13 Bankers: The Wall Street Takeover and the Next Financial Meltdown (26 page)

Finally, the Federal Reserve hooked its massive air pump to the housing bubble by keeping interest rates historically low from 2001 well into 2005. The federal funds rate (the rate at which banks borrow money from each other overnight) stood at 6.5 percent for most of 2000, before a recession and the terrorist attacks of September 11, 2001, prompted the Fed to cut it to 1.75 percent by the end of 2001.
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It fell as low as 1.0 percent in 2003 and only began climbing again in June 2004, by which point real housing prices were 58 percent above their levels of January 2000. The federal funds rate didn’t reach 3.0 percent—the
lowest
level of the entire 1990s—until May 2005, when real housing prices were 77 percent above their levels at the beginning of the decade.
⁸³

Cheap money was important because low mortgage rates were a central ingredient in the housing and securitization boom. Low rates made it easier for people to afford larger mortgages, pushing up housing prices. Low rates also induced existing homeowners to refinance their mortgages, providing more raw material for the securitization pipeline. At any point in the decade, a sharp increase in interest rates could have punctured the housing bubble by making houses less affordable and forcing prices down. But the Federal Reserve, true to the conclusion of Greenspan’s 1996 “irrational exuberance” speech—that the Fed should not attempt to identify bubbles but should simply clean up afterward—declined to act.

The irony is that the Fed’s flood of cheap money did not even have the healthy effect that it should have had. Ordinarily, businesses should take advantage of low interest rates to make capital investments, which contribute to overall economic growth. In the 2000s, however, as Tim Duy notes, business investment in equipment and software grew more
slowly
than in the 1990s, despite the lower interest rates. The problem was that the cheap money was misallocated to the housing sector, resulting in anemic growth.
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That misallocation was due to the new mortgage products that made it so easy to borrow large amounts of money, the voracious appetite of Wall Street banks and investors for securities backed by those mortgages, and a decade of government policies that encouraged the flow of money into housing. And the more money that flowed into new subdivisions in the desert, the less flowed into new factories where Americans could go to work. Ultimately, the price of the housing bubble and the financial crisis is not just trillions of dollars of losses on mortgages and mortgage-backed securities, but a decade of poor economic growth and declining real household incomes.
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Even before the financial crisis of 2007–2009, politicians and officials in Washington had opportunities to witness the potential consequences of financial innovation run riot. But they drew the wrong lessons each time, allowing the banks to take more risks and make more money. The derivatives scandals of 1994 had cost clients hundreds of millions or billions of dollars, but posed no real danger to the financial system as a whole. The same could not be said of the near collapse of Long-Term Capital Management in 1998, which led to its bailout by a group of New York banks (facilitated by the Federal Reserve Bank of New York).
⁸⁶

The LTCM bailout was the right move for the Fed to make in the short term. It protected the financial system without putting public money directly at risk. However, the successful rescue sent the message that the Fed would not let private market actors suffer the consequences of their own bad decisions; while the LTCM partners lost most of their money, the banks that had blindly lent money to the fund lost none of theirs. It is impossible to say just what effect the rescue had on the behavior of Wall Street over the next decade. But it is clear that LTCM, with its $130 billion in debts and seven thousand open derivatives positions with a face value of $1.4 trillion,
⁸⁷
was considered “too big to fail”—words that would become infamous almost exactly ten years later.

In addition, the ability of the Fed to avert disaster—and even to keep the stock market rising by cutting interest rates in September, October, and November 1998—undermined any incentive to do anything about the root causes of the LTCM near disaster. If this was the worst damage that unregulated financial institutions trading unregulated products could do, then perhaps regulation was unnecessary. Congress apparently agreed; it was in October 1998, only a month after LTCM had been saved, that it imposed the moratorium preventing the CFTC from regulating custom derivatives.

The collapses of Enron, WorldCom, and other high-flying companies in 2001–2002 also should have made clear that free markets did not deter fraud on their own. WorldCom committed straightforward accounting fraud that was missed by its auditors, the banks underwriting its new debt, and the credit rating agencies rating that debt.
⁸⁸
Enron used special-purpose entities, derivatives, disguised loans, and aggressive accounting to shift revenues forward and backward in time, create phantom profits, and hide debts; while its intentions seemed to be fraudulent, the financial techniques it used were so novel that it was not clear which were illegal and which were merely innovative.
⁸⁹
Some of its financial engineering techniques would reemerge in the financial crisis of 2007–2009, as would the banks it used—a class-action lawsuit named JPMorgan Chase, Citigroup, Credit Suisse First Boston, CIBC, Bank of America, Merrill Lynch, Barclays, Deutsche Bank, and Lehman Brothers as its enablers.
⁹⁰

Enron and WorldCom showed both the consequences of hyperactive financial innovation and the failure of “self-regulation” by the free market. Enron’s creditors, who should have been lending money carefully, instead were helping it create fake transactions.
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The credit rating agencies failed to disentangle Enron’s web of special-purpose entities and maintained its investment-grade rating until well after the company’s problems were front-page news. Old-fashioned regulation was also missing in action. In the wake of the Enron collapse, the Senate Governmental Affairs Committee concluded, “The Securities and Exchange Commission largely left the search for fraud to private auditors and boards of directors.”
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Confronted with this wake-up call, Congress and the Bush administration limited themselves to bolting the particular barn door exploited by the Enron-WorldCom generation. The Sarbanes-Oxley Act of 2002 established new standards for corporate financial statements (and, by 2007, was under widespread attack from the business community for being too stringent). It did not occur to anyone in power that some of the ingredients that made Enron possible—financial innovations dreamed up by Wall Street banks hungry for large transaction fees, off-balance-sheet accounting, weak credit rating agencies, credulous investors, a largely fawning media, and ineffectual federal regulators—might already be recombining in a different form.

