Read 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown Online
Authors: Simon Johnson
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A money market fund is a mutual fund that invests in short-term, liquid debt such as Treasury bills or commercial paper. Although money markets are generally not guaranteed against losing value, they attempt to maintain a share price of $1, which makes them look and function like savings or checking accounts.
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To create a mortgage-backed security (MBS), a large number of mortgages are pooled together; the mortgage-backed securities each have a claim on the payments made on those mortgages. The net effect is that each investor in the MBS owns a tiny piece of each mortgage, distributing each mortgage’s risk of default among a large number of investors.
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The mismanagement and outright fraud that led to these failures were one of the inspirations for George Akerlof and Paul Romer’s paper on “looting.”
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Bonds are IOUs issued by companies or governments. They are given ratings by credit rating agencies; those ratings are supposed to reflect the probability that the issuer will default on the IOU. “Investment-grade” bonds are those that are highly rated, meaning that there is a small probability of default. “Junk” bonds are any bonds that do not earn investment-grade ratings.
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In financial markets, it is possible to sell assets that you don’t actually have, known as selling “short.” In a short sale, the seller borrows an asset (say, a share of stock) from Party A and then sells it to Party B; at some point in the future, the seller must buy the asset from someone in order to return it to Party A. The seller is betting that the price will have fallen in the meantime, earning it a profit.
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Arbitrage trading received a tremendous boost from the rapid drop in the cost of computing power. Using computers, banks could search the markets for pricing discrepancies and profit from them, provided that they could finance their positions long enough for prices to converge.
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Simple options—in which the farmer pays a small amount now for the right, but not the obligation, to sell wheat in the future for a pre-specified price—were also common before the 1970s.
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In general, a derivatives dealer (a bank) attempts to hedge its positions; that is, if it sells one client an option to buy yak pelts in the future, it will try to buy an equivalent option from another counterparty so its positions cancel out. To hedge a complex trade that is customized for an individual client, the dealer may have to execute multiple trades with other counterparties, which may result in an imperfect hedge.
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The risk of a floating rate liability, such as an adjustable rate mortgage, is that interest rates will go up and your periodic payments will go up. The risk of a fixed rate liability, such as a fixed rate mortgage, is that interest rates in general will go down and you will be stuck paying a high interest rate. Depending on the nature of their business, different parties prefer one type of risk or the other.
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In the interest rate swap example above, the face value, or notional value, is $100 million. However, the amount of money that changes hands is much smaller; if, at the end of a given year, the floating rate is 7.25 percent, then the dealer only pays the company 0.25 percent (the difference between the floating and fixed rates), or $250,000.
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“GREED IS GOOD”
The Takeover
Derivatives have been an extraordinarily useful vehicle to transfer risk from those who shouldn’t be taking it to those who are willing to and are capable of doing so.… The vast increase in the size of the over-the-counter derivatives markets is the result of the market finding them a very useful vehicle.
—Alan Greenspan, chair of the Federal Reserve, July 16, 2003
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The 1980s came to a close with the peak of the savings and loan crisis. The failure of over 2,000 banks between 1985 and 1992 was by far the largest financial sector mass die-off since the Great Depression.
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The government bailout of the S&L industry cost more than $100 billion, and hundreds of people were convicted of fraud.
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In 1990, Michael Milken, the junk bond king, pleaded guilty to six felonies relating to securities transactions. In 1991, Citibank was facing severe losses on U.S. real estate and loans to Latin America and had to be bailed out by an investment from Saudi prince Al-Waleed bin Talal. In 1994, Orange County lost almost $2 billion on complicated interest rate derivatives sold by Merrill Lynch and other dealers; county treasurer Robert Citron pleaded guilty to securities fraud, although no one on the “sell side” of those transactions was convicted of anything. In 1998, Long-Term Capital Management collapsed in the wake of the Russian financial crisis and had to be rescued by a consortium of banks organized by the Federal Reserve.
Scandals are a constant refrain throughout the history of the financial services industry. Particularly severe episodes of wrongdoing often lead to the implementation of new rules that at least close the particular barn door that had been left open in the past; the most important example was the new regulatory scheme created during the Great Depression. The failures and scandals of the late 1980s and 1990s were closely linked to recent deregulatory policies or financial innovations: expansion of savings and loans into new businesses; junk bonds and leveraged buyouts; quantitative arbitrage trading; and over-the-counter derivatives. Someone familiar with the history of the financial system might have expected this record of disaster to lead to greater skepticism of financial innovation and closer oversight of the industry.
Instead, the 1990s witnessed the final dismantling of the regulatory system constructed in the 1930s. The Riegle-Neal Act of 1994 practically eliminated restrictions on interstate banking, allowing bank holding companies to acquire banks in any state and allowing banks to open branches in new states. The Gramm-Leach-Bliley Act of 1999 effectively demolished the remaining barriers separating commercial and investment banking—barriers that had already been significantly weakened during the preceding decade—by allowing holding companies to own subsidiaries engaged in both businesses (as well as insurance).
These laws only confirmed trends that had begun in the 1970s, and signified that the federal government would no longer attempt to resist the desires of the large commercial banks to become national, full-service financial supermarkets. More important, the government turned its back on the new financial products that had recently emerged, refusing to regulate over-the-counter derivatives or to police the new Wild West of mortgage lending that appeared late in the decade. Instead, leading policymakers from Alan Greenspan on down chose to rely on “self-regulation” of financial markets—the idea that market forces would be sufficient to prevent fraud and excessive risk-taking.
