Warren’s Mistake About Wall Street Risk-Taking
When U.S. Senator Elizabeth Warren, the former law-school professor and self-appointed scourge of Wall Street, gets her history terribly wrong -- and proposes a new law based on that lack of understanding -- there must be a reckoning.
On July 11, Warren introduced the “21st Century Glass-Steagall Act of 2013,” theoretically designed to “reduce risks to the financial system by limiting banks’ ability to engage in certain risky activities and limiting conflicts of interest.” Warren’s allusion to the original Glass-Steagall Act of 1933 -- which gave Wall Street’s commercial banks and investment banks one year to choose to be one or the other -- was intentional, of course.
The firebrand Democrat from Massachusetts -- and, apparently, the bill’s unlikely co-sponsor, Arizona Senator John McCain -- seems to believe that the 2008 financial crisis was caused by commercial banks taking undue risks with depositors’ money. According to Warren, actions by the Federal Reserve Board, the Office of the Comptroller of the Currency, the federal courts and Congress itself -- with its 1999 repeal of Glass-Steagall -- allowed commercial banks to “engage in an increasing number of risky financial activities that had previously been restricted.”
While it’s true enough that these banks courted too much risk, Warren’s conclusion that this caused the financial crisis is simply inaccurate.
As I have detailed extensively in two books about the financial crisis -- “House of Cards,” about the collapse of Bear Stearns Cos., and “Money and Power,” which in part documents how Goldman Sachs Group Inc. made it through financially unscathed - - its causes were many and complex. What was key, though, was institutional investors’ justifiable loss of confidence in the quality of the assets on the balance sheets of the large Wall Street investment houses -- Bear Stearns, Lehman Brothers Holdings Inc., Merrill Lynch & Co. Inc. and Morgan Stanley.
These banks had been financing their short-term cash needs in the “overnight repo” market. And the nightly lenders -- institutional investors such as Fidelity Investments and Federated Investors Inc. -- used as collateral the piles of mortgaged-backed and other squirrelly, hard-to-value securities that had been building up on the banks’ balance sheets. Fidelity and Federated began to question the value of these assets, then finally stopped accepting them as collateral.
During the middle of March 2008, for instance, Bear Stearns had $18 billion on its balance sheet but needed around $75 billion in cash daily to run its business. When the overnight-financing crowd stopped accepting its mortgage-related securities as collateral, the bank was left with only two options: File for bankruptcy or seek a merger partner. Ultimately, JPMorgan Chase & Co., with a $30 billion assist from the federal government, bought Bear Stearns for $10 a share.
In September of that year, similar scenarios played out at Merrill Lynch, which was bought by Bank of America Corp. hours before it would have filed for bankruptcy, and at Lehman Brothers, which did declare bankruptcy when no viable buyer could be found. Morgan Stanley avoided bankruptcy only after the Federal Reserve allowed it to become a bank-holding company, giving it immediate access to cheap federal funding and paving the way for a $9 billion investment from Mitsubishi UFJ Financial Group Inc.
These events shared two common denominators: The big Wall Street investment banks were far too reliant on cheap, short-term financing. And the go-to saviors were the big, diversified commercial banks: JPMorgan Chase for Bear Stearns, Bank of America for Merrill Lynch and Mitsubishi for Morgan Stanley. Barclays Plc stepped in, too, if only to buy as much as it wanted of a bankrupt Lehman.
The one exception to this narrative was Citigroup Inc., which failed despite being a diversified, global bank -- in large part because, under the leadership of former Treasury Secretary Robert Rubin, it abandoned any semblance of risk-taking discipline. (For that, it should have been euthanized rather than bailed out.)
I sympathize with Senator Warren’s desire to rein in imprudent risk-taking. Since the mid-1980s, when so many investment banks went from being private partnerships -- in which partners largely risked their own capital -- to being public companies with no personal exposure, the financial system has been subject to one crisis after another. Wall Street’s ongoing problem is not the risk-taking itself but rather the incentives to engage in it. Bankers, traders and executives earn big bonuses for taking foolish chances with other people’s money, but incur no liability -- criminal, civil or financial -- when things go wrong.
If Warren were serious about preventing the next crisis, she would do well to focus on changing how people on Wall Street get rewarded. Glass-Steagall kept financial calamity at bay for some 60 years by making risk-takers pay when things went wrong.
(William D. Cohan, the author of “Money and Power: How Goldman Sachs Came to Rule the World,” is a Bloomberg View columnist. He was formerly an investment banker at Lazard Freres & Co., Merrill Lynch and JPMorgan Chase.)
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