13 Bankers: The Wall Street Takeover and the Next Financial Meltdown (17 page)

THE WALL STREET–WASHINGTON CORRIDOR

When it came to money, however, Wall Street had no particular advantage over other industries, except that it had more of it. And while campaign contributions gave Wall Street influence on Capitol Hill, important decisions elsewhere in Washington are made by appointed officials who do not depend on campaign money. Congress can pass legislation that constrains the activities of financial institutions (or not), but that legislation must be translated into regulations and those regulations must be enforced by the executive branch—either administration officials, primarily in the Treasury Department, or regulators serving in the Federal Reserve or one of an alphabet soup of agencies (SEC, CFTC, OCC, OTS, FDIC, NCUA, and so on).
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A second source of Wall Street’s political power was its ability to place its people in key positions in Washington. As the big banks became richer, more of their executives became top-tier fund-raisers who could be tapped for administration jobs. More important, as the world of finance became more complicated and more central to the economy, the federal government became more dependent on people with modern financial expertise—which meant people from the big banks and from their most cutting-edge businesses. This constant flow of people from Wall Street to Washington and back ensured that important decisions were made by officials who had absorbed the financial sector’s view of the world and its perspective on government policy, and who often saw their future careers on Wall Street, not in Washington.

The core problem in regulation is whether regulators will enforce rules that harm the interests of the industry they oversee, or whether they will be “captured” by that industry, as described in George Stigler’s 1971 paper “The Theory of Economic Regulation”: “as a rule, regulation is acquired by the industry and is designed and operated primarily for its benefit.”
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Capture does not imply that regulators are corrupt, or that their actions are motivated by their personal interests. By contrast, regulatory capture is most effective when regulators share the worldview and the preferences of the industry they supervise. And as banking insiders gained power and influence in Washington, the positions they held—that complex financial products, free financial markets, and large, sophisticated financial institutions were good for America—became orthodoxy inside the Beltway.

Throughout the past two decades, many senior officials moved back and forth between Wall Street and Washington. This was not a new phenomenon; after all, financial services have been an important part of the American economy for a long time. In the last two decades, however, two things changed. First, as the industry changed, the type of leaders it sent to Washington changed. Instead of people who had grown up managing large commercial banks or traditional investment banking firms, now it was people from the newer, riskier, more profitable businesses who were entering public service. Robert Rubin, President Clinton’s first director of the National Economic Council (NEC) and second treasury secretary, began his Goldman Sachs career in risk arbitrage (betting on the likelihood of corporate events, such as acquisitions), branched out into relative value arbitrage (capitalizing on pricing discrepancies between similar securities), and co-headed Goldman’s fixed income trading department before becoming co-chair of the firm.
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Henry Paulson, President George W. Bush’s last treasury secretary, headed Goldman Sachs from 1999 to 2006, at a time when its trading operations were the most profitable part of the firm.

Second, the increasingly complex nature of finance changed the balance of power between Wall Street insiders and other economic policymakers. Executives from major financial institutions had always been prized in Washington for their relationships with major corporations in all industries. But as finance became more esoteric and policy questions became more technical, Wall Street experience became even more important. On many issues crucial to the financial sector—such as derivatives, securitization, or capital requirements—all the people with relevant expertise were Wall Street veterans. Financial policy took on the trappings of a branch of engineering, in which only those with hands-on experience on the cutting edge of innovation were qualified to comment. In order to stay informed about what was going on in the world of finance, the government had to borrow people from the major banks, who consequently had disproportionate influence over policy. For example, Frank Newman was CFO at Bank of America before joining Treasury in 1993 as undersecretary for domestic finance and later as deputy secretary. During the controversy triggered by the 1994 derivatives losses of Orange County, he wrote a letter urging Congress to “indefinitely postpone” legislation regulating derivatives. In 1995 he became senior vice chair of Bankers Trust, the derivatives dealer most tainted by the 1994 scandals; he was promoted to CEO in 1996.
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Many Wall Street bankers took on major positions in the government during the Clinton and George W. Bush administrations. Besides Rubin and Paulson, Goldman Sachs supplied treasury undersecretaries to both administrations—Gary Gensler under Clinton and Robert Steel (who went on to become CEO of Wachovia) under Bush. Other Goldman alumni included Senator Jon Corzine, a member of the Senate Banking Committee; Stephen Friedman, director of the NEC under Bush and chair of the New York Fed; William Dudley, an executive under Tim Geithner at the New York Fed and later its president; Joshua Bolten, director of the Office of Management and Budget (OMB) and chief of staff to President Bush; and a slew of Paulson advisers at Treasury, including Neel Kashkari, head of the Troubled Asset Relief Program (TARP). Other Wall Street executives in the Clinton administration included Roger Altman of Lehman Brothers and the Blackstone Group (a private equity firm) as deputy treasury secretary and Lee Sachs of Bear Stearns as a deputy assistant secretary and later as assistant secretary for financial markets.
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Rapid change in the financial sector put key regulators in the position to make important decisions affecting the industry, and many of those decisions were friendly to the industry. In 1993, Wendy Gramm, chair of the Commodity Futures Trading Commission (CFTC), issued an order exempting most over-the-counter derivatives from federal regulation; in the same year she was named to the board of directors of Enron, a leading trader of energy derivatives and major supporter of that order.
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As chair of the CFTC from 1999 to 2001, William Rainer co-authored a report recommending that an existing ban on single-stock futures be lifted;
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that recommendation was implemented by the Commodity Futures Modernization Act of 2000. In 2001, Rainer became CEO of OneChicago, a new exchange to trade single-stock futures.
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James Gilleran, former CEO of the Bank of San Francisco, became head of the Office of Thrift Supervision in 2001. During his tenure, the agency became known for its lax regulation of thrifts; Gilleran said, “Our goal is to allow thrifts to operate with a wide breadth of freedom from regulatory intrusion.”
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In 2005, he left to become CEO of Federal Home Loan Bank of Seattle. As a Treasury official during the George H. W. Bush administration, John Dugan led a study that advocated the repeal of interstate banking restrictions and of the Glass-Steagall Act; as a lawyer advising the American Bankers Association, he helped steer the Gramm-Leach-Bliley Act through Congress. In 2005, George W. Bush named Dugan Comptroller of the Currency, in which capacity he helped shield federally chartered banks from state regulators.
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The close connections between the private and public sectors were also enhanced by longtime government officials who chose to move to the private financial sector. Michael Froman, a member of Rubin’s NEC and then his chief of staff at Treasury, followed Rubin to become an executive at Citigroup. Gerald Corrigan worked at the Federal Reserve for over twenty years, serving as the president of the New York Fed from 1985 to 1993; in 1994 he joined Goldman Sachs, where he became a partner and senior executive in 1996. David Mullins, a former assistant secretary at Treasury and vice chair of the Federal Reserve Board of Governors, resigned from the Fed in 1994 to become a partner in Long-Term Capital Management.

