Out of Lehman's Ashes Wall Street Gets Most of What It Wants
Wall Street’s biggest banks, whose missteps caused a global financial crisis and economic slowdown two years ago, were more agile when it came to countering the political and regulatory response.
The U.S. government, promising to make the system safer, buckled under many of the financial industry’s protests. Lawmakers spurned changes that would wall off deposit-taking banks from riskier trading. They declined to limit the size of lenders or ban any form of derivatives. Higher capital and liquidity requirements agreed to by regulators worldwide have been delayed for years to aid economic recovery.
“We continue to listen to the same people whose errors in judgment were central to the problem,” said John Reed, 71, a former co-chief executive officer of Citigroup Inc., who estimated only 25 percent of needed changes have been enacted. “I’m astounded because we basically dropped the world’s biggest economy because of an error in bank management.”
The last two years have been the best ever for combined investment-banking and trading revenue at Bank of America Corp., JPMorgan Chase & Co., Citigroup, Goldman Sachs Group Inc. and Morgan Stanley, according to data compiled by Bloomberg. Goldman Sachs CEO Lloyd Blankfein, 56, and his top deputies are in line to collect more than $100 million in delayed 2007 bonuses -- six months after paying $550 million to settle a fraud lawsuit related to the firm’s behavior that year. Citigroup, the bank that needed more taxpayer support than any other, has a balance sheet 14 percent bigger than it was four years ago.
Army of Lobbyists
Wall Street’s army of lobbyists and its history of contributions to politicians weren’t the only keys to success, lawmakers, academics and industry executives said. The financial system’s complexity gave bankers an advantage in controlling the narrative and dismissing the ideas of would-be reformers as infeasible or dangerous. A revolving door between government and banking offices contributed to a mind-set that what’s good for Wall Street is good for Main Street.
To make their case, bankers and lobbyists characterized proposed regulations as stifling innovation, competitiveness and economic growth. They said the industry had learned its lessons and that firms were adopting changes voluntarily to be more transparent and accountable. Successful companies shouldn’t be punished for the sins of those that failed, they said.
“It is important to look beyond the rhetoric and ask the tough questions about underlying structural changes that promote responsible reforms and stability to our financial system, yet support the ability of financial firms to innovate and serve the needs of families and employers,” Timothy Ryan, CEO of the Securities Industry and Financial Markets Association, an industry lobbying group, wrote in a Feb. 5 op-ed piece for the Washington Post.
‘Culture of Greed’
That argument resonated with lawmakers under pressure to boost a fragile economy and bring down an unemployment rate that has hovered near 10 percent since August 2009, its highest level in more than a quarter of a century.
“The big financial industry has convinced a lot of people, particularly in Congress and on the regulatory side, that they bring value to the economy with new instruments and new approaches,” said Byron Dorgan, a Democratic senator from North Dakota who is retiring this year. “Anybody who wants to do things that seem aggressive is called a radical populist.”
U.S. President Barack Obama was elected in 2008, weeks after Lehman Brothers Holdings Inc. collapsed in the largest bankruptcy and the Federal Reserve and government provided unprecedented support to insurance company American International Group Inc. as well as nine of the largest banks. Obama, who raised $15 million on Wall Street, promised that his administration would “crack down on the culture of greed and scheming” that he said led to the financial crisis.
While Obama vowed to change the system, he filled his economic team with people who helped create it.
Timothy F. Geithner, 49, who had been responsible for overseeing banks including Citigroup while president of the Federal Reserve Bank of New York, became Treasury secretary and named a former Goldman Sachs lobbyist as his chief of staff. Lawrence H. Summers, 56, who is stepping down as Obama’s National Economic Council director, opposed derivatives regulation and supported the 1999 repeal of the Depression-era Glass-Steagall Act, which separated commercial and investment banking, when he served as deputy Treasury secretary and Treasury secretary in President Bill Clinton’s administration.
“It was very clear by February 2009 that the banks were going to get a free pass,” said Simon Johnson, a former chief economist for the International Monetary Fund who is now a professor at the Massachusetts Institute of Technology’s Sloan School of Management. “You could see from the hiring of Tim Geithner and from the messages that he and his team were putting out that this was going to go very badly.”
