Economist and author Robert Kuttner saw the writing on the wall long before many in Washington were even aware of the looming economic collapse. He was so incensed by the lack of foresight by our nation’s leading financial giants that he wrote Obama’s Challenge: America’s Economic Crisis and the Power of a Transformative Presidency. The book is nothing short of prescient.
Here’s an excerpt:
In the current financial collapse, all of the complex, separate abuses that caused the current crisis really boiled down to three: too much speculation with borrowed money; too little transparency and disclosure; and too many insider conflicts of interest. These abuses, in turn, were the bitter fruit of deregulation. The parallels to similar abuses of the 1920s are exact.
All of these abuses will need to be remedied. We did precisely that as part of the New Deal. But beginning in the 1970s, much of the New Deal system of financial regulation was repealed in the name of more modern and innovative markets that supposedly did not need government. By 2000, a clean, transparent financial system that had made American capital markets the envy of the world was destroyed. The business geniuses who brought America this wisdom are now humbled by events. Their allies and enablers among financial economists based convoluted theories on the general premise that financial markets were entirely self-correcting. These economists are roughly in the position of pre-Copernican astronomers who hung elaborate models on the premise that the sun revolved around the earth. They should seek honest employment.
Former Federal Reserve chairman Paul Volcker, in a high-profile address to the Economic Club of New York last April, put it well:
We have moved from a commercial bank centered, highly regulated financial system, to an enormously more complicated and highly engineered system. Today, much of the financial intermediation takes place in markets beyond effective official oversight and supervision, all enveloped in unknown trillions of derivative instruments. It has been a highly profitable business, with finance accounting recently for 35 to 40 percent of all corporate profits.
It is hard to argue that the new system has brought exceptional benefits to the economy generally. Economic growth and productivity in the last 25 years has been comparable to that of the 1950’s and 60’s, but in the earlier years the prosperity was more widely shared.
In the last months of the lame-duck Bush administration, however, something very odd happened. As the situation became more dire, with threats to the largest banks and to mortgage giants Fannie Mae and Freddie Mac, as well as the looming risk of a general financial collapse, Treasury Secretary Henry Paulson became a reluctant paladin of big government. Paulson had assumed office in June 2006 with an agenda of further financial deregulation. In the months after he joined the cabinet, there was a well-coordinated flurry of activity with reports by conservative task forces all pointing to the evils of financial regulation, including a Committee on Capital Markets Regulation chaired by Paulson himself. That body’s report, released in November 2006, recommended several steps toward regulatory weakening in the name of greater competitiveness.
However, by the time Paulson issued a follow-up report in March 2008 on behalf of a resurrected President’s Working Group on Financial Markets, reality had overtaken his design. In mid-2007, credit markets had suddenly frozen because of fallout from the subprime collapse. The Federal Reserve had to advance hundreds of billions of dollars to banks to keep credit flowing. So Paulson’s 2008 report was a thoroughly contradictory overlay of two documents— one expressing his earlier dogma praising the genius of unregulated markets, the other promoting government rescue and promising stricter supervision of large banks that posed systemic risks.
Thus did the champion of deregulation become the leader of a squad tasked with cleaning up the mess deregulation had made. Paulson, improvising as he went along, offered a deus ex machina as his counterweight to further deregulation. He proposed to give the Federal Reserve yet-to-be-defined blanket authority to monitor the largest commercial and investment banks, to make sure that none were posing excessive risks to the system. The trouble with this approach is that by the time a large institution shows signs of distress, it is far too late.
As the crisis deepened, Paulson at the Treasury and Ben Bernanke at the Federal Reserve lurched from ad hoc bailout to ad hoc bailout, with no coherent regulatory theory or policy either to prevent unacceptably risky behavior before the fact, or to determine when to bail out an institution after it got into trouble. A bank deemed “too big to fail” because of the risk of spillover dangers was like Justice Potter Stewart’s famous definition of pornography: You just knew it when you saw it. Indy Mac, a medium-size regional bank, was allowed to fail. But Bear Stearns, Fannie Mae, and Freddie Mac got taxpayer bailouts. In the shotgun acquisition by Citi, Bear’s shareholders lost almost everything. Fannie’s were partly protected. So it goes.
