The Great Read-cession, Part XI

It’s the final post of The Great Read-cession! Just shut up and read!

The End...

The End…

What should the government have done differently?

 

This is a very loaded question. When I first started reading about the issue, while it was going on in 2008-09, I got the sense that this was really a rare case where the government was not at fault. This wasn’t like Watergate or Iraq, where people in power abused that power—it was just a case of private companies going wrong. But it becomes a lot trickier when you look closely at how intermeshed the government and the financial world actually are.

A lot of the conversation about the government’s role in the collapse has surrounded the issue of deregulation, specifically the issue of Glass-Steagall. On the other end of the political spectrum, Republicans have focused on the GSEs as responsible for the decline in lending standards. But both of these issues seem more like scapegoats than real sources of the problem.

As most of the data makes clear, the Community Reinvestment Act of 1992, which directed Fannie and Freddie to purchase more mortgages from certain minority groups, had very little to do with the subprime boom and decreased lending standards. Fannie and Freddie bonds defaulted at a lower rate than those sold to wholly private firms, and there was clear market demand for housing securities absent any government pressure.

The repeal of Glass-Steagall, on the other hand, at least bears some of the blame for allowing companies like Citigroup and Bank of America to get so big. While the law had, since 1933, separated the activities of commercial and investment banks, its repeal allowed the biggest commercial banks in the country to expand their proprietary trading.

With that said, the repeal of Glass-Steagall was mostly symbolic—banking regulators had been allowing more trading at commercial banks for decades before its official repeal in 1999. And the most notable failures of the financial crisis—Lehman, Bear, AIG, Fannie, Freddie—would not have been affected at all by the law.

The general culture of deregulation that grew around Wall Street bears more responsibility. Things like the CFTC’s refusal to treat derivatives like futures, the Fed’s lack of oversight on predatory lending, and the SEC’s allowance of excessive leverage at the investment banks all contributed to the crisis. And all these things ultimately came from a belief in the power of “self-regulation,” a belief propagated by Greenspan that insisted the best people to regulate the financial industry were those participating in it.*

*I should clarify that when I refer “the government” in this post I am generally referring to the federal government and its massive network of regulating agencies. State governments actually did make attempts to combat the industry’s abuses. Attorney generals in states like Iowa, Minnesota, Washington, and Illinois made concerted efforts to target predatory lending. Eliot Spitzer in New York famously went after abuses on Wall Street. In many of these cases, though, the federal government interfered, claiming jurisdiction and then letting banks “self-regulate.”

But while it’s easy to see how all these things contributed to the crisis, it’s hard to know if stopping any one of them would have prevented it. It’s very easy to say that the right law at the right time would have prevented a disaster, but it’s harder to design laws ahead of time that will be effective and appropriate.

The more dangerous factor isn’t really deregulation, but the way regulation itself works. Greenspan’s belief in self-regulation would have possibly been acceptable if the government had truly taken a hands-off approach to the economy under his helm, but that’s not at all what happened. In fact, it’s possible that there has never been a more interventionist Fed Chairman than Greenspan. Greenspan was famous for “the Greenspan put,” or his strategy of lowering interest rates whenever the stock market fell. When Long Term Capital Management failed, the Fed helped organize a privately funded bailout to ease the shocks to the market. During the Mexican currency crisis of 1994, he (along with then-Treasury Secretary Robert Rubin and his deputy, Larry Summers) helped bail out the Mexican government to avert losses on Wall Street.

The message, in short, was that whenever something threatens to harm the financial industry, the government will intervene. By bailing out creditors and making borrowing easier, the government effectively shielded the financial industry from risk, which only encouraged banks to take on more risk in pursuit of revenues. Simultaneously, the Fed was stimulating one of the greatest increases in private debt* in American history. These things—the financial industry’s disregard for risk and the increase in private debt—were much more fundamental causes of the crisis than any CFTC decision on derivatives.

