13 Bankers: The Wall Street Takeover and the Next Financial Meltdown (19 page)

With Greenspan at the Federal Reserve, Rubin and Summers at Treasury, a reliably friendly and compliant set of regulators, and millions of dollars flowing into Congress with each election cycle, Wall Street had friends throughout Washington in the 1990s. Little changed in the following decade under the Bush administration, which believed even more strongly in deregulation. Rarely has one industry enjoyed such unchecked power in Washington.

THE IDEOLOGY OF FINANCE

It is one thing to have important congressmen dependent on your campaign contributions, and to have your own people in key positions of power, and even to have some regulators enthralled by the prospect of lucrative jobs. Those factors alone gave Wall Street tremendous political power. But in addition to these traditional forms of political capital, the major banks amassed another form of power: cultural capital.

Politics is like sales. If you are trying to close a large deal with a major corporation, it helps to have friends on the inside, it helps to have buyers who see their fortunes aligned with yours, and it can even help to dangle the prospect of a high-paying job before the key decision-maker. But it is even better if the buyers really, independently want what you are selling. It is best of all if they believe that buying what you are selling is a symbol of their own judgment and sophistication—that buying your product marks them as part of the informed elite.

Any industry—say, Big Tobacco—can buy friends in Washington, who will work hard behind the scenes to help that industry. But over the last two decades, Wall Street’s friends could work in the light of day, as the causes they championed gained an enthusiastic following among elites in Washington and New York (and major European capitals). The idea that a sophisticated, unrestrained financial sector was good for America became part of the conventional wisdom of the political and intellectual class. As a result, deregulation was no longer something to be buried in thousand-page bills—although that did happen—but was instead the focus of celebratory photo opportunities. In June 2003, representatives of three industry organizations joined the vice chair of the FDIC and the director of the OTS to kick off a project to “identify and eliminate any regulatory requirements that are outdated, unnecessary or unduly burdensome.” Each of them threatened a symbolic stack of paper documents with a pair of garden shears—except for James Gilleran, director of the OTS, who brought a chainsaw.
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Over the past twenty years, finance changed in the public eye from a boring and slightly untrustworthy pursuit to the glistening centerpiece of the modern American economy. In much of the country, suspicion of bankers remained high or even increased with the prosecutions of people from Ivan Boesky and Michael Milken (insider trading) to Henry Blodget (talking up bad stocks). But where it mattered most—on elite academic campuses, in the business and financial media, in think tanks, and in the halls of power in Washington—banking became the latest chapter of the American Dream, the way to make vast riches by working hard and creating innovative new products that would supposedly improve life for everyone.

The positive image of Wall Street had at least three main components. The first was the idea that financial innovation, like technological innovation, was necessarily good. The second was the idea that complex financial transactions served the noble purpose of helping ordinary Americans buy houses. The third was that Wall Street was the most exciting place to be at the turn of the new millennium.

Innovation, in American English, is an unambiguously positive word. Dating back to Benjamin Franklin and Eli Whitney, we like to see ourselves as a nation of creative, resourceful inventors who solve problems through ingenuity and hard work. More recently, when we think of innovation, we think of technology: of Hewlett and Packard in their garage, or Jobs and Wozniak in theirs. And given all the material benefits that technological innovation has given us, it seems logical that financial innovation must be equally beneficial.

The language of innovation has been widely used to describe recent changes in the financial sector. In a 1995 paper, Robert Merton wrote, “Looking at financial innovations … one sees them as the force driving the global financial system towards its goal of greater economic efficiency. In particular, innovations involving derivatives can improve efficiency by expanding opportunities for risk sharing, by lowering transaction costs and by reducing asymmetric information and agency costs.”
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Two years later, Alan Greenspan said,

The unbundling of financial products is now extensive throughout our financial system. Perhaps the most obvious example is the ever-expanding array of financial derivatives available to help firms manage interest rate risk, other market risks, and, increasingly, credit risks.… Another far-reaching innovation is the technology of securitization—a form of derivative—which has encouraged unbundling of the production processes for many credit services.… These and other developments facilitating the unbundling of financial products have surely improved the efficiency of our financial markets.
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As the financial sector became a bigger part of the U.S. economy, the celebration of financial innovation only increased. In 2006, even as he warned about potential risk management challenges generated by derivatives, Tim Geithner (then New York Fed president) said of the current wave of financial innovation,

These developments provide substantial benefits to the financial system. Financial institutions are able to measure and manage risk much more effectively. Risks are spread more widely, across a more diverse group of financial intermediaries, within and across countries.

These changes have contributed to a substantial improvement in the financial strength of the core financial intermediaries and in the overall flexibility and resilience of the financial system in the United States. And these improvements in the stability of the system and efficiency of the process of financial intermediation have probably contributed to the acceleration in productivity growth in the United States and in the increased stability in growth outcomes experienced over the past two decades.
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Even in April 2009, after the financial crisis, Greenspan’s successor, Ben Bernanke, said, “Financial innovation has improved access to credit, reduced costs, and increased choice. We should not attempt to impose restrictions on credit providers so onerous that they prevent the development of new products and services in the future.”
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The fact that Bernanke, a brilliant and widely respected academic, would sing the praises of financial innovation even after the financial crisis shows the powerful hold this ideology exerted on both economists and policymakers.