By August 2008, the government had brokered an emergency takeover of Bear Stearns by JPMorgan Chase at fire-sale prices, putting $29 billion of taxpayer money at risk; offered a general line of credit to large investment banks that previously enjoyed no special government guarantee or supervision; put government capital at the disposal of Fannie Mae and Freddie Mac; and invited banks and investment companies to exchange dubious paper for Treasury bills, in order to recapitalize banks and move markets in risky securities that nobody else wanted to buy. The Fed, which has about a trillion dollars at its disposal, tied up something like 40 percent of its own capital in these serial rescues.
All of this was done under the Federal Reserve’s emergency authority enacted during the Roosevelt administration. With the exception of the Fannie Mae/Freddie Mac bailout, none of it had congressional authorization, nor did the Bush administration announce an explicit reversal of the general policy of financial deregulation. All the moves had the same panicky, ad hoc character.
Now, it is a very good thing that Paulson put aside his ideological blinders and worked with Ben Bernanke and Tim Geithner at the Federal Reserve to prevent the credit freeze from becoming a complete economic collapse. But people like Paulson, former head of Goldman Sachs, want the emergency rescues without the prudential regulation. The next administration will need to combine the two strategies, as Roosevelt’s did.
In the summer of 2008, a new and alarming element deepened the crisis: runs on banks, but with two twists. Deposits were insured by the Federal Deposit Insurance Corporation—a core part of the New Deal that had not been repealed during the orgy of deregulation. So there was no reason for depositors to trigger runs on banks, the traditional worry prior to creation of the FDIC. But these new runs were shareholder runs. As details of the crisis unfolded, it became ever clearer to investors that bank balance sheets were seriously weakened in two distinct respects.
First, these balance sheets were full of dubious securities that suddenly nobody wanted to buy. These included not just securities based on subprime loans but also other exotic forms of securitized credit backed by everything from car loans to credit cards, and even more abstruse securities that insured other securities against default. If banks followed normal accounting practices and “marked to market” securities that had no buyers and technically had a value of zero, the banks would be declared insolvent. In a credit crunch, it was this fear that caused the Fed to pump so much emergency liquidity (money) into the banking system. In fact, the agency that governs financial accounting standards moved, under pressure from the SEC and the Treasury, to scrap a rule that required banks to mark down the valuation of their assets to their current trading value (in many cases zero)—lest all the large banks be judged insolvent. Second, much of the banks’ fee and interest income had been based on underwriting or trading these very same securities, or making other highly leveraged and highly risky deals. If this lucrative line of business was suddenly no longer available, banks not only had trouble on their balance sheets in the reduced value of their assets—they also had serious problems with their earnings.
As these twin vulnerabilities became apparent and bank losses mounted, shareholders began fleeing banks. No bank was big enough to be safe. During the first seven months of 2007, when the broad stock market lost about 20 percent, the index of bank stocks went down almost by half. Some large regional banks did far worse. Cleveland-based National City Bank’s stock was down 90 percent. Washington Mutual fell 76 percent. The stock of the Swiss-based global giant UBS lost 70 percent. Shares in the flagship brokerage firm Merrill Lynch lost more than half.
In the case of a commercial bank, the value of a bank’s shares is a major portion of the equity against which it can lend. The other major component of bank equity is its capital reserves. As losses mounted in 2008, both forms of capital footings took a huge hit, worsening the general credit contraction.
One other factor deepened the crisis—the abuse and proliferation of “short selling.” This twist also has instructive ideological implications. In selling a stock short, an investor who thinks a stock price is headed downward borrows the shares from a broker, delivers them to a purchaser, buys back the identical number of shares on the open market after the price has fallen, and then pockets the difference. This is how some investors make money in a falling market. The practice of short selling doesn’t do much damage in a normal market, but organized on a large scale it can turn a bear market into a crash.
In the summer of 2008, short sellers (many of them hedge funds) smelled blood in the financial waters. They savagely bid down the price of bank stocks. Human nature being what it is, many short sellers invented or passed along rumors that exaggerated the weak condition of several large banks. Executives of Bear Stearns blamed their demise on rumormongers and short sellers. The venerable firm of Lehman Brothers seemed headed for insolvency, pulled down by short sellers’ rumors that turned out to be untrue. The same psychology threatened Fannie Mae.
