13 Bankers: The Wall Street Takeover and the Next Financial Meltdown (13 page)

Despite Fama’s caveats, the strong form became the intellectual justification for financial deregulation. If a free market will always produce fundamentally correct asset prices, then the financial sector can be left to its own devices. This principle applies directly to securities and derivatives; for example, if a municipality buys an interest rate swap from an investment bank, it must be getting a good deal, since the price it pays is set by the “market” (even if the transaction is negotiated privately between the parties). It applies more broadly to the fees charged for financial services; if the penalty interest rate on a credit card is 30 percent, that must be the true price of the risk that the card issuer is taking on that customer. And conceptually, it even applies to compensation in the financial sector; if a trader takes home a $5 million bonus at the end of the year, that must be the true value of his labor. (Or, as Goldman Sachs CEO Lloyd Blankfein recently asserted in defense of his bankers’ high pay, “If you examine our practices on compensation, you will see a complete correlation throughout our history of having remuneration match performance over the long term.”)
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These were not mathematical consequences of the Efficient Market Hypothesis, but they flowed naturally from it. The basic belief was that if a financial transaction was taking place, it was a good thing. This belief reflects a general economic principle; given perfectly rational actors with perfect information and no externalities, all transactions should be beneficial for both parties. But few economists ever believed that these assumptions actually held in the real world. And over the next few decades, dozens of leading economists such as Joseph Stiglitz, Robert Shiller, and Larry Summers set about knocking holes in the Efficient Market Hypothesis.
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Brad DeLong, Andrei Shleifer, Summers, and Robert Waldmann created a model showing that “noise trading can lead to a large divergence between market prices and fundamental values.”
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Even Fischer Black (of Black-Scholes fame) agreed. At the 1985 meeting of the American Finance Association, he argued that it was impossible to differentiate between noise and information, and hence impossible to determine who was a noise trader and who was an information trader. Consequently, prices could wander far away from fundamental values for indefinite periods of time.
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The Efficient Market Hypothesis did not develop in a vacuum; it was in the vanguard of a broad movement in economics arguing for decreased regulation and increased liberalization of markets. By the 1990s, there was also an emerging consensus that developing countries should abandon restrictions on the flow of capital and open their economies up to foreign money. The argument, as advanced by Stanley Fischer, then second-in-command at the International Monetary Fund, was that “free capital movements facilitate a more efficient global allocation of savings, and help channel resources into their most productive uses, thus increasing economic growth and welfare,” providing benefits that would outweigh any risks.
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Again, there were important skeptics. Jagdish Bhagwati argued in 1998 that trade in dollars was not the same as trade in goods, because free capital flows would generate financial crises whose potential costs needed to be taken into account.
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But the belief in free movements of capital, like the belief in efficient markets, became strong enough in some circles to shrug off the need for empirical justification.
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The Efficient Market Hypothesis, like the doctrine of free capital flows, provided ready ammunition for anyone who wanted to argue that banks should be allowed to do as they pleased, that financial innovations were necessarily good, and that free financial markets would always produce optimal social outcomes. Even so, it might have remained only a cry in the academic wilderness or an esoteric Wall Street doctrine. But it had the fortune of being in the right place at the right time—of coinciding with a once-in-a-generation shift in the American political climate.

The election of Ronald Reagan marked a crucial turning point in American political history. Although Richard Nixon had already shown how to build a new Republican majority by capitalizing on resentment against Lyndon Johnson’s Great Society and the culture of the 1960s, it was Reagan who gave that movement a usable political ideology. Although Jimmy Carter had overseen the beginnings of deregulation with airlines, railroads, and trucking, it was more a topic for policy wonks than for the broader electorate; drawing in part on the ideas of economist Milton Friedman, Reagan made deregulation an ideological crusade.
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Like many successful leaders, Reagan managed to bring together many conflicting movements and beliefs in his coalition. But his central message, as he said in his first inaugural address, was that “government is not the solution to our problem; government is the problem.”
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According to Reagan, making government smaller and weaker would not only increase personal freedom, it would unleash the creativity and productivity of the private sector.

Reagan fought this battle on many fronts. He cut taxes in an unsuccessful attempt to “starve the beast”—force government to shrink by cutting its funding. He reduced funding to regulatory agencies, hoping to achieve through understaffing what he could not pass through Congress. He installed people who had no interest in regulation at the head of major regulatory agencies. Faced with a Democratic majority in the House of Representatives through his entire presidency, he was unable to fully achieve his goal of dismantling government regulation, but he set the tone for both Republican and Democratic administrations that would follow. (Reagan’s ascent to power also closely followed the formation of Margaret Thatcher’s first government in the United Kingdom in 1979; Thatcher’s deregulatory policies helped unleash the forces of financial innovation in London, with similar results.)