Even when changes were advocated by people who couldn’t be characterized as radical populists, their ideas were dismissed as unrealistic, misinformed, advancing ulterior motives or damaging to U.S. competitiveness.
Such tactics helped bat back suggestions from billionaire hedge fund manager George Soros and Berkshire Hathaway Inc. Vice Chairman Charles Munger that regulators ban purchases of so-called naked credit-default swaps -- contracts that allow speculators to profit if a debt issuer defaults.
Geithner was an early opponent of any such ban, arguing at a March 2009 House Financial Services Committee hearing that it wasn’t necessary and wouldn’t help.
“It’s too hard to distinguish what’s a legitimate hedge that has some economic value from what people might just feel is a speculative bet on some future outcome,” he said.
Dorgan, 68, who offered an amendment to the Dodd-Frank bill that would have banned such swaps and who wrote a 1994 article for Washington Monthly warning about the dangers posed by over-the-counter derivatives, said supporters in Congress backed down because they didn’t get pressure from their constituents.
“The debate that’s necessary on these subjects is a debate that is so unbelievably complicated that the larger financial institutions have always controlled the narrative,” Dorgan said. “Even things that were fairly mild were contested as anti-business and going to injure and ruin the economy.”
Instead Dodd-Frank gave regulators at the Commodity Futures Trading Commission and the Securities and Exchange Commission the responsibility of writing rules governing the $583 trillion market in over-the-counter derivatives. The law, named after Connecticut Senator Christopher Dodd and Massachusetts Representative Barney Frank, requires that most derivatives be traded on third-party clearinghouses and regulated exchanges.
The CFTC withdrew a proposed rule on Dec. 9 after at least one commissioner, Scott O’Malia, a former aide to Republican Senator Mitch McConnell, objected. The rule would have required dealers of private swaps to quote prices to all market users before trades could be executed on an electronic system. A new version, approved Dec. 16, will save dealers billions of dollars, according to Moody’s Investors Service, because they will be able to limit price information to select participants.
An amendment requiring banks to spin out their swaps-dealing operations into separately capitalized units, so they wouldn’t have access to government backstops, made it into the Dodd-Frank bill. It was diluted at the end to exempt interest-rate and foreign-exchange contracts that make up more than 90 percent of the derivatives held by U.S. banks.
Banks were also allowed to trade derivatives used to hedge their own risks and given up to two years to trade other types of derivatives, such as credit-default swaps that aren’t standard enough to be cleared through a central counterparty.
A suggestion that banks deemed too big to fail should be broken up or made small enough to fail -- an idea backed by former Federal Reserve Chairman Alan Greenspan, Bank of England Governor Mervyn King and hedge-fund manager David Einhorn -- also failed to win support from U.S. policy makers, as bank executives argued that size alone didn’t make a company risky and that it could be essential for banks to compete.
Jamie Dimon, JPMorgan’s CEO, said in a January 2010 interview that most of the financial firms that collapsed during the crisis were narrowly focused investment banks, insurers, mortgage brokers or thrifts, not big integrated conglomerates.
“A lot of companies are big because they’re required to be big because of economies of scale,” he said.
The closest the Obama administration came to trying to limit the size of banks was in January, when the president proposed levying a fee on financial firms with assets of more than $50 billion. The idea was never adopted by Congress. Instead, it supported Geithner’s plan for a so-called resolution authority that would give regulators the ability to manage an orderly wind-down of a large financial company. Critics say the authority is unlikely to work in practice because regulators won’t have power over a bank’s international operations.
“The resolution authority as drawn up by Dodd-Frank does not apply to the megabanks and doesn’t apply to JPMorgan Chase, nor can it because that authority only applies to U.S. domestic financial entities,” said MIT’s Johnson, a Bloomberg contributor. “If anything, it’s gotten worse because we have fewer big banks. The ones that remain are undoubtedly too big to fail.”
