Bought and Paid For (16 page)

And the news from Gensler wasn't good. The hedge fund Long-Term Capital Management (known as LTCM), run by trading whiz John Meriwether, had made massive profits in recent years from trading esoteric bonds based on computer models designed by Nobel Prize-winning economists. LTCM had made fortunes from exotic bets on little-known corners of the financial world, like Danish mortgage bonds, of all things. But now it was imploding, literally ready to collapse, because it had bet enormously wrong on the direction of everything from the bonds issued by the U.S., European, and Japanese governments to the share price of the Royal Dutch Shell petroleum company.

Instead of letting LTCM fail—a move that true free-market devotees would advocate as a way to punish excessive risk taking and teach the gamblers not to gamble—Rubin's idea was to bail it out. Once again, as with the Mexican peso, Rubin worried about systemic risk. Rubin was concerned about this possibility because the big Wall Street firms, which dealt with LTCM, piggybacked (i.e., copied) many of its trades and would lose massive amounts of money too.

The panic selling an LTCM collapse, Rubin thought, would lead to massive losses in the market at all the major firms, including his old firm, Goldman Sachs. At least two firms, Lehman Brothers and Merrill Lynch, might take such heavy losses they might not survive. Goldman would have to postpone, maybe indefinitely, its IPO.

As Rubin put it in his biography,
In an Uncertain World
, “In normal circumstances, the government shouldn't worry about the tribulations of any particular firm or corporation. But if the situation threatens the financial system, some kind of government action might be the best among bad choices.”

The solution that the Treasury and the Fed came up with demonstrated the true strength of the ties between the big Wall Street firms (or at least most of them) and their benefactors in Washington. The firms were summoned to the offices of the New York Federal Reserve Bank, the most important of the Fed's regional banks because it provides oversight of the banking system and conducts “open-market operations” that control the nation's money supply. The solution was pretty simple: The Fed was ready to pump money into the banking system in an effort to help eliminate the losses on the bad trades the banks had copied from LTCM. Each of the big banks (with the exception of Bear Stearns, whose CEO refused to join the effort) would each pony up around $300 million (Lehman Brothers could just afford $100 million) and buy the fund's assets for $3.6 billion.

Taken another way, they each spent hundreds of millions to save countless billions, because after a few hectic weeks and some modest losses at Merrill Lynch, Lehman, Goldman, and the rest, Wall Street recovered. It wasn't just the dot-com bubble, then in full swing, that generated such massive profits for the Wall Street firms that took all those fleeting Internet companies public. The bond markets exploded as well, thanks to the Fed's dumping all that money into the system with low interest rates. In the months after the LTCM collapse, Wall Street was standing tall. Combined with the revenues from underwriting dot-com IPOs, the soaring trading revenues breathed new life into Lehman Brothers and Merrill Lynch; Morgan Stanley had one of its longest periods of prosperity in years, as did Goldman Sachs, Rubin's old firm, which finally completed its long-awaited IPO.

With Wall Street on a roll, Main Street prospered as well. It didn't matter that many of the dot-com stocks underwritten by the Wall Street firms would turn out to be busts. It didn't matter that President Clinton's chief regulator, Arthur Levitt, chairman of the SEC and the man charged with making sure mom and pop investors get a fair shake, seemed blind to this massive fleecing of the investment public. It also didn't matter that the bond traders who were minting money once again by buying, selling, and packaging esoteric debt had been given the signal from government that they could take as much risk as they wanted without suffering the consequences.

Everyone was happy, at least for the moment.

It is impossible, of course, to know whether letting market forces take their course and allowing LTCM to fail would have created the type of financial tsunami that Rubin feared—the same tidal wave that nearly destroyed the system ten years later when Lehman Brothers was allowed to fail. Wall Street was smaller then, and the risk in the system from derivatives and the funky mortgage bonds that would doom the banks in 2008 was far, far less.

But one thing is certain: By bailing out Wall Street, Rubin and his cohorts at the Federal Reserve essentially doubled down on moral hazard. It's why, for example, insurance companies insist on deductibles or copayments; if they didn't, customers would have no reason to, say, worry about getting into a car accident (aside from the possibility of personal injury) because they wouldn't bear any cost for doing so. In the context of Wall Street, bailouts create a moral hazard by planting the idea in the minds of firms that if one of their competitors is bailed out, they will be too if they run into trouble. As a result, these firms have no qualms about engaging in reckless and excessive risk taking.

And yet first with the Mexican peso crisis and later with the LTCM bailout, the federal government was introducing moral hazard into Wall Street in a big way. Unsurprisingly, the risk taking on Wall Street would rise over the next decade to unprecedented levels. Until, of course, the system came crashing down.