Merton and Greenspan’s argument about “risk sharing” and “unbundling” added intellectual heft to the ideology of innovation. According to this story, derivatives and securitization have the beneficial effect of spreading risk out among more market participants and allocating specific risks to the people who most want to hold them. Credit default swaps, for example, allow banks to divide up interest rate risk and default risk between different investors. Since all parties are negotiating freely in an open market, these transactions should be good for everyone—and they can be, if those parties know what they are doing. The rebranding of complexity as innovation, however, provided a blanket justification to any new financial products, paving the way not only for the inverse floaters sold to Orange County but for similar products sold to individual investors. Reverse convertibles, for example, are structured notes where the investor gets either a fixed interest rate
or
a share of stock, depending not only on the final stock price but on the path it takes getting there; because of their complexity, few investors are able to value them accurately, making them prey to unscrupulous brokers and banks.
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(“I was told there was no risk with these,” said one retiree who lost over $90,000 on reverse convertibles.)
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The ideology of innovation had its skeptics. Warren Buffett famously labeled derivatives “financial weapons of mass destruction” in the Berkshire Hathaway 2002 annual report.
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In his 2001 book
Fooled by Randomness,
Nassim Taleb argued that modern financial technology underestimated the likelihood of extreme events, with potentially catastrophic implications.
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Janet Tavakoli’s 2003 book,
Collateralized Debt Obligations and Structured Finance,
discussed the potential problems involved in securitization, including the risk of fraud.
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And decades before, Hyman Minsky had pointed out the role of innovation in enabling financiers to increase their profits at the risk of destabilizing the economy.
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They could all be ignored as long as market conditions remained benign. But the Merton-Greenspan “risk unbundling” story was proven horribly wrong by the financial crisis that began in 2007—caused in part by innovative products that made it possible for financial institutions and investors to take on massive amounts of risk hidden inside AAA-rated securities that later plummeted in value. Eventually even Greenspan was forced to admit his mistake in a congressional hearing.
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The recent orgy of financial innovation turned out so badly because financial innovation is
not
like technological innovation. There are financial innovations that do benefit society, such as the debit card. And derivatives, as discussed earlier, can be useful tools to help companies hedge their operational risks. But there is no law of physics or economics that dictates that
all
financial innovations are beneficial, simply because someone can be convinced to buy them. The core function of finance is financial intermediation—moving money from a place where it is not currently needed to a place where it is needed. The key questions for any financial innovation are whether it increases financial intermediation and whether that is a good thing.

Much recent “innovation” in credit cards, for example, has simply made the
pricing
of credit more complex. Card issuers have lowered the “headline” price that they advertise to consumers while increasing the hidden prices that consumers are less aware of, such as late fees and penalty rates. These tactics have increased the profits of credit card issuers, but have not increased financial intermediation—except insofar as they helped consumers underestimate the cost of credit and therefore borrow excessive amounts of money.
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Innovation that increases the availability of credit can also be harmful. The stated-income mortgage, where loan originators explicitly did not verify borrowers’ incomes, made it easier for some people to borrow more money to buy houses, but also served as an invitation to fraud (by both borrowers and mortgage brokers) and left many borrowers unable to repay their mortgages. Investments can be economically value-creating or value-destroying; when financial intermediation increases to the point where value-destroying investments are being funded, financial innovation is doing more harm than good.

But in the 1990s and 2000s, the theory of risk unbundling and diversification reigned largely unchallenged in Washington; people who didn’t subscribe to it could be written off as ignoramuses who failed to understand the elegance of modern finance. Merton and his colleague Myron Scholes, after all, won the Nobel Prize in economics in 1997 (a year before the collapse of their hedge fund). It also helped that financial services were one arena where U.S. firms were in the international vanguard, inventing most of the new products and markets of the past few decades. With the trade deficit in manufactured goods widening continuously, structured securities were one of our most attractive exports, especially to European banks and investors looking for higher-yield investments. After the Internet bust, Wall Street became our most prestigious economic center, and keeping it that way became an end in itself. As Senator Schumer said in 2007 of existing financial regulations, “We are not going to rest until we change the rules, change the laws and make sure New York remains No. 1 for decades on into the future.”
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The New American Dream was to make tens of millions on Wall Street or as a hedge fund manager in Greenwich, Connecticut. But it was also connected to the Old American Dream—to own a house of one’s own. In the last thirty years, the Wall Street ideology borrowed heavily from the older, more deep-rooted American ideology of homeownership, which became widely accepted after World War II as government programs and economic prosperity made possible a homeowning middle class. Wall Street co-opted this ideology to justify the central place of modern finance in the economic and political system, especially as the homeownership rate climbed from 64 percent, where it sat from 1983 to 1994, to a high of 69 percent in the 2000s.
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The ideology of homeownership has its roots in two sources. The first is the idea that homeownership is intrinsically good—it encourages individual responsibility, provides financial security, promotes community attachment, encourages people to take care of property, and so on. This ethos may have something to do with the important place of independence and self-reliance in the constellation of American values. Or it may be the product of various government policies designed to encourage homeownership. There may also be an element of truth to this idea; homeownership is generally thought to create positive externalities, since homeowners are on average more likely to devote effort to improving their communities. After reviewing other empirical studies and doing their own analyses, Edward Glaeser and Jesse Shapiro conclude: