Getting the American economy back on solid ground will require new financial regulations. Goldman Sachs alums aren’t the people for the job. [As published in the American Conservative on October 20, 2008.]
As bewildered Americans survey the wreckage of their nation’s once vaunted financial system, they could do worse than reacquaint themselves with one of Wall Street’s oldest and most revealing parables.
The story goes that an out-of-town customer dropped by to talk to his broker and afterwards was ushered around Lower Manhattan’s yacht-filled docks.
“Here is Mr. Morgan’s yacht,” his guide pointed out. “This is Mr. Bache’s, and over there is Mr. Drexel’s.”
“Where are the customers’ yachts?” the visitor naïvely asked.
The story is at least a century old and its punch line long ago figured as the title of a hilarious tell-all book by a Wall Street insider. But if we substitute executive jets for yachts, the message remains as true today as ever: Wall Street is run for the benefit of Wall Street.
This goes a long way toward explaining the origins of the current crisis. The subprime bubble was pumped up by a massive blast of “don’t worry, be happy” sales talk. Powerfully incentivized salespeople who pushed so much toxic debt on to unwitting investors were making far too much money in the short run to worry about the long-term havoc they were creating for everyone else, not least stockholders in their own firms.
The parable also illuminates the mindset guiding the bailout effort. Both Treasury Secretary Henry Paulson and his key adviser, Neel Kashkari, formerly held top jobs at Goldman Sachs, and it seems clear that their highly controversial and, to economic historians, bafflingly unorthodox bailout plan serves Wall Street’s interests—particularly those of their former employer—far more than the American public’s.
The amazing aptitude of Wall Street insiders to feather their own nests at the taxpayers’ expense should be a crucial concern as legislators try to craft a stable and productive future for the American financial system. A key question is how Wall Street’s greed can be reined in. In truth, there is no substitute for regulation.
This isn’t a view that will find immediate favor with conservative readers. But it is being espoused by no less a plutocrat than Michael Bloomberg, the former Wall Street insider who has recently morphed into a budget-cutting mayor of New York. More significantly, it has been vociferously championed by Paul Craig Roberts, the chief architect of President Ronald Reagan’s economic program.
Before we consider in detail the case for a return to regulation, let’s first understand how we have come to this pass.
Think of it this way: there is a hierarchy of lenders and sublenders that begins with, say, a saver in Germany who puts money on deposit in a Berlin bank. This deposit, along with countless others, is used to buy highly complex U.S. mortgage-backed securities peddled by an American investment banker in Frankfurt. These securities are a claim on thousands of mortgages advanced to homeowners in the United States by various American mortgage lenders. In an ideal world, all the American borrowers remain happily solvent and make their repayments on time. Out of these repayments the German bank will receive a regular flow of interest followed eventually by the return of its capital—after various middlemen have taken juicy cuts, not least the American investment banker, who has already taken a nice commission upfront.
As long as home prices continue to rise, the system works. That’s the theory. But in reality, a natural real estate correction—along with rampant corruption—combined to produce devastating effects.
In the search for someone to blame, predatory lenders are obvious culprits. As the subprime mortgage industry grew, so did the tendency to seek out weak borrowers, particularly elderly people with valuable homes but little income. In one case reported to the Senate Special Committee on Aging, an elderly couple living on Social Security in Brooklyn was sucked into a financial quagmire after a salesman promised he could have their windows repaired for payments of $43 a month over 15 years—a grand total of less than $8,000. Six years later, they had paid tens of thousands of dollars in fees, accumulated $88,000 in new debt, and been served with foreclosure papers.
Situations like this meant fat income for the predatory lender, with the added bonus of exorbitant rake-offs when he foreclosed on the unfortunate borrower. The whole plot was funded by an expected rise in home values.
And for a time, prices soared—124 percent between 1997 and 2006. Lured by teaser rates and convinced that they could either refinance later or flip for big gains, average Americans got in the game. As of March 2007, the value of subprimes was estimated at $1.3 trillion of the $12 trillion total U.S. mortgage market—a significant proportion, to be sure. But not all lenders were trawling for defaults; money was cheap and the market was hot.
