13 Bankers: The Wall Street Takeover and the Next Financial Meltdown (3 page)

Free from the threat of regulation, OTC derivatives grew to over $680 trillion in face value and over $20 trillion in market value by 2008. Credit default swaps, which were too rare to be measured in 1998, grew to over $50 trillion in face value and over $3 trillion in market value by 2008, contributing to the inflation of the housing bubble;
¹⁶
when that bubble burst, the collapse in the value of securities based on the housing market triggered the financial crisis. The U.S. economy contracted by 4 percent, financial institutions took over one trillion dollars of losses, and the United States and other governments bailed out their banking sectors with rescue packages worth either hundreds of billions or trillions of dollars, depending on how you count them.
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Brooksley Born was defeated by the new financial oligarchy, symbolized by the thirteen bank CEOs who gathered at the White House in March 2009 and the “thirteen bankers” who lobbied Larry Summers in 1998. The major banks gained the wealth and prestige necessary to enter the halls of power and sway the opinions of the political establishment, and then cashed in that influence for policies—of which derivatives nonregulation was only one example—that helped them double and redouble their wealth while bringing the economy to the edge of a cliff, from which it had to be pulled back with taxpayer money.

The choices the federal government made in rescuing the banking sector in 2008 and 2009 also have significant implications for American society and the global economy today. Not only did the government choose to rescue the financial system—a decision few would question—but it chose to do so by extending a blank check to the largest, most powerful banks in their moment of greatest need. The government chose
not
to impose conditions that could reform the industry or even to replace the management of large failed banks. It chose to stick with the bankers it had.

In the dark days of late 2008—when Lehman Brothers vanished, Merrill Lynch was acquired, AIG was taken over by the government, Washington Mutual and Wachovia collapsed, Goldman Sachs and Morgan Stanley fled for safety by morphing into “bank holding companies,” and Citigroup and Bank of America teetered on the edge before being bailed out—the conventional wisdom was that the financial crisis spelled the end of an era of excessive risk-taking and fabulous profits. Instead, we can now see that the largest, most powerful banks came out of the crisis even larger and more powerful. When Wall Street was on its knees, Washington came to its rescue—not because of personal favors to a handful of powerful bankers, but because of a belief in a certain kind of financial sector so strong that not even the ugly revelations of the financial crisis could uproot it.

That belief was reinforced by the fact that, when the crisis hit, both the Bush and Obama administrations were largely manned by people who either came from Wall Street or had put in place the policies favored by Wall Street. Because of these long-term relationships between Wall Street and Washington, there was little serious consideration during the crisis of the possibility that a different kind of financial system might be possible—despite the exhortations of prominent economists such as Paul Krugman, Joseph Stiglitz, and many others. There was no serious attempt to break up the big banks or reform financial regulation while it was possible—when the banks were weak, at the height of the crisis. Reform was put off until after the most powerful banks had grown even bigger, returned to profitability, and regained their political clout. This strategy ran counter to the approach the U.S. Treasury Department had honed during emerging market financial crises in the 1990s, when leading officials urged crisis-stricken countries to address structural problems quickly and directly.

As we write this, Congress looks likely to adopt some type of banking reform, but it is unlikely to have much bite. The measures proposed by the Obama administration placed some new constraints on Wall Street, but left intact the preeminence and power of a handful of megabanks; and even these proposals faced opposition from the financial lobby on Capitol Hill. The reform bill will probably bring about some improvements, such as better protection for consumers against abusive practices by financial institutions. But the core problem—massive, powerful banks that are both “too big to fail” and powerful enough to tilt the political landscape in their favor—will remain as Wall Street returns to business as usual.

By all appearances, the major banks—at least the ones that survived intact—were the big winners of the financial crisis. JPMorgan Chase, Bank of America, and Wells Fargo bought up failing rivals to become even bigger. The largest banks increased their market shares in everything from issuing credit cards to issuing new stock for companies.
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Goldman Sachs reported record profits and, through September 2009, had already set aside over $500,000 per employee for compensation.
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Lloyd Blankfein, CEO of Goldman Sachs, was named Person of the Year by the
Financial Times.
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The implications for America and the world are clear. Our big banks have only gotten bigger. In 1983, Citibank, America’s largest bank, had $114 billion in assets, or 3.2 percent of U.S. gross domestic product (GDP, the most common measure of the size of an economy). By 2007, nine financial institutions were bigger relative to the U.S. economy than Citibank had been in 1983.
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At the time of the White House meeting, Bank of America’s assets were 16.4 percent of GDP, followed by JPMorgan Chase at 14.7 percent and Citigroup at 12.9 percent.
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A vague expectation that the government would bail them out in a crisis has been transformed into a virtual certainty, lowering their funding costs relative to their smaller competitors. The incentive structures created by high leverage (shifting risk from shareholders and employees onto creditors and, ultimately, taxpayers) and huge one-sided bonuses (great in good years and good in bad years) have not changed. The basic, massive subsidy scheme remains unchanged: when times are good, the banks keep the upside as executive and trader compensation; when times are bad and potential crisis looms, the government picks up the bill.

