust-busting strategy. If “too big to fail” is the problem, then no financial entity should be allowed to become “too big to fail”. The present Wall Street financial behemoths should be required to segment themselves into separate, competing entities small enough to fail without threatening the financial system.
There would be hysterical opposition to this idea because, at present, Wall Street is free to make giant profits from short-term risky marketing, secure in the knowledge that the taxpayers will have to bail them out when their irresponsible behavior implodes. Everyone would play roulette if the casino reimbursed their losses, but allowed them to keep their winnings.
This, of course, is not the publicly claimed basis for opposition to downsizing the investment banks. They claim that they will not be able to compete globally if they are too small to serve the needs of large, multinational corporations. Johnson and Kwak have a simple answer to this one: Large companies now use multiple investment banks when they engage in huge financial transactions. Smaller banks could work together in those situations, just as they do now.
I don’t know enough about these matters to appreciate all of the nuances, but it is plain that the present situation is so untenable as to border on insanity. In the Mexico of 1910-1920, the answer would be “Al paredon!”And the problem would be solved. [I haven’t figured out how to put the accent mark on the last syllable. The effect is lost if not shouted “Al PAreDON!] After reading this book, if that solution were available, I would have a hard time deciding which group to send to the wall first: The financial pirates who created the problems or the politicians who empowered and enabled them. I’m leaning toward the latter. One thing is clear: Our government has created a frightful fiend and it is still on the loose.