Despite the scandals and crises that marked the 1990s, this was the decade when Wall Street translated its growing economic power into political power and when the ideology of financial innovation and deregulation became conventional wisdom in Washington on both sides of the political aisle. The unprecedented amounts of money flowing through the financial sector, increasingly concentrated in a handful of megabanks, were the foundation of the new financial oligarchy. In the United States, however, political power on a national scale is generally not bought through simple corruption—by exchanging money under the table for political favors. Instead, Wall Street used an arsenal of other, completely legal weapons in its rise to power. The first was traditional capital: money, which wielded its influence directly via campaign contributions and lobbying expenses. The second was human capital: the Wall Street veterans who came to Washington to shape government policy and shape a new generation of civil servants. The third, and perhaps most important, was cultural capital: the spread and ultimate victory of the idea that a large, sophisticated financial sector is good for America.
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Together, these powerful forces gave Wall Street a degree of political influence that no amount of payoffs to corrupt politicians could have bought.
CAMPAIGN MONEY
Money has long played an important role in American electoral politics. The interpretation of the First Amendment to protect the financing of political speech, along with the relative weakness of political parties (compared to other advanced democracies) in enforcing discipline among their members, has made it a requirement for individual legislators to devote considerable time and effort to raising money. The escalating cost of campaigning has increased the importance of money. Between 1974 and 1990, the cost of a seat in the House of Representatives—the average expenses of an election winner—grew from $56,500 to $410,000; from 1990 to 2006, it tripled to $1,250,000 (more than doubling even after accounting for inflation).
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The financial sector was a central player in this evolution. The sector was the leading contributor to political campaigns throughout the past two decades. But campaign contributions from the financial sector (including finance, insurance, and real estate) grew much faster than contributions overall, more than quadrupling, from $61 million in 1990 to $260 million in 2006. (After excluding insurance and real estate, the sector still contributed over $150 million in 2006; the second-ranking industry group, health care, contributed only $100 million in 2006.) Over the same time period, contributions from the securities and investment industry
sextupled
from $12 million to $72 million, and that $72 million omits the millions of dollars in contributions from the law firms that served the securities industry. (According to one analysis, from 1998 to 2008, the financial sector spent $1.7 billion on campaign contributions and $3.4 billion on lobbying expenses; the securities industry alone spent $500 million on campaign contributions and $600 million on lobbying.)
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The largest commercial and investment banks, which stood to gain the most from deregulation and consolidation, were also the largest sources of campaign cash. In 1990, the companies in the banking sector that contributed the most money were Goldman Sachs, Salomon Brothers, Barnett Banks (the largest bank in Florida, bought by NationsBank in 1997), Citibank, J.P. Morgan, and Morgan Stanley; in 2006, they were Goldman, Citigroup, Bank of America, UBS, JPMorgan Chase, and Morgan Stanley.
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Money from the financial sector flowed precisely where it could do the most good. After becoming chair of the Senate Banking Committee in 1999, Phil Gramm raised more than twice as much money from the securities industry than from any other industry. In 1998, the securities industry’s primary beneficiary in the Senate was Alfonse D’Amato, Gramm’s predecessor as chair of the Senate Banking Committee; in 1996, D’Amato trailed only Gramm. More recently, the chair of the Senate Banking Committee, Christopher Dodd, received $2.9 million from the securities industry in 2007–2008—more than three times as much as any other senator who was not a major presidential candidate.
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The securities industry was also the top donor to Barney Frank, chair of the House Financial Services Committee. And the securities industry’s favorite member of Congress over the decades has been New Yorker Charles Schumer, first a member of the House Financial Services Committee and later a member of the Senate Banking Committee (and chair of the Democratic Senatorial Campaign Committee in 2006 and 2008), who has aggressively championed Wall Street over the years.
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There is a perpetual debate over whether politicians help their major donors because they want to make sure the money keeps flowing, or whether the donors give the money because they appreciate the politicians’ positions. In any case, the 1990s, a period of increasing financial sector contributions, were also the decade when the deregulatory campaign crashed through any remaining congressional opposition. Powerful members of Congress sponsored legislation on the financial sector’s wish list. Gramm put his name on the 1999 Gramm-Leach-Bliley Act, which largely repealed the Glass-Steagall separation of commercial and investment banking. Gramm was also the major force behind the Commodity Futures Modernization Act of 2000, which prohibited federal regulation of over-the-counter derivatives. Schumer was a major proponent of Gramm-Leach-Bliley, and in 2001 he and Gramm passed legislation to cut in half fees paid by financial institutions to the SEC.
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(Gramm left the Senate in 2002 to become a vice chair at UBS Warburg.)
Over the past twenty years, the financial services industry became an extremely powerful lobby in Washington, able to win votes in both Republican and Democratic Congresses. In April 2009, Senator Richard Durbin said, “the banks—hard to believe in a time when we’re facing a banking crisis that many of the banks created—are still the most powerful lobby on Capitol Hill. And they frankly own the place.”
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No one thought he was saying anything extraordinary.