Far from putting on the brakes, government revved the engine. President Bush advanced his notion of the “ownership society” as integral to national identity: “the idea of people owning a home is part of the American Dream.” Legislation like the Home Mortgage Disclosure Act and the Community Reinvestment Act facilitated risky lending. The Federal Reserve contributed to the problem as well. “The Fed’s loose money policies under Alan Greenspan encouraged the technology bubble” of the 1990s, notes sociology professor Walden Bello, a leading critic of globalization. “When it collapsed, Greenspan, to try to counter a long recession, cut the prime rate to a 45-year low of one percent in June 2003 and kept it there for over a year. This had the effect of encouraging another bubble—in real estate.”
Finally the bubble burst, as bubbles always do, and it’s been a rough ride back to reality. Last year, 1.3 million properties went into foreclosure, 43 percent of them funded by subprime loans. Borrowers had taken out mortgages representing nearly 100 percent of their homes’ value. In a rapidly depreciating market, these mortgages went deeply underwater, and now the whole scheme has come to a halt.
Hence the calls from almost all quarters, even some of the most unexpected, for new regulation and intervention in the economy. But not every emergency measure that has been put forward is sound. Indeed, the policies advocated by President Bush and his Treasury secretary may only lead to further problems.
Henry Paulson’s strategy seems not so much strange as perverse. His intention is to buy stricken institutions’ bad loans on a highly cumbersome case-by-case basis. As many observers, not least Washington economist Dean Baker and New York Times columnist Paul Krugman, have pointed out, this inherently opaque process will open the door to all sorts of mischief. It is easy to imagine perfectly solvent institutions sticking the U.S. taxpayer with dud loans at hugely inflated prices.
To say the least, this is not how financial bailouts are generally structured. The traditional practice—not just in the United States but around the world—has been to steer clear of buying a stricken bank’s assets and instead to operate on the other side of the balance sheet by buying its “paper.” That is, to buy either newly issued bonds or stocks. In the 1930s, for instance, the federal government bought large amounts of preferred stock issued by insolvent banks. That meant not only that it received good dividends while work-outs proceeded, but ranked ahead of ordinary stockholders in the event of a bankruptcy. Such an approach leaves to individual banks the question of how they should deal with their underwater loans—a policy congruent with the best traditions of market freedom. It is not only inherently elegant and transparent, but positions the taxpayer to profit if, as frequently happens, a financial institution shakes off its problems faster than expected. In the 1930s, this approach proved a resounding success not only in restoring stability but in eventually generating large profits for the federal government.
But that isn’t Paulson’s approach. Perhaps the most startling aspect of his strategy is that the Treasury secretary seems determined to marginalize the Federal Deposit Insurance Corporation. Yet as economic analyst Pat Choate points out, the FDIC is purpose-built to handle rescues of this sort. Not only does it enjoy enormous institutional memory from past rescues—not least mopping up after countless savings and loan collapses in the 1980s—but it has a staff of 4,000 to mobilize at a moment’s notice.
The FDIC’s potential to play a pivotal role has been underlined by William Isaac, who chaired the institution between 1981 and 1985. On his figures, the FDIC’s handling of the savings and loan bailout proved so effective that the net cost to taxpayers was reduced to a mere $2 billion from an original estimate of $100 billion.
The FDIC’s cause has been espoused by one of the House conservatives who opposed the Paulson bailout plan, John Shadegg (son of Steve Shadegg, who organized the Draft Goldwater campaign of 1964), as well as by such Democratic Paulson-bashers as Reps. Marcy Kaptur, Peter DeFazio, and Donna Edwards.
Why has Paulson been so determined to stand-down the FDIC? Choate, author of Dangerous Business, a devastating new book on the downside of globalism, offers a telling explanation: although the FDIC enjoys full powers to address the problems of American creditors, foreign creditors are a different matter. In previous financial bailouts this mattered little, as foreign capital played a minimal role. Things are different now.
The hugely increased role of foreign capital catches Paulson and his lieutenant Neel Kashkari on the horns of a terrible dilemma. On the one hand, as true Wall Streeters, they are probably inclined to curry favor with their many foreign financial friends. They have made big money from such connections in the past and no doubt look forward to doing so after returning to Wall Street. On the other hand, they realize that any overt effort to help foreign fat cats at a time of severe strain for millions of ordinary Americans would mean pouring tanker-loads of gasoline on an already white-hot political inferno. Given that foreign indebtedness is rightly associated with America’s ever worsening trade imbalances—and by extension with American industrial decline—it is hardly viewed kindly in the heartland.