The dot-com bubble would end in 2000, and by the time President George W. Bush took office in 2001, a mild recession had set in, soon compounded by the September 11 terrorist attacks, which caused a major sell-off in the market. A new government was in power, but “Rubinomics” was administered from Washington once again. Following the attacks, the Fed began slashing interest rates to historic lows, igniting the bond markets once again and setting the stage for the biggest housing bubble of all time as banks, flush with cash, lent money to anyone with a heartbeat.

Robert Rubin was at one of those banks.

“I had a number of offers,” Rubin would later brag, “but Citigroup was the best.” Rubin, of course, was talking about his new gig at Citigroup, where he carried the amorphous title of “chairman of the executive committee.” Before he left the Treasury Department in July 1999, Rubin did several things. First, he began looking for a job on Wall Street. He held extensive talks with Hank Greenberg, the fair-minded but volatile CEO of insurance giant American International Group (AIG). They couldn't reach a deal, Greenberg later said, because “I didn't want to pay him $8 million a year to fly around the world.”

Citigroup and its CEO, Sandy Weill, ultimately would pay him this much and more, offering Rubin a job at Citigroup to advise on its businesses, do deals, consult with bureaucrats in Washington, and generally think big thoughts. He did all this for an estimated $15 million per year, not counting stock options. Rubin also received a seat on the board of directors and a promise that he would have no responsibilities as a supervisor. This meant nobody really reported to him, and if anything went wrong, he could blame someone else.

“I did that once,” he later said, referring to his job running Goldman Sachs, “and I didn't want to do that again.” No, Rubin had bigger goals. He told the
New York Times
that what he really wanted was some type of job at a large financial institution that would give him time to “fish, read books, and play tennis, but life is a trade-off.” With such a plum assignment, it was little wonder his colleagues at Citigroup could hardly contain their envy. “Bob has the best job in the company; no line responsibilities. But he will be a full partner” was how co-CEO John Reed described Rubin's position. And why would Rubin need to work all those long hours? He was, after all, on Clinton's speed dial. With Big Government connections like that, Citi was sure to have a massive year, even if Rubin spent much of his time playing tennis.

Of course, a lot would go wrong at Citigroup over the next decade, and to be fair, Rubin wasn't without accomplishments at the firm. But by far his most notable—and probably most historic—“achievement” in his time there was doing what he'd meant to do for years—repeal the Glass-Steagall Act.

By late fall 1999, just before Rubin was to begin his job at the firm, Citigroup was still technically an illegal enterprise. The Glass-Steagall Act wasn't dead quite yet. And that's when Rubin went to work, participating in the massive Wall Street lobbying effort to kill the law once and for all and thus allow the big firms to grow even bigger.

Rubin's old firm, Goldman Sachs, shuddered at the thought of competing with the massive Citigroup empire—which could entice clients with bank loans in order to get other types of deals. A decade earlier, as chairman of Goldman, Rubin would have been lobbying against its repeal. But times were changing.

Glass-Steagall was finally repealed in late 1999, and Rubin ended up on the cover of
Time
magazine as one of the wise men of the great economic boom of the late 1990s. Despite his fame, it's difficult to tell exactly how much influence Rubin had over his old boss, President Bill Clinton, in killing the law.

But two things are certain: The end of Glass-Steagall made Bob Rubin richer than ever before, and it paved the way for the eventual collapse of the economic system nine years later. The megabanks like Citigroup, Bank of America, and JPMorgan Chase weren't the only culprits in the massive risk taking that occurred in the decade preceding the 2008 financial collapse, but their existence propelled the others to take more risk. Bear Stearns, Lehman Brothers, Morgan Stanley, and even the great Goldman Sachs, the one firm that seemed to reduce risk taking to an art, ramped up their borrowing so they could compete with the big banks.

Profits soared, at least for a while, and Wall Street fulfilled its end of the bargain it had struck with Washington, namely aiding and abetting the policy goal of treating the earned benefit of homeownership as something nearly approaching a right of citizenship. Under President Clinton, the big mortgage lenders, Fannie Mae and Freddie Mac (which in essence function as part of the government), were pushed to guarantee loans to people in lower and lower income categories. Meanwhile, Clinton's housing secretaries, Henry Cisneros and Andrew Cuomo (who as I write this book is running for governor of New York, after serving as the state's attorney general since 2006), did all they could to use policies such as the Community Reinvestment Act to make sure banks gave mortgages to the disadvantaged, regardless of the borrowers' ability to repay.

So Wall Street did its part as well: With Washington giving its blessing to a policy of “housing for all,” the Street came up with new ways to implement that policy. Banks, of course, couldn't do it alone. They had just so much capital from which they could make loans. Luckily, they had a fallback plan: the plain-vanilla mortgage-backed security, developed by Larry Fink and others on Wall Street in the late 1970s and early 1980s, morphed into several new generations of bonds, including the “collateralized debt obligation,” or CDO. A CDO is a gigantic stew of mortgages packed into bonds that are in turn packed into a bigger bond.