If the basic conditions of the financial system are the same, then the outcome will be the same, even if the details differ. The conditions that created the financial crisis and global recession of 2007–2009 will bring about another crisis, sooner or later. Like the last crisis, the next one will cause millions of people to lose their jobs, houses, or educational opportunities; it will require a large transfer of wealth from taxpayers to the financial sector; and it will increase government debt, requiring higher taxes in the future. The effects of the next meltdown could be milder than the last one; but with a banking system that is even more highly concentrated and that has a rock-solid government guarantee in place, they could also be worse.

The alternative is to reform the financial system now, to put in place a modern analog to the banking regulations of the 1930s that protected the financial system well for over fifty years. A central pillar of this reform must be breaking up the megabanks that dominate our financial system and have the ability to hold our entire economy hostage. This is the challenge that faces the Obama administration today. It is not a question of finance or economics. It is ultimately a question of politics—whether the long march of Wall Street on Washington can be halted and reversed. Given the close financial, personal, and ideological ties between these two centers of power, that will not happen overnight.

We have been here before. The confrontation between concentrated financial power and democratically elected government is as old as the American republic. History shows that finance can be made safe again. But it will be quite a fight.

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The CEOs and their banks were Ken Chenault, American Express; Ken Lewis, Bank of America; Robert Kelly, Bank of New York Mellon; Vikram Pandit, Citigroup; John Koskinen, Freddie Mac; Lloyd Blankfein, Goldman Sachs; Jamie Dimon, JPMorgan Chase; John Mack, Morgan Stanley; Rick Waddell, Northern Trust; James Rohr, PNC; Ronald Logue, State Street; Richard Davis, US Bank; and John Stumpf, Wells Fargo. There were also two representatives of industry organizations at the meeting.
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*
Because the accounting treatment of derivatives was unclear, the amount of capital that banks had to set aside for their derivatives positions was generally disproportionately low compared to the amount of risk they were taking on. Because they could generate higher profits with less capital, their “return on equity” was higher.

†
Derivatives are essentially zero-sum transactions. The face value, or notional value, of a derivative is the basis on which the value of the transaction is calculated. For example, in an interest rate swap, the payments made by the two parties are calculated as interest rates (percentages) on the notional value; the amount of money that changes hands is much lower than the notional value. The market value of a derivative contract is calculated by the Bank for International Settlements as the current value of the contract to the party that is “in the money”—in other words, the amount of money that would change hands in order to close out the contract at this moment.

1
THOMAS JEFFERSON AND THE FINANCIAL ARISTOCRACY

Great corporations exist only because they are created and safeguarded by our institutions; and it is therefore our right and our duty to see that they work in harmony with these institutions.

—Theodore Roosevelt, State of the Union message, December 3, 1901
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Suspicion of large, powerful banks is as old as the United States, dating back at least to Thomas Jefferson—author of the Declaration of Independence, secretary of state under President George Washington, third president of the United States, and staunch proponent of individual liberty. Although Jefferson is one of the most revered founders of the republic, according to conventional wisdom he was not much of an economist.
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Jefferson believed in an agrarian society with decentralized institutions and limited political and economic power. He was deeply suspicious of banks and criticized them in vitriolic terms, writing, “I sincerely believe, with you, that banking institutions are more dangerous than standing armies.”
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In a letter to James Madison, Jefferson even suggested, quite seriously, that anyone who cooperated with a federally chartered bank was guilty of treason and should be executed.
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The United States, however, did not turn out to be a decentralized agrarian society, in part because finance, commerce, and industry have also had their supporters throughout American history. Jefferson was opposed by Alexander Hamilton, Washington’s secretary of the treasury, who favored a stronger federal government that actively supported economic development. In particular, Hamilton believed that the government should ensure that sufficient credit was available to fund economic development and transform America into a prosperous, entrepreneurial country. This would require the introduction of modern forms of finance opposed by Jefferson. This tension between Jefferson and Hamilton has endured to the present day.

Hamilton favored a publicly chