13 Bankers: The Wall Street Takeover and the Next Financial Meltdown (15 page)

One crucial innovation in the recent history of derivatives, which played an important role in creating the latest financial crisis, was the credit default swap. A credit default swap is a form of insurance on debt; the “buyer” of the swap pays a fixed premium to the “seller,” who agrees to pay off the debt if the debtor fails to do so. Typically the debt is a bond or a similar fixed income security, and the debtor is the issuer of the bond. Historically, monoline insurance companies provided insurance for municipal bonds, and Fannie Mae and Freddie Mac insured the principal payments on their mortgage-backed securities. With credit default swaps, however, now anyone could sell insurance on any fixed income security.

Credit default swaps were invented in the early 1990s by Bankers Trust, but were popularized by J.P. Morgan later in the decade as a way for banks to unload the default risk of their asset portfolios; this enabled them to lower their capital requirements, freeing up money that could be lent out again.
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Credit default swaps also provide a way for a bond investor to hedge against the risk of default by the bond issuer. But because there is no requirement that the buyer of a credit default swap own the debt in question, these derivatives are also a handy way to gamble on the chances of
any
company defaulting on its debts (similar to buying insurance on your neighbor’s house); this quality made them a new type of security that could be minted in infinite quantities and traded, providing another source of profit for derivatives dealers. And as discussed later, they would play a crucial role in greasing the wheels of the securitization machine that grew enormously in size in the last decade.

This explosion of new products created vast new profit-making possibilities for financial institutions. These opportunities were mainly available to a handful of investment banks and large commercial banks that could invest in powerful new computer technology and attract highly trained mathematicians and scientists from leading research universities. These large banks also had the scale required to build full-service derivatives operations that could assemble complex transactions and hedge their component parts. These new businesses helped blur the traditional line between commercial and investment banks, replacing it with a divide between small banks, which continued taking deposits and making loans, and big banks, which could branch out into securitization, proprietary trading, and derivatives.

BIGGER BANKING

At the same time, large banks were also growing by invading each other’s territories and acquiring smaller rivals. Banks had been trying to get around the restrictions on interstate banking and the constraints of the Glass-Steagall Act for decades. Congress responded repeatedly with legislation limiting bank activities, including the Bank Holding Company Act of 1956, the Savings and Loan Holding Company Act of 1967, and the Bank Holding Company Act Amendments of 1970. Beginning in the 1970s, however, the banks became more aggressive, while Congress’s resolve waned.

On the one hand, commercial banks sought to raise money for corporate clients, a traditional function of investment banks. In 1978, Bankers Trust began placing commercial paper (short-term debt) issued by corporations with investors. The Federal Reserve Board of Governors ruled that this practice did not violate the Glass-Steagall Act, opening a loophole that was ultimately (after an initial setback in the Supreme Court) upheld by the D.C. Circuit Court of Appeals in 1986.
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In 1986, the Federal Reserve opened up another loophole, allowing commercial banks to set up affiliated companies (through a common bank holding company) to deal in specific securities that were off-limits to commercial banks, subject to limits on the revenues earned from those securities. Over the next decade, under the direction of chair Alan Greenspan, the Fed expanded the loophole, which began with municipal bonds, mortgage-backed securities, and commercial paper, to include corporate bonds and equities;
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the Fed also raised the limit on revenues from the securities business and relaxed rules that enforced a separation between banking and securities operations within a single bank.
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Commercial banks happily took advantage of the opportunity to plunge into new and esoteric businesses. In 1993, for example, NationsBank created a securities subsidiary, NationsSecurities, which began selling its clients mutual funds that invested heavily in inverse floaters and other complex derivatives; the next year, those funds plummeted in value when rising interest rates caused losses on many derivatives.
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On the other hand, investment banks sought to encroach on the territory of commercial banks. In the mid-1970s, for example, Merrill Lynch introduced the cash management account (CMA)—a brokerage product that included a money market account with check-writing privileges. This was a key element in Donald Regan’s strategy to provide a full spectrum of financial services; as he said, “I wanted to get into banking, and CMA was the way to do it.”
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Cash management accounts competed directly with traditional savings and checking accounts for deposits, and enabled securities firms to sweep up a larger share of their clients’ assets.

Investment banks also benefited from the general shift in financial intermediation (the movement of money from people who have it to people who need it) from banks into the capital markets. Traditionally, households and businesses would put their excess cash in deposit accounts at commercial banks or S&Ls, which would lend the cash out as mortgages and commercial loans. However, the high interest rates of the 1970s convinced investors to move their savings from bank accounts to money market funds, which invested in short-term bonds and commercial paper. Increasing affluence also fed the growth of mutual funds and pension funds, which sought out higher-yield investments. This demand for yield created the opportunity for investment banks to raise money for corporate clients by issuing commercial paper and bonds and selling them directly to large institutional investors. Money still flowed from households to corporations, but instead of passing through commercial banks, now it could pass through a money market fund or mutual fund—with a helping hand from Wall Street.

Mortgage-backed securities had a similar effect. Institutional investors bought mortgage-backed securities created by investment banks; the cash flowed to mortgage lenders, who no longer needed to be affiliated with traditional banks, because they did not rely on deposits for funding. This flow of money—from investors to special-purpose entities created by investment banks to nonbank mortgage lenders to homebuyers—bypassed the traditional banking system, escaping traditional banking regulation. Large commercial banks also got in on the action, using securitization to tap the capital markets for funds to complement the money deposited by their banking customers.