The revolving door not only placed Wall Street veterans in important positions in Washington. It also ensured the development of strong personal relationships between leading bankers and government officials, giving the large banks privileged access to key policymakers, and promoted the spread of the Wall Street worldview in the corridors of political power. The prospect of landing prestigious or high-paying jobs in the financial sector may also have influenced the decisions of regulators and administration officials, who may have had an incentive not to make enemies among their potential future employers.

But banks also had a more direct means of putting pressure on their regulators—the market for regulatory fees. The Federal Reserve makes the money for its day-to-day operations from its banking activities, and the FDIC makes its money from insurance premiums levied on banks. But the other major regulators, including the Office of the Comptroller of the Currency (OCC) and the Office of Thrift Supervision (OTS), are funded by fees levied solely on the banks that they regulate. And while each regulator nominally had its own sphere of jurisdiction—bank holding companies for the Fed, national banks for the OCC, and so on—financial institutions that fell under multiple regulatory agencies were allowed to select their primary regulator. As a result, regulatory agencies had to compete for funding by convincing financial institutions to accept their regulation, which created the incentives for a “race to the bottom,” in which agencies attract “customers” by offering relatively lax regulatory enforcement.

The OTS stood out in this competition. According to William Black, a law professor and former official at the Federal Home Loan Bank Board, “The reputation of the Office of Thrift Supervision was that it was the weakest, and the laxest, and it was indeed outright friendly to the worst of the non-prime lending.”
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American International Group (AIG), a massive insurance company with one of the largest derivatives trading operations in the world, opened a savings and loan—and then chose the OTS as its primary regulator, even though the agency, with its focus on mortgage lending, had no chance of monitoring the risks taken on by AIG’s infamous Financial Products division. In 2005, the giant mortgage lender Countrywide, then regulated by the OCC, met with the OTS to discuss switching regulators. According to
The Washington Post,
“Senior executives at Countrywide who participated in the meetings said OTS pitched itself as a more natural, less antagonistic regulator than OCC and that [Countrywide CEO Angelo] Mozilo preferred that. Government officials outside OTS who were familiar with the negotiations provided a similar description.”
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In March 2007, the OTS approved Countrywide’s application to convert itself from a bank holding company into a savings and loan holding company in order to fall under the OTS’s regulation.
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Between the revolving door and the competition for regulatory “business,” there was a confluence of perspectives and opinions between Wall Street and Washington that was far more powerful than emerging-market-style corruption. Wall Street’s positions became the conventional wisdom in Washington; those who disagreed with them, such as Brooksley Born, were marginalized as people who simply did not understand the bright new world of modern finance. This groupthink was a major reason why the federal government deferred to the interests of Wall Street repeatedly in the 1990s and 2000s.

One of history’s curiosities is that this shift happened within a Democratic administration, headed by a president elected largely because of middle-class economic insecurity. Of all the people to migrate from Wall Street to Washington, the most important was Robert Rubin. When Rubin joined the Clinton administration in 1993—having first gained entrance to the party’s inner circles through his fund-raising prowess
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—the transformation of the financial sector into a risktaking, moneymaking colossus was well underway. But the right of big banks to make money free from government intervention was not yet secured. There was still a major force in American politics that was skeptical about Wall Street and the unbridled pursuit of profit: the Democratic Party, which had helped block deregulatory legislation in Congress in the 1980s.

Bill Clinton was elected president in 1992 without any apparent strong opinion of the financial sector. Although his campaign theme was “the economy, stupid,”
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as a challenger he was able to propose a broad economic platform (including health care reform, a middle-class tax cut, and education spending) without having to take a position on Wall Street. When Clinton took office, his appointments reflected a broad range of views within the Democratic Party. Lloyd Bentsen, a moderate who had spent the past twenty-two years in the Senate, was secretary of the treasury; Roger Altman, from both Wall Street and the Carter administration, was his deputy; Robert Reich, a traditional liberal (in the American sense) was secretary of labor; Laura Tyson, an advocate of industrial policy, was chair of the Council of Economic Advisers; and Rubin was director of the NEC, a new body created by Clinton to coordinate economic policymaking.