For the financial sector, Reaganism meant breaking down the rules that constrained the activities of financial institutions. As his first treasury secretary (and later chief of staff), Reagan named Donald Regan, the Merrill Lynch CEO who had championed deregulation of brokerage commissions and sought to make Merrill into a diversified financial services company. It was not unusual for a treasury secretary to come from the banking industry. But it was unusual for a treasury secretary to embrace a deregulatory agenda as broad as the one Regan espoused. In an October 1981 interview, he said that his top priority was “the deregulation of financial institutions … trying to deregulate as quickly as possible in the field of interest rates, mandatory ceilings, things of that nature.”
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The savings and loan industry, still struggling with high interest rates and overreliance on mortgage lending, presented an opportunity for the new administration to test out its theories. In 1982, Congress passed the Garn–St. Germain Depository Institutions Act—hailed by President Reagan as “the first step in our administration’s comprehensive program of financial deregulation”
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—which lifted many regulations on the savings and loan industry, allowing them to expand further into new businesses, such as commercial lending and investing in corporate bonds (including junk bonds), to compensate for the collapse of the “boring banking” business model.
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In addition, the bill authorized state-chartered banks to offer mortgages with adjustable rates
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(national banks had been able to offer adjustable rate mortgages since the previous year)
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—a central feature of the last twenty-five years of innovation in residential lending—and relaxed other constraints on mortgage lending for national banks. The following year, acting under the authorization granted by the bill, the Office of the Comptroller of the Currency lifted all restrictions on loan-to-value ratios (the percentage of a house’s appraised value that could be borrowed), maturities (fifteen years, thirty years, etc.), and amortization schedules (meaning that banks could offer mortgages where the principal balance went up over time).
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The Garn–St. Germain Act also made it easier for banks to operate across state borders by allowing interstate mergers between banks and S&Ls.
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The Reagan administration’s willingness to help the banking industry also extended to the new innovations that were beginning to take hold on Wall Street. Lewis Ranieri, one of the legendary traders at Salomon Brothers, worked directly with administration officials to create a new market for mortgage-backed securities.
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In 1968, the federal agency Ginnie Mae had begun securitizing mortgages—buying mortgages from lenders, combining them in pools, and issuing securities backed by those pools to the lenders (who could then sell them to investors).
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The principal on these mortgages (but not the risk that borrowers might prepay) was guaranteed by Ginnie Mae, and therefore by the U.S. government. This guarantee insulated banks from the risk of default by their borrowers and also provided a way to attract money from a wide range of investors to the housing market. In the 1970s, Salomon attempted to create its own mortgage-backed securities out of Bank of America mortgages, but ran into problems with tax laws and with state regulations.

The solution to Salomon’s problem was a new bill, the Secondary Mortgage Market Enhancement Act of 1984, which Ranieri helped create and defended before Congress.
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This bill cleared away the tax issues and state regulations that had hampered Salomon’s earlier efforts, giving investment banks the ability to buy up virtually any mortgages, pool them together, and resell them in slices with varying levels of risk. Securitization was made even easier when the Tax Reform Act of 1986 created the Real Estate Mortgage Investment Conduit, or REMIC, which created tax advantages making mortgage-backed securities more attractive. These new laws were unequivocally good for the investment banks, which gained a new market from which they could earn millions of dollars in fees. In return, they were supposed to increase the flow of money into the housing sector, making it easier for people to buy houses. The new market for private mortgage-backed securities also helped commercial banks and S&Ls, which could now pass on the risk of their fixed rate mortgages (which lose value if interest rates increase) to investors in the new securities.
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These legislative victories showed the growing influence of Wall Street, but they also depended on Wall Street’s ability to wrap itself in the ideology of homeownership—the idea that making it easier for people to buy houses is always a good thing. In contrast to the thrifts, the major commercial and investment banks did not make major gains in the 1980s, despite the friendly attitude of the Reagan administration. Major legislation to break down the Glass-Steagall barrier fell victim to Democrats in Congress. (It also faced opposition from some investment banks, which did not want commercial banks invading their turf.) The Financial Institutions Deregulation Act of 1983, which would have allowed bank holding companies to expand into securities and insurance, died in Congress.
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Comprehensive deregulation was also derailed by the savings and loan crisis, which worsened steadily through the 1980s. As it turned out, the Garn–St. Germain Act, by allowing S&Ls to expand into new businesses, prompted many of them to gamble on high-risk investments. S&Ls lacked experience in these businesses, as did their regulators, and over 2,000 banks failed between 1985 and 1992, with a peak of 534 in 1989. (By comparison, only seventy-nine banks failed during all of the 1970s.)
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Ultimately, over one thousand people were indicted and thrifts suspected of fraud cost the government over $54 billion.
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When Ronald Reagan left office, his program to deregulate the financial sector remained incomplete. The industry still faced significant constraints, such as limits on interstate banking and the Glass-Steagall separation of commercial and investment banks. But although his ambitions remained unfulfilled, Reagan had transformed academic theories and policy prescriptions into a potent ideology that would play a major role in political discourse for at least the next two decades. The collapse of much of the communist bloc beginning in 1989 lent further support to the idea that free market capitalism was the right answer to any question.

EXCITING BANKING

The basic principle behind any oligarchy is that economic power yields political power. The legislative failures of the Reagan administration showed that, in the 1980s, Wall Street did not yet hold sway in Washington. While academic finance provided the intellectual justification for financial nonregulation and the Reagan Revolution provided the political ideology of weak government, these would have mattered less had finance remained simply one industry among many. Instead, the banking industry went through a revolution of its own—one aided in part by academic theories and incipient deregulation, but largely driven by the creativity and competitiveness of a generation of talented bankers. Their serial innovations created the new money machines that fueled the rapid, massive growth in the size, profitability, and wealth of the financial sector over the last three decades—all of which helped Wall Street become a dominant political force in Washington.