Even before Obama took office in January 2009, former Federal Reserve Chairman Paul A. Volcker, an economic adviser to the president-elect, was calling for clear distinctions between banks that take deposits and make loans and those that engage in riskier capital markets businesses. The recommendation, a modern version of Glass-Steagall, was put forward in a report by the Group of 30, an organization of current and former central bankers, financial ministers, economists and financiers whose board Volcker chairs.
Reed, the former Citigroup co-CEO, and David Komansky, a former CEO of Merrill Lynch & Co., were among those who said publicly that they regretted having played a role in overturning Glass-Steagall. Both of their former companies were crippled by investments in mortgage-linked securities during the crisis, and Merrill was sold to Bank of America in a hastily reached agreement the same weekend Lehman Brothers went bankrupt.
“We have to think of the original reasons why Glass-Steagall was brought down in the first place, and that is the U.S. banks were competing with large, universal banks around the world,” Goldman Sachs CEO Blankfein said in a March 2009 interview with Bloomberg Television. “So I don’t think we’d turn the clock back.”
The idea was left out of Geithner’s original financial regulation proposals and didn’t gain much support until January, after a Republican upset a Democrat in a Massachusetts senate race. Obama and his economic team, including Volcker, then announced they were supporting a so-called Volcker rule that would ban proprietary trading at regulated banks and prohibit them from owning hedge funds and private equity funds.
E. Gerald Corrigan, a former New York Fed president who worked under Volcker at the Fed and is now a managing director at Goldman Sachs, told a Senate hearing that banks shouldn’t be prevented from owning and sponsoring hedge funds or private equity funds because they promote “best industry practice.” He urged a distinction between proprietary trading and “market making” for clients or hedging related to such market making.
In the final version of Dodd-Frank, the Volcker rule ended up looking much more like the Corrigan rule. Banks were allowed to own or sponsor hedge funds and private equity funds and even to invest in them as long as their holdings didn’t account for more than 3 percent of the bank’s capital or 3 percent of the fund’s capital.
The ban on proprietary trading exempted dealing in government and agency securities. Regulators were charged with deciding what other types of trading would be considered proprietary and which would be deemed market-making.
Volcker was disappointed with the final version, according to a person with knowledge of his views.
Goldman Sachs Chief Financial Officer David Viniar, who told analysts in January that “pure walled-off proprietary trading” accounted for about 10 percent of the firm’s revenue, said in October that the company had closed one such business and was waiting to see if the rules would require other changes.
While the Dodd-Frank Act is the most sweeping financial legislation in decades, creating a consumer-protection office for financial products and a council of regulators charged with monitoring systemic risk, it won’t fundamentally change a U.S. banking system dominated by six companies with a combined $9.4 trillion of assets, MIT’s Johnson said.
The law won’t prevent lenders with federally guaranteed deposits from gambling in the derivatives markets, though it will place restrictions on some types of contracts and require more transparent trading and central clearing. It does little to solve the danger posed by leveraged firms reliant on fickle markets for funding.
“It’s not my point to say that the legislation enacted is worthless,” said Dorgan. “It requires more transparency and disclosure and a series of things that are useful, even though it falls short of what I think should have been done.”
The Treasury Department takes a more positive view. The law “fundamentally changes the landscape of our financial regulatory system for the better,” said Steven Adamske, a Treasury spokesman, in an e-mailed statement.
“The Obama administration and Secretary Geithner fought hard to enact a tough set of reforms that reins in excessive risk on Wall Street, protects the economic security of American families on Main Street, and makes certain taxpayers are never again put on the hook for the reckless acts of a few irresponsible firms,” Adamske said. “It also creates a safer, more transparent derivatives market through comprehensive reform, bans risky pay practices, and it puts in place the strongest consumer protections in history.”
The biggest financial companies increased their spending on lobbying in the first nine months of 2010 as they sought to influence the legislative outcome, according to Senate records. JPMorgan’s advocacy spending grew 35 percent, to $5.8 million from $4.3 million, while Goldman Sachs’s jumped 71 percent to $3.6 million.
Banks had “2,300 pages worth of reasons” for spending, said Scott Talbott, a lobbyist at the Financial Services Roundtable, which represents the largest lenders and insurance firms, referring to the size of the Dodd-Frank bill. “The issues on Capitol Hill required more attention.”