As banks created new markets and expanded into new businesses, they inevitably got bigger. But they also got bigger the old-fashioned way: by buying each other. Especially after the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 relaxed constraints on interstate banking, a handful of large regional banks rushed to construct coast-to-coast networks. NationsBank bought Boatmen’s Bancshares in 1996 and Barnett Bank in 1997 to become the biggest bank holding company in the country, passing Bank of America (which had bought Security Pacific in 1992); then NationsBank bought Bank of America in 1998, and in 2004 the new Bank of America bought FleetBoston (itself the merger of the three largest banks in New England). JPMorgan Chase was the product of the mergers of Chemical Bank and Manufacturers Hanover (1991), First Chicago and National Bank of Detroit (1995), Chemical and Chase Manhattan (1996), Bank One and First Chicago (1998), J.P. Morgan and Chase Manhattan (2000), and JPMorgan Chase and Bank One (2004). Wells Fargo bought First Interstate in 1996 and merged with Norwest in 1998. Wachovia was built out of the mergers of First Union, CoreStates, and Wachovia between 1998 and 2001. The largest financial services conglomerate of all (at the time) was put together by Sandy Weill, who began with Commercial Credit, bought Primerica (which owned Smith Barney) in 1988, added Travelers Insurance in 1993, bought Salomon Brothers in 1997, and finally merged his empire with Citicorp in 1998.

The major commercial banks used acquisitions not only to become bigger, but also to push their way into investment banking. Bank of America bought Robertson Stephens in 1997; NationsBank bought Montgomery Securities in 1997; and Chase Manhattan bought Hambrecht & Quist in 1999. European banks joined in, with Credit Suisse buying First Boston in 1988 and Donaldson, Lufkin & Jenrette in 2000, Swiss Bank Corporation (now part of UBS) buying Dillon, Read in 1997, and Deutsche Bank buying Bankers Trust in 1998. America remained populated with thousands of small community banks. But at the top of the pyramid, a handful of financial juggernauts were scrambling over each other to become as big and as broad as possible, as fast as possible. The goal was to create ubiquitous financial “supermarkets” that could provide the full range of financial services to both retail and corporate customers, anywhere.

In short, the financial sector was getting bigger. Between 1980 and 2000, the assets held by commercial banks, securities firms, and the securitizations they created grew from 55 percent of GDP to 95 percent.
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Financial sector profits grew even faster, from an average of 13 percent of all domestic corporate profits from 1978 to 1987 to an average of 30 percent from 1998 to 2007.
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The growth was faster still for the largest banks. Between 1990 and 1999, the ten largest bank holding companies’ share of all bank assets grew from 26 percent to 45 percent, and their share of all deposits doubled from 17 percent to 34 percent.
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And they continued to grow. In 1998, the merged Travelers and Citibank had $700 billion in assets;
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at the end of 2007, Citigroup had $2.2 trillion in assets, not counting $1.1 trillion in off-balance-sheet assets,
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even after the spinoff of the Travelers insurance businesses. Bank of America was not far behind, growing from $570 billion after the NationsBank–Bank of America merger to $1.7 trillion at the end of 2007.
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The transformation of the financial sector through expansion into new businesses and wave after wave of mergers changed the nature of the industry. At its peak was a handful of megabanks with hundreds of billions or trillions of dollars in assets. All of these banks, whatever their origins, were heavily involved in underwriting securities, manufacturing securities (securitization), trading securities, and trading derivatives. Some of them—the ones with roots in commercial banking, such as Citigroup, JPMorgan Chase, and Bank of America—also had wide-ranging branch operations taking hundreds of billions of dollars of deposits. Others—the traditional investment banks and brokerages such as Goldman Sachs, Morgan Stanley, and Merrill Lynch—chose to avoid the hassle and fixed cost of the deposit-taking business altogether, funding their operations through the capital markets. But these alternatives were simply different strategies to obtain the funds necessary to play in the riskier, more profitable world of modern finance. Although greater size should make banks safer, the largest banks compensated by engaging in riskier activities. In 2004, Gary Stern and Ron Feldman—president and senior vice president of the Federal Reserve Bank of Minneapolis—found that “after becoming larger, banks ‘spend’ their diversification benefit by taking on additional risk. For example, larger banks hold assets in riskier categories, such as commercial and industrial loans, relative to smaller banks.”
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The goal was to be big
and
to take on risk.

The main divide in the industry was no longer between commercial and investment banks; it was between the megabanks, with their portfolios of businesses that had hardly existed three decades before, and the thousands of traditional banks that still made their money taking deposits and extending loans (although now they were more likely to sell those loans off to be securitized). Federal Reserve governor Daniel Tarullo recapped the story in a 2009 speech:

The regulatory system accommodated the growth of capital market alternatives to traditional financing by relaxing many restrictions on the type and geographic scope of bank activities, and virtually all restrictions on affiliations between banks and non-bank financial firms. The result was a financial services industry dominated by one set of very large financial holding companies centered on a large commercial bank and another set of very large financial institutions not subject to prudential regulation.
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These megabanks, whether based downtown, in midtown, or in North Carolina, were the new Wall Street.

*
To create asset-backed securities, a new legal entity buys and holds some assets (such as mortgages) and then issues new bonds that are backed by those assets. So the assets behind asset-backed securities are
in addition to
the assets on the balance sheets of commercial and investment banks.

*
Depositing money in a savings account is the same as lending money to your bank; buying short-term commercial paper is lending money to a company; buying a Treasury bill is lending money to the U.S. government. Since interest rates on savings accounts were capped but interest rates on other lending were not, people moved money out of savings accounts into other forms of lending.