*When thinking about the increase in private debt, it’s worth bringing up the fact that the years preceding the crisis saw a growth in income inequality. Between 1979 and 2007, the top 1% of American earners went from earning 11.3% of all income to 20.9%. Since 1980, almost all the gains in wealth and income have gone to the top 1%, while real wages for most Americans have been stagnant.

We hear so much about economic inequality and get so inured to the statistics that we can forget why it even matters. After all, there’s no guarantee of equal results, so why should we begrudge successful people their success?

But as the crisis makes clear, growing inequality leads to a growth in debt. When some people have a lot of money and others have only a little, it’s almost inevitable that those with a lot will lend it to those with a little. Indeed, it was only through an increase in debt that consumption could sustain the levels that it did over the last few decades. It’s no wonder, then, that people tapped into their home equity to buy cars and laptops and Beanie Babies and Taylor Swift CDs—for most people, their house is their greatest asset and the only real collateral they have.

The expansion of private debt, though, can ultimately lead to abuse and crisis, as it did in this case. Economic inequality, then, is unsustainable for everyone.

And, of course, the government’s response during the crisis itself possibly only exacerbated it. As I said in the discussion of Paulson’s book, any type of coherent response—whether that meant more government intervention or less—would likely have been better than what the government did, bailing out some firms while letting Lehman fail, repeatedly changing the justification for bailing out AIG, orchestrating mergers between dysfunctional companies, etc.

Of course, that response, like actions under Greenspan, was motivated by the same ideology. There was no rational philosophy behind the decisions, just an instinctual desire to help Wall Street. The lip service Paulson paid to “moral hazard” was just like Greenspan’s disingenuous gestures toward “free markets.” Both were simply rationales for helping the financial industry.

So you’re saying the government should not have bailed out Wall Street?

 

Well, not really. Maybe. Kind of. It’s complicated.

Basically, it’s a red herring to focus on the passage of TARP. As the dissenters to the FCIC Report spell out, it would have been reckless for Congress to refuse to pass TARP, given the situation people like Bernanke and Paulson had laid out for them. If the leading economic regulators in the country come to you and say, “If we don’t pass this law, there’s a 95% chance the banking industry will collapse,” only the most strident opponent of government spending is going to object to the law.

Plus, the most high profile measures in TARP—the “Capital Purchase Program” that essentially handed money directly to the banks without any strings—actually made money for Treasury, since most of the money was very quickly repaid.* And, of course, the TARP money that ultimately went to the auto industry is often cited as a resounding success for the American car companies, though much that is exaggerated for political points.

*After the scandal about the AIG bonuses, most banks didn’t want to risk government attempts to limit compensation.

The dishonesty that surrounded TARP was actually far more damaging than the policies themselves. Originally pitched as a plan to buy mortgages directly from the banks, TARP seemed like a broad plan to address the economic calamities. Buying mortgages and mortgage-backed assets from the banks would get the distressed assets off the banks’ balance sheets while simultaneously allowing the government to restructure the mortgages of people who were now underwater on their homes.

Ultimately, of course, Treasury just handed the banks money directly. Even the rationale for this was misleading: Paulson, Geithner and Bernanke insisted that handing the banks money would lead them to make more loans and stimulate the economy. But they never made an effort to ensure that the money was lent out at all—and indeed, most evidence suggests it wasn’t. In fact, the reason for the capital injections was to make the banks appear more stable than they really were, allowing them to persist through the economic storm.

It’s possible this was still the right decision—that not capitalizing the banks would have led banks to fail en masse, leading to catastrophic consequences. But the speed with which the loans were paid back indicates that only a few firms truly needed the money. More importantly, though: If that’s the real reason for the bailout, then just say that. Claiming the injections were going to increase lending misled people about the nature of the response and misled Congress about what they were actually funding with taxpayer money.

In other words, a broad plan to fix the economic challenges facing the entire nation became a plan specifically designed for the banks. Instead of getting the bad loans off the banks’ books, they stayed there, to be unloaded gradually while the banks “earned their way back” through things like proprietary trading (in, say, European debt). This trading was, of course, aided by loans from the federal government. In sum, then, TARP went from a comprehensive economic program to yet another law designed to aid banks.