Spending during 2010 probably played only a small role in the ability of financial companies and trade groups to influence legislators, according to Anthony J. Nownes, a political science professor at the University of Tennessee in Knoxville whose books on the role of lobbyists include “Total Lobbying: What Lobbyists Want (and How They Try to Get It)” (Cambridge University Press).
“The idea that they stepped up their activity has some truth, but the larger truth is that they always spend a lot of money and this was no exception,” Nownes said. “They’re always there, their viewpoints are always heard and it is a cumulative effect -- they’ve been saying the same things for years and years and years.”
Even as they were spending more on lobbying, the largest U.S. banks cut their political giving for the 2010 elections. Of the 10 biggest financial firms, only Goldman Sachs, MetLife Inc. and the U.S. subsidiary of Deutsche Bank AG spent more from their political action committees during the 2009-2010 election cycle than they did in 2007-2008, according to Federal Election Commission filings.
Talbott said the decrease was partly because of the economic slump, and also because some members of Congress refused to take donations from banks that received federal funds during the crisis.
The financial industry is adept at hiring people with experience in Congress and government, which gives it an edge in understanding the best tactics to use, Nownes said. This month Citigroup recruited former Obama administration budget director Peter Orszag as a vice chairman in its global banking business, and Goldman Sachs hired Theo Lubke from the New York Fed, where he oversaw efforts to make the derivatives market safer.
Research shows that lawmakers are more susceptible to lobbying on issues that are complex, technical or economic, which benefits the banks, Nownes said.
“This certainly was a huge advantage for them, especially in designing some of the more intricate details of this piece of legislation,” he said. “The more technical and complex, the bigger the informational advantage they have.”
Tax on Bonuses
Even in areas that weren’t technical, such as bonuses, the financial industry was able to resist tough regulation.
With polls showing strong popular support for limits on pay, former British Prime Minister Gordon Brown pressed for a tax on banker bonuses and one on financial transactions to deter speculative trading.
Obama didn’t go that far. Instead, the administration appointed Washington lawyer Kenneth Feinberg to review pay for the 100 top executives at firms receiving “exceptional assistance” from the Troubled Asset Relief Program. Feinberg ordered cuts at Bank of America, Citigroup and AIG, as well as at two bankrupt car companies and their finance divisions.
The administration, while opposing any pay caps, urged regulators to require changes that would better align compensation with risk, such as paying bonuses in restricted stock. Several banks responded by raising bankers’ salaries. So far this year, five Wall Street banks -- Bank of America, JPMorgan, Citigroup, Goldman Sachs and Morgan Stanley -- have set aside more than $91 billion for salaries and bonuses.
In early 2010, Virginia Senator James Webb and California Senator Barbara Boxer, both Democrats, proposed an amendment to a jobs bill that would have imposed a 50 percent tax on any bonuses above $400,000 collected in 2009 by executives at banks that received at least $5 billion in TARP funds.
The U.S. Chamber of Commerce, which opposed the tax, urged senators to reject the idea because it “would likely hamper efforts to resolve the ongoing financial crisis, restore economic growth, spur job creation and is likely unconstitutional.” The bill never made it to a vote.
“Neither party wanted to touch that issue,” Webb said at the Washington Ideas Forum on Oct. 1. “Quite frankly, the way that money affects the political process sometimes paralyzes us from doing what we should do.”
In a Bloomberg News National Poll conducted Dec. 4 through Dec. 7, 71 percent of Americans said big bonuses should be banned this year at Wall Street firms that took taxpayer bailouts, and 17 percent said bonuses above $400,000 should be subject to a one-time 50 percent tax. Only 7 percent of the respondents said they consider bonuses a reflection of Wall Street’s return to health and an appropriate incentive.
Reed, the former Citigroup executive, said he didn’t understand why lawmakers gave so much credit to arguments made by financial-industry participants whose job it is to put the interests of their shareholders above any concern for the safety of the financial system.
“I’m surprised that the people in Washington think that the stockholders are the people that they should protect,” Reed said. “It would seem to me that the people who should be protected are the overall banking system and the many, many, many companies that depend on it.”
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