The legal status of such rumor mongering is ambiguous. Short selling is permissible, but deliberately manipulating markets is a felony. Deciding when passing along a juicy rumor becomes deliberate market manipulation is a Jesuitical endeavor at best. But in July 2008, one of the most ideologically conservative Securities and Exchange Commissions since the institution was created during the New Deal did something startling. Faced with organized short-selling raids that were depressing the stocks of major financial institutions and threatening their very solvency, the SEC rushed out an emergency thirty-day order warning that it would be on the lookout for short-selling abuses against the shares of nineteen flagship financial firms, and would vigorously go after violators. The order prohibited new short sales of shares in such wounded giants as Lehman Brothers, Merrill Lynch, Citigroup, Fannie Mae, and Bank of America unless the seller had already borrowed the stock. Christopher Cox, one of the most anti-regulation ideologues ever to chair the SEC, boasted, “There have long been clear rules in place that prohibit market manipulation. But for the entirety of its 74-year history until 2008, the Commission has never brought an enforcement action of this kind.”
Behind this surprising turnabout hangs a tale. Reformers have actually been trying to ban short selling since the late 1920s. For generations, however, conventional financial economists have defended short selling as helping to lubricate the efficient functioning of markets. Anyone who argued that short selling was needless mischief that did nothing for the real economy was ridiculed as a hopeless radical.
In fact, the original design of Franklin Roosevelt’s 1934 securities legislation recognized the hazards of short selling and sought to ban it outright. One of the many abuses of the 1920s had been market manipulation via short selling, known as bear raids. Even before Roosevelt took office, liberal members of Congress had introduced legislation to either discourage short selling by collecting windfall taxes on the proceeds, or simply prohibit it.
The Securities Exchange Act of 1934, policing the conduct of stock exchanges and creating the Securities and Exchange Commission, was the object of fierce battles between progressives and conservatives in the Congress and the country. The draft bill included a flat ban on short selling as well as other abuses that came back to haunt financial markets in the past two decades—excessive leverage, conflicts of interest, and favored treatment of insiders. But by the time the Wall Street lobbies got finished with the bill—enlisting small-town bankers and national networks of retail stockbrokers as their allies—all these teeth had been removed.
For eight decades, short selling has been part of the financial landscape. It is a mark of just how dire are current conditions that in 2008 a panicky and conservative SEC that doesn’t much believe in regulation embraced an ad hoc remedy that had eluded even Roosevelt. The fact that Wall Street, at the nadir of its disgrace in 1933, still had the clout to block these reforms suggests something of the residual power that the Obama administration will be up against.
The men and women currently in charge of the executive branch, deep believers in laissez-faire, have no coherent theory of financial regulation, so their separate emergency measures lack policy coherence. In their hearts, they oppose what they are being compelled to do in a crisis. And so we still have a system that privatizes speculative gain and socializes the risks. Obama, unlike Bush, will have an entirely different cast of cabinet and regulatory officials as well as technical experts, all of whom presumably believe in the enterprise of regulation.
Criteria for prudent regulation need to rebuilt from the ground up. The core principle is that any financial institution that creates credit (and thereby creates risks that could undermine the system) needs to be subjected to the same kind of regulatory criteria—whether that institution calls itself a bank, a mortgage company, an investment bank, a hedge fund, or a private equity firm. Indeed, if Congress were to extend requirements on capital adequacy, leverage, and greater transparency from commercial banks to investment banks, Goldman Sachs (a very lightly regulated investment bank) would turn itself into a hedge fund. And if Congress extended prudential requirements to hedge funds, Goldman would become a private equity company.
The point is that these financial firms increasingly all do the same kinds of things. And they buy and sell products with one another, many of them poorly understood, highly speculative, and sometimes toxic; it all goes into the same financial bloodstream. Last year, about 60 percent of the credit created in the United States was created by lightly regulated firms other than depository institutions. As Barack Obama grasped so well in his Cooper Union speech, which I quoted in chapter 1, “We need to regulate institutions for what they do, not what they are.”
As he declared in that speech last March, when many Democrats were still rather timid about confronting the ideology of deregulation head-on,
There needs to be general reform of the requirements to which all regulated financial institutions are subjected. Capital requirements should be strengthened, particularly for complex financial instruments like some of the mortgage securities that led to our current crisis. We must develop and rigorously manage liquidity risk. We must investigate rating agencies and potential conflicts of interest with the people they are rating. And transparency requirements must demand full disclosure by financial institutions to shareholders and counterparties.