But there were already countless such deals in place, and these other government programs, these “backdoor bailouts,” were actually far more insidious than TARP itself. There were a myriad of actions taken by the federal government, aside from outright bailouts, that were essentially just aid to the banks.

Some of these were relatively harmless, though secretive, like the government guaranteeing mutual funds; others were insidious but persistent, like the Fed offering investment banks the discount rate (usually reserved for commercial banks) and lowering its standards for the collateral; some were borderline corrupt, like Treasury’s insistence on paying AIG’s debt off in full even as the company was heading to bankruptcy. One SIGTARP report tallied up the potential cost of all these guarantees and loan programs, and found that they came to $23.7 trillion, or more than the entire GDPs of the United States and China combined.*

*When this number was released it (obviously) raised a lot of alarm in the press, but it’s important to keep the number in perspective: The government was never in danger of LOSING that amount of money, since many of the loans were backed up and not all mutual funds can fail at once. But the number at least shows how small a piece TARP—which was a meager $700 billion—was in the overall scheme of bailouts.

Of course, the policies of Paulson/Bernanke/Geithner were effectively the same as the policies of Rubin/Greenspan/Summers. If Wall Street needed help, it would get it, while the rest of the world had to live with “free markets” and “moral hazard.” When the economy was in free fall, the idea of “saving the system” really meant “saving the banks.” The orthodoxy that banks cannot be allowed to suffer extreme losses had become so ingrained that there was hardly a second thought about it.

It is perhaps the most perverse thing about the financial crisis that this thinking—that Wall Street must be protected from potential losses—has not only persisted through the events of 2008, but actually has gotten more entrenched. The bailouts only made official what has been government policy for 20 years: The government will not let Wall Street fail.

What about Wall Street reform? Hasn’t the Dodd-Frank Bill helped this?

 

No. Dodd-Frank, for the most part, only codified these policies, and certainly didn’t do anything to change the regulatory structure.

Geithner’s strategy of “stabilize, then reform” had exactly the effect you’d expect—by the time Congress got around to negotiating legislation on financial reform, the urgency was gone. The connection between reform and the crisis wasn’t as stark—by 2010, people were more worried that Dodd-Frank would hurt the recovery. As a result, there was little resistance to industry pressure to water down the law. Some of the pressure, in fact, came not from Wall Street lobbyists, but from Treasury itself, which worried that reform would prevent its bailout program from continuing.*

*Of course, for many, this was the whole point of the law.

Suskind and Barofsky go over the unsavory details of how the most meaningful provisions of Dodd-Frank—the Volcker Rule which prohibited banks from proprietary trading, the Brown-Kaufman amendment which would limit the size of banks, Senator Al Franken’s amendment to reform the credit rating agencies—were slowly gutted or removed from the final bill.

Instead, the main thing the bill did was create the Financial Stability Oversight Council,* or yet another federal agency tasked with monitoring the behavior of Wall Street. The FSOC was designed in a fashion typical for Washington: By endowing the council with the abilities to set capital requirements, limit proprietary trading, identify systemic risks, and other tasks, the law got credit for addressing these issues. But by requiring two-thirds of the council to vote for material changes in size and structure of the bank, as well as making the council’s chair a political appointee (the Treasury Secretary), the government ensured that no serious concrete steps will ever actually be taken.

*It also set up the Consumer Financial Protection Bureau, which is tasked with monitoring financial products aimed at consumers—things like mortgages, credit cards, foreclosure relief. This seems like a more worthwhile endeavor—depending on the execution—but I didn’t read much about it, as it doesn’t deal directly with the banks.

Barofsky’s time working with the FSOC revealed it to be just another weak federal regulator with no serious inclination to affect change. In fact, it’s reasonable to think that the FSOC will become counterproductive as it gets dominated by the same thinking that dominates Treasury, the SEC, the Fed, and every other significant regulator.

In order to truly reform Wall Street and Washington, the entire regulatory apparatus needs to be reworked. If the financial crisis proved anything, it’s that the vast array of federal agencies doesn’t work. It’s not always their fault—they generally have fewer resources and less expertise than the firms they are regulating—but the result is that they are ineffective. Their main accomplishment is only to lend an air of government approval to Wall Street’s recklessness.