The SEC—the nation’s chief regulator of the securities markets and investment banks—stepped up enforcement briefly after Enron, but enforcement actions declined again during the chairmanship of Christopher Cox from 2005 to 2009. Under Cox, the five-member commission that governed the agency often delayed action on opening investigations, delayed approval of settlements, or reduced penalties recommended by enforcement officials, resulting in an 84 percent decline in penalties.
⁹³
Instead of focusing on enforcement, powerful commissioners such as Paul Atkins argued that the SEC should pare back regulations that were seen as imposing excessive costs on the free market.
⁹⁴

The SEC also failed to exercise its powers to oversee the securities industry. In the wake of the collapse of Bear Stearns, the SEC inspector general found that the agency not only took no meaningful action under the Consolidated Supervised Entity program, but also did a poor job implementing its Broker-Dealer Risk Assessment program (created in 1992 in response to the failure of Drexel Burnham Lambert). Under that program, the SEC received quarterly and annual reports from 146 broker-dealers—but generally only reviewed six of them.
⁹⁵
Most famously, the SEC managed to overlook Bernie Madoff’s $65 billion Ponzi scheme, despite tips and investigations going back to 1992.
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This failure to regulate the securities markets effectively was a consequence of the deregulatory ideology introduced by Ronald Reagan as well as the political influence of Wall Street. James Coffman, a former assistant director of the SEC’s enforcement division, wrote,

Elected deregulators appointed their own kind to head regulatory agencies and they, in turn, removed career regulators from management positions and replaced them with appointees who had worked in or represented the regulated industries. These new managers and, in many cases, the people they recruited and promoted, advanced or adhered to a regulatory scheme that, at least with respect to the most important issues, advanced the interests of the regulated.
⁹⁷

After all, the industry’s mantra was that financial markets could self-regulate, so there was no need for the government. Once the government accepted this logic, it unilaterally disarmed in a sweeping abdication of its responsibility to the people it served.

THE GOLDMAN SACHS SAFETY NET

As much as the Wall Street banks wanted Washington’s hands off their moneymaking businesses, they still had no stomach for doing business without the protection of the U.S. government. This attitude is consistent with the history of the business-government relationship in the United States. While occasional libertarian academics and politicians have favored deregulation in its pure form, real companies see regulatory or deregulatory policies simply as a way to improve their market position or profit-making potential. And one benefit Wall Street banks wanted was the security of knowing that the government’s effectively unlimited balance sheet and borrowing power would be there for them should they need it.

Did bank executives consciously take excessive risks because they expected taxpayers to cushion their potential losses? This is not something that a Wall Street CEO is likely to admit, and it is possible that on an individual level they simply underestimated the risks involved and expected their winning streaks to continue indefinitely. But the government safety net was on at least some bankers’ minds. Andrew Haldane, executive director for financial stability at the Bank of England, has told the story of a meeting (prior to the recent crisis) where government officials asked private-sector bankers why they did not conduct rigorous “stress tests” of their own portfolios; the answer, according to one participant, was that in the event of a severe shock, “the authorities would have to step in anyway to save a bank and others suffering a similar plight.”
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In any case, the behavior of major financial institutions made sense largely because of implicit government guarantees. Increasing leverage, increasing the proportion of assets held for trading purposes, buying riskier assets, and selling out-of-the-money options (such as credit default swaps) are all strategies that increase returns in good times but increase losses in bad times; therefore, they make the most sense for banks that can shift those higher losses onto someone else. (Ordinarily, banks’ creditors would prevent them from pursuing these risky strategies, because their money would be on the line; if creditors expect to be bailed out by the government, however, there is no need for them to monitor the banks closely.) And they are all strategies that were pursued during the recent boom by major global financial institutions, including those in the United States.
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We do know that executives of at least one major bank thought about the government safety net. Since 1932, Section 13 of the Federal Reserve Act had given the Fed the power, in “unusual and exigent circumstances,” to make loans to anyone—but only if the collateral provided in exchange arose “out of actual commercial transactions.”
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This requirement specifically excluded investment securities, which meant that in a crisis, investment banks might not have any valid collateral with which to borrow from the Fed.

This danger worried the remarkably prescient executives at Goldman Sachs. At their suggestion, the “actual commercial transactions” requirement was dropped in a “miscellaneous provision” of the Federal Deposit Insurance Corporation Improvement Act of 1991, ensuring that the Fed could lend against
any
collateral in a time of crisis.
¹⁰¹
This change gave the Fed the power to widen its protective umbrella to encompass investment banks, at the same time that those banks were increasing the riskiness of their operations by expanding their derivatives and proprietary trading businesses and taking on additional leverage. This seemingly minor change would be of crucial importance seventeen years later; when the housing bubble of the 2000s ended—and with it the seemingly unlimited supply of money flowing from novel and largely unregulated financial products—not only investment banks but a major insurance company would have to be rescued with government money.