It logically follows that some entire categories of financial transactions and instruments need to be banned as adding more risks than benefits. We should revisit the old arguments about short selling. There is a strong case that the abuses outweigh any benefits. We should reconsider the original draft of Roosevelt’s securities legislation, which proposed to make it illegal for members of stock exchanges to trade for their own accounts as an inherent conflict of interest with their arm’s-length service to their customers. We need to investigate the inherent conflict of interest in the stock exchanges’ specialist system, in which traders can also profit by trading ahead of their customers.
Bond rating agencies, as presently constructed, display multiple conflicts of interest. They are paid by originators of securities for consulting work to enable those securities to earn a triple-A rating—bestowed by the same bond rating agencies. Had these agencies operated at arm’s length, bonds based on subprime mortgage loans would have fetched few buyers. The bond rating companies, which do business with firms that insure securities against default, systematically punish municipal bonds with lower ratings than comparable private-sector bonds to help the insurance firms capture fees. The whole system would be more efficient and transparent if bond rating were vested in a public or nonprofit institution, whose costs could be covered by a very small fee on all financial transactions.
We need to recall and reclaim the fundamental purpose of credit and capital markets—channeling funds from investors to entrepreneurs. The whole business has become riddled with middlemen who invent complex products that add little to the efficiency of credit markets, magnify systemic risks, and mainly serve to line their own pockets and corrupt their confederates.
Supervision needs to be tightened across the board, and not just of the largest institutions, based on explicit criteria of safety and prudence. This approach could not be ventured by the Bush administration, both because the clock ran out and because it was considered an ideological abomination. Reconstructing principles of financial regulation will fall to Obama.
In making the case for a reversal of ideology and practice, Obama needs to help the public grasp the astonishing double standard in current policy. Trillions of dollars of help are going to bail out the nation’s wealthiest speculators and the financial institutions that they put at risk of collapse. The usual rules are waived for these emergency bailouts, while tens of millions of ordinary Americans suffering from these abuses get little or nothing. As John Bogle, founder of Vanguard Group of mutual funds and the rare Wall Street statesman, aptly put it, “The banks are too big to fail and the man in the street is too small to bail.”
There is also an international dimension to restoration of effective financial regulation. Many hedge funds and private equity firms are registered offshore in regulatory havens that provide even less regulation than the feeble scrutiny such firms get in the United States. If we are going to apply Obama’s principle that we must “regulate institutions for what they do, not what they are,” then there can’t be an all-purpose loophole for those domiciled offshore. This is not as difficult as it sounds. All it would take is a rule that any financial firm that does business with a bank operating in the United States must be subjected to a level of scrutiny equal to that of domestic firms. Many of our trading partners, nations whose economies are suffering grave harm because of a financial crisis created in the United States, would welcome this regulatory toughening.
Obama needs to define the moment. And he needs to begin anew. Presumably, he will assemble the best minds—a set of advisers who have an entirely different conception of the necessary role of financial regulation—and reclaim a theory of market failure based on the potent evidence of recent events. Here, too, Obama will have to fight an undertow, for much of the deregulation that spawned the current financial disaster dates to the Clinton administration. The Clinton Treasury Department was headed by Robert Rubin, a fervent believer in deregulation, who provides Obama with occasional advice and who is cited as a wise counsel in The Audacity of Hope. Even Rubin, however, is singing something of a different tune after the credit collapse.
Obama’s administration will need to sort which practices must be prohibited outright as inherently prone to abuse, and which should be subject to exactly what sort of tighter regulation, and by which new or old government agencies. Only then can he send Congress legislation to implement policy. And along the way, he needs to rely on his gift as a teacher—as Roosevelt did in the banking crisis of 1933, and Obama himself did so brilliantly in his Cooper Union address.
However, turning around public and congressional opinion on the subject of financial regulation will be no mean feat. Wall Street welcomes the bailouts; it still resists the regulation. A massive job of public education will be required. Before this financial crisis ends, the government may well end up recapitalizing America’s banks. One could fairly say that the process has already begun, piecemeal, based on the ad hoc bailouts orchestrated by Secretary Paulson and the Federal Reserve. We have been here before, but with a difference. In the 1930s, Roosevelt’s Reconstruction Finance Corporation recapitalized many banks and corporations. But the difference was this: On a parallel track, the New Deal was also building a modern system of financial regulation to spare future generations the pattern of speculation, crash, and bailout. This is now the historic task of the Obama administration. It should not have been necessary a second time.