The real solution probably involves fewer agencies and fewer laws, but more aggressive penalties and punishments. Instead of having the SEC or the FSOC try to figure out how much leverage a company can have, companies should be allowed to borrow all the money they want—but if they misrepresent the extent of that leverage publicly, they ought to be prosecuted for fraud (cue Senator Warren). Fines that amount to rounding errors on the firms’ balance sheets can’t possibly be effective deterrents. But sending a handful of financial executives to jail would do more than a hundred of these settlements and fines.

Why hasn’t anyone gone to jail?

 

The premise of this question is a little unfair. There have been a fair number of prosecutions stemming from the crisis, and a fair number of people have gone to jail. There have been famous fraudsters like Bernie Madoff and Allen Stanford whose Ponzi schemes were exposed by the crisis, and there have been people sentenced for mortgage fraud throughout the country.

But for the most part these have been small-time offenders trafficking in a few million dollars worth of fraud—the equivalent of street-level drug dealers—while big banks made billions. In some cases, the government has gone after borrowers themselves, who in many cases were really victims. Meanwhile, not a single executive at any of the financial institutions that enabled and profited off of these fraudulent loans has seen any jail time.

There is a line of thinking that says Wall Street’s behavior, while reckless and stupid, was not criminal. To some extent this is true, but it’s naïve to think the banks didn’t do anything wrong. Bubbles this big are almost always accompanied by a growth in fraud and criminality, and the evidence that the banks knew about fraud in the housing market, and didn’t do anything about it, is staggering in some cases.

Knowingly selling worthless securities, wrongfully foreclosing on peoples’ homes, misleading investors about the nature of your exposure—all of these are or ought to be considered crimes. And the fact that not a single person from the major banks has been convicted of any crime—or even suffered personally at all*—is not evidence of innocence, but of a flawed criminal justice system.

*Even those executives who lost their jobs in the crisis often got lucrative golden parachutes or were quickly rehired.

For the most part, punishment of Wall Street has taken the form of settlements and deals with regulators. These deals make headlines for their big numbers, but when you look at the details, they don’t do much to punish Wall Street at all. In a country that imprisons people at a higher rate than any other in the world, people who work for banks simply do not face a realistic threat of imprisonment.

For all the talk of “corporate personhood” and whether or not corporations have the same rights as individuals, people sometimes forget that, on a basic level, corporations are made up of people. When we say, “Bank of America did X” or “Goldman Sachs did Y,” we’re really saying that people who work at those companies did X and Y. And those people should be held responsible for their actions if they are criminal.

This means sending people to jail. When employees at Bank of America sign names that aren’t their own, and claim knowledge of documents that don’t exist, they ought to go to jail—both low-level employees and the executives who approved it. This would certainly require some changes to the criminal justice system—increased sentencing for white-collar crimes, harsher penalties and stricter standards for criminal negligence, and possibly making some crimes strict liability to prevent executives from pleading ignorance—but it’s the only way to meaningfully combat the crimes and frauds that persist on Wall Street.

Of course, this won’t happen unless the guiding philosophy in Washington fundamentally changes. The same logic that says banks should get capital injections and loans when they need money, federal guarantees when investors lose confidence, and whatever else they need to prevent economic collapse, says that people at banks ought to be allowed to bend and break the law if it helps them stay profitable.

Will something like this happen again? 

 

Almost certainly. We’ve already seen how, after the housing market burst, Wall Street quickly moved to the next du jour investment. First it was European sovereign debt, then it was commodities, and now it appears to be housing again. The same patterns and procedures are still in place in these financial firms. And eventually all the variables will align to create a crisis similar to the crisis of 2008. All of this has happened before and all of this will happen again…

And the financial industry is in even worse shape than it was then. The Too Big To Fail banks have only gotten bigger—the five biggest banks hold the equivalent of 56% of the US economy, up from 43% in 2007. Relatively to the economy, they are twice as large as they were a decade ago.