Paulson’s wiggle room is further constrained by the fact that he is known to be close to the Chinese establishment. He has palled around with former Chinese president Jiang Zemin—they even worked together on an environmental project. He holds a highly symbolic sinecure at Tsinghua, one of China’s top universities.
If a conflicted Paulson is motivated to hide how much of the $700 billion fund is destined for foreign creditors, his original “zero-accountability” bailout plan was perfect for the task. The revised version does incorporate an element of accountability, but, as Choate points out, plenty of loopholes exist to end-run any real disclosure.
Another notable example of Paulson’s conflicts concerns the rescue of American International Group. As reported by Gretchen Morgenson of the New York Times, Goldman Sachs was AIG’s largest trading partner. An AIG bankruptcy would have blown a hole of perhaps as much as $20 billion in Goldman’s balance sheet—significant even by masters-of-the-universe standards. Although the insurer’s rescue was conducted by the Federal Reserve Board, not the Treasury, Paulson’s views were probably not immaterial to the outcome. Moreover, Lloyd Blankfein, Paulson’s successor at Goldman, was reportedly in the room as the AIG bailout was negotiated.
Under the circumstances, it is hard to see why Paulson did not long ago resign as Treasury chief. Even if he had not suffered so clearly from conflicts of interest, his failure to take timely action long ago was itself sufficient reason for him to fall on his sword. After all, it was not as if the crisis came as a complete surprise. As far back as 2002, the inflating bubble was presciently identified by Dean Baker, as well as by Warren Buffett. Yale economist Robert Shiller and financier Jim Rogers were among others who saw the disaster coming, and the Basel-based Bank of International Settlements gave Paulson a particularly blunt warning in the summer of 2007.
Paulson’s tough-it-out demeanor seems in character, however, when viewed in the context of the Bush administration’s appalling record on predatory lending. In the face of strong pressure from state attorneys general and other officials in 49 states in the first half of this decade, the administration chose not just to sweep shocking evidence under the carpet but actively took the predators’ side against their critics. The scandal was highlighted in a Feb. 14 op-ed by Eliot Spitzer, who charged that America’s financial markets would be “threatened” if predatory lending was left unchecked. (In the view of many observers, it was not a coincidence that less than a month later federal investigators leaked evidence of a sex scandal that forced the New York governor’s resignation.)
The Bush administration aside, almost everyone else in the American policymaking and intellectual establishment is coming round to the idea that financial deregulation has gone too far. Finance simply cannot be left to its own notoriously conflicted devices. Not only does it play a central role in any economy—think of it as a central nervous system—but it is an industry in which unique temptations are at work—perverse incentives that, in the absence of wise and effective oversight, constantly foster exploitative practices, instability, and all too often, as is abundantly clear from recent events, outright self-destruction.
Of course, many commentators on the Right condemn regulation as incompatible with conservative tradition. But a glance at history reveals that this is not necessarily the case. The move to regulate finance in Britain, for instance, has been often led by the Tories, who during Robert Peel’s term as prime minister passed the Companies Act of 1844 and went on under Harold Macmillan to pass the Prevention of Frauds (Investment) Act in 1958. In the United States, the Sherman Act of 1890, the first U.S. legislation to rein in monopolies, was pushed through by Republican Sen. John Sherman and signed into law by fellow Republican Benjamin Harrison. The McFadden Act of 1927, which curbed the right of banks to do business across state lines, similarly reflected Republican concerns.
True, the Glass-Steagall Act of 1933 was authored by two Democrats, Sen. Carter Glass and Rep. Henry Steagall. But neither was a Naderite radical. These Democrats of the Old South—hailing from Virginia and Alabama respectively—were stout conservatives. Their legislation not only created the FDIC, but built a famous firewall between commercial banks and brokerage houses by banning the former from underwriting securities. This firewall, finally dismantled in 1999, was intended to avoid certain notorious conflicts that had often left the public shortchanged in the Roaring Twenties.
In this regard it is interesting to reread the American conservative movement’s favorite economist, Milton Friedman. It was Friedman more than any other thinker who inspired the rightward shift in American economic thinking that began in the latter half of the 1970s. Few economists have been more often cited by the U.S. banking and brokerage lobby in pressing for ever greater deregulation.