Creditors are behaving as if “Too Big To Fail” is the official policy of the federal government. They are granting big banks more favorable terms than smaller competitors. This will only drive smaller banks out of business or encourage them to get bigger and more “systemically important.”

The other consequence of this favoritism is that big banks are able to borrow money more cheaply than they otherwise would. Recall that it was the “implied government guarantee”—the assumption that the federal government would cover any debts in an emergency—that allowed Fannie Mae and Freddie Mac to amass the crippling debt that forced them into conservatorship.* The government has now essentially extended the same protection to banks which, together, are about five times the size of the GSEs.

*Though, as I said, the GSEs did not cause the crisis, their failure was possibly the most costly to the taxpayer. According to the CBO, the cost was over $300 billion.

With the ability to borrow money so cheaply, these banks will inevitably make riskier investments. Just as homebuyers will reach for bigger homes when credit is cheap, banks will indulge in greater leverage and higher yield investments when they have access to cheap credit. In this case, though, it’s the taxpayer that’s ultimately on the hook.

The federal government, meanwhile, is only encouraging this extensive leverage. In addition to the impotent requirements within Dodd-Frank, the Federal Reserve last year allowed banks to deplete their capital by buying back stock and issuing dividends.* And the lack of criminal prosecutions have left many on Wall Street without any compunctions about criminal behavior, something the recent deal with HSBC cannot help but exacerbate.

*Both dividends and stock buybacks drive up the price of a stock, which will of course benefit the executives working at these banks, who are generally given stock bonuses.

And the policy of bailouts continues on its own momentum. If we bail out a hedge fund, then why can’t we bail out an investment bank? If we bail out an investment bank, then why can’t we bail out a commercial bank? If we bail out the banks, why can’t we bail out the auto industry? Each one makes it easier to rationalize the next one. Unless there is a clear and definitive step towards repudiating this policy, then there’s no reason to think the streak won’t continue.

So, ultimately, it’s only a matter of time before another bank, now bigger than ever and as risky as ever, runs into trouble. At which point the federal government, dedicated to the idea that as goes Wall Street, so goes the rest of the economy, will intervene with more taxpayer money. Meanwhile, some new group of victims will replace the underwater homeowners of this crisis. But who will be looking out for them?

What good is Wall Street?

 

While reading these books, no question went through my head as often as this one. Given the economic damage done in the crisis of 2008, what good does Wall Street actually do? Is it even worth it?

Of course, it’s unfair to blame all the damage on the financial industry. It’s not like bubbles are anything new. Bubbles have existed for almost as long as capitalism itself.

But something stands out about the credit bubble. Normally, when there’s a speculative frenzy, it is based on some new discovery or innovation. The Internet comes to mind, or the transcontinental railroad, or some newly discovered land. The hype around these things led to speculation and fraud, and when these bubbles burst many people suffered. But when it was all over, there was at least something good. The dot-com bubble gave us Pets.com, but it also gave us Amazon. Railroad mania gave us a railroad. Even previous real estate bubbles, like the Florida land boom that preceded the Great Depression, at least led to the development of new communities and homes.

Credit bubbles, though, don’t leave anything tangible in their wake. Homeownership rates are below where they were a decade ago, meaning all those fancy new types of mortgages were not actually effective in extending credit to worthy buyers. The number of new businesses started did not actually increase significantly during the bubble (though it did fall dramatically in the years following the crisis), meaning the extension of credit did not create more new companies. There was a bump in the number of houses built, but this was almost entirely the result of speculative building, as housing starts plummeted after the crash. After all, it’s not like there was some major new innovation in the world of homebuilding that made new homes better or cheaper, or a dramatic population increase that drove up demand. It was simply that Wall Street had figured out new ways to invest in housing via MBSs and CDOs.

The one thing that all these Wall Street innovations have created is debt. By creating all these instruments to extend credit, the financial industry enabled consumers to increase their debt load. Between 1997 and 2007, the private debt-to-GDP ratio increased by 40% and exceeded 150% for the first time since 1929. The massive GDP contractions in the following years stemmed from people trying to pay off their debts—mortgages, credit card bills, student loans, etc. The only reason so much of this debt is still outstanding is because the levels were so high to begin with.

That is what all the innovation in the financial industry over the past decade has done for average people: It has helped load them with debt. And while there is nothing wrong with borrowing money, at a certain level debt becomes unsustainable. All the debt created by Wall Street has prevented the economy from growing, leaving people with fewer job opportunities and fewer options.

Of course, defenders of the financial industry will talk about how all these credit instruments help efficiently allocate capital, allow people to buy things they need with credit cards and home equity loans, and help grow the economy. But if that is true, then where is the economic growth? If the money is being distributed so efficiently, then why does debt keep increasing? Where, in short, are the customers’ yachts?

As Paul Volcker said, the last useful thing the financial industry invented was the ATM. At least that helps people.

Conclusion

Volcker, the former Fed Chairman, has a unique perspective on the crisis. He is someone with extensive knowledge of the financial industry, but who, in the years before and after the crisis, was removed enough from the industry to be objective and critical.

At one point, Suskind quotes Volcker talking about the lack of engineers in American colleges:

“It always used to bother me—not so much anymore, but for a long time—how I spent all my life in government, doing things that were so intangible. What’s there to show for it, what’s left behind? And I just thought, imagine saying, ‘There’s a goddamn bridge I built. Or I designed that building, or I shaped that beautiful landscape.’ I always wanted to build something in my life. All I did was stop inflation.”

It was completely staggering to read those words. It’s not that Volcker was the only one to express regret or reservations about the role of the financial industry (it was actually a refreshing surprise to see how many of the people in these books were seriously reflective about the good they’d done). But here’s someone like Volcker, who many people credit with one of the major accomplishments of the Federal Reserve, fixing the inflation of the late 1970s.* And yet he’s lamenting the fact that he never built a bridge.**

*I had a high school teacher who called Volcker his “hero,” though this was likely an exaggeration.

**Margin Call, one of the first feature films about the crisis, has an excellent scene illustrating this.

When I read this, amid everything else, I could only conclude that Wall Street is evil. And I don’t mean that in a cartoon villain, bad-guy-cackling-in-a-dark-room, “vampire squid” way. Or even in the way people say oil companies or tobacco companies or gun companies are evil. For all their ills, these companies are just inevitable responses to societal demands. But Wall Street is evil in ways that are both prosaic and profound, unremarkable and undeniable, easy to miss and impossible to ignore. It is evil in subtle, simple ways that go deeper than general condemnations of private industries.

Wall Street is full of brilliant, hard-working, and well-meaning people, people who love their families and have nuanced political views and favorite charities. They come from the best schools and have families who devoted countless resources to their upbringing.

Wall Street attracts these people with the promise of respect, power, status, and godlike sums of money. Then these people dedicate their intelligence and their work-ethic and their lives to an industry that produces almost nothing of value, that can hardly be ignored or opted out of, that affects peoples’ lives in ways they often cannot comprehend. And what does society have to show for it? Nothing beside remains…

If you look around the country, you see a shortage of doctors that is driving up health care costs, a crumbling infrastructure stemming in part from a dearth of engineers, and an education system suffering from a lack of quality teachers. Where are all the potential doctors, engineers, and teachers? They are designing CDOs on Wall Street.

This, I submit, is evil. An institution is evil when it takes the best and the brightest and devotes them to a task of no real value. An institution is evil when its gains are given to a select few and its losses are borne by innocent bystanders. And people who go to work there—as good, honest, smart, hard-working as they may be—are deliberately choosing to work for an evil institution.

When I started this project, I, like most people, had a vague feeling of anger directed at nobody in particular. I thought reading about it might make the figures seem more reasonable, the problems more inevitable, and that this would dissipate my anger.

Instead, my anger has only sharpened, and it is directed squarely on Wall Street. But I shouldn’t be so vague: I mean at the people who work there. The despicable, worthless, good, smart, decent people who work there, who could be doing so much better.

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