But while Friedman was an outspoken critic of regulation in most other aspects of the economy, he was largely silent on financial regulation. The subject is notable for its complete absence from his influential 1980 book Free to Choose. Writing with his wife Rose, he railed against many other forms of regulation, not least the Interstate Commerce Commission, the Food and Drug Administration, and the Environmental Protection Agency. Yet the book made no mention of the Glass-Steagall Act or the other financial regulations introduced in the 1930s—this despite the fact that banks were already promoting the cause of financial deregulation at the time of the book’s publication. This is more remarkable for the fact that Friedman was probably the world’s foremost authority on the 1929 Wall Street crash and the Great Depression.
More generally, the evidence of American history strongly suggests that judicious financial regulation can be a powerful force for good. It is surely not an accident that beginning in the latter half of the 1930s, the United States enjoyed a respite of nearly 50 years in which there was not a single serious banking crisis and no serious stock-market setbacks except those triggered by the oil shocks of the 1970s. This period coincided exactly with America’s era of tightest financial regulation. It is notable, moreover, that for most of the period the United States enjoyed a unique combination of fast growth at home and unquestioned economic leadership abroad. With the exception of a few radically libertarian economists, no one questioned the basic case for regulation. During the Eisenhower years it was taken for granted by Republicans and Democrats alike that though regulatory restraints could be a nuisance at times, the positives overall greatly outweighed the negatives. The same went for the Reagan administration, which, as Paul Craig Roberts recently pointed out, “most certainly did not deregulate the financial system.” Roberts went on to name the Clinton and George W. Bush administrations as the instigators of the radical deregulation being widely blamed for the current crisis. (An earlier piece of deregulation was passed during Jimmy Carter’s term.)
Prior to the 1930s, American finance had for more than a century been repeatedly shaken to its core by crises that occurred at approximately 20-year intervals. The half-century of remarkable banking stability that began in the late ’30s was broken only when an oil patch scandal brought down Continental Illinois in 1984. Since then, the crises have come thick and fast. The late 1980s and early 1990s saw a wave of savings and loan collapses, followed in 1998 by the spectacular implosion of Long-Term Capital Management. In all these disasters and several lesser ones, deregulation provided executives with the financial rope with which they hanged themselves. The current subprime crisis is the clearest case yet in which regulation of the sort that ruled midcentury American finance could have minimized the trauma.
Regulation has received bad press in recent decades—often deservedly so. There is a difference, however, between good regulation and bad. Good regulation in this context requires minimalism and transparency. Instead of regulators involving themselves in the minutiae of every financial transaction, they should confine themselves mainly to setting prudential guidelines to keep firms generally within safe limits and to building appropriate firewalls to stop financial conflagrations from sweeping through the entire system. That said, regulators should have extensive powers to evaluate and, where necessary, ban what are euphemistically known as “new products.” As the present crisis amply demonstrates, such products generally serve only one real purpose: to enable Wall Street to confuse—and frankly short-change—its customers.
Why is regulation so necessary? A key problem is the notoriously asymmetrical nature of financial knowledge. Put another way, your broker knows more than you do. If he wants to do well for you, that is fine. But few securities salespersons become rich that way, and they have often preferred to prey on their customers’ ignorance. Usually this is done subtly, at least where Wall Street’s more reputable firms are concerned, and in recent years the tool of choice has been the invention of ever more esoteric “new products” that just happen to be ever more difficult to price accurately.
Writing in the Financial Times in 2004, economic commentator John Kay itemized some of the self-evidently absurd new products then being touted in financial markets: “Why would anyone want to buy a bond whose return is proportional to the square of the current interest rate? Why would someone in search of high income buy a security that offers it, but also offers a risk of large capital loss if one of three stock market indices should fall more than 25 percent below its initial level?” He added, “The only people well-equipped to assess the value of these instruments are the people who are selling them.”
For thinking conservatives the question is this: if easily analyzed, plain-vanilla financial products were good enough for the Eisenhower era, what has changed in the interim to suggest that today’s highly complex products serve society better? In truth, Wall Street’s perennially self-serving mindset and its periodic crises are two sides of the same coin. It is time to end the failed experiment with radical deregulation.
Eamonn Fingleton is the author of In the Jaws of the Dragon: America’s Fate in the Coming Era of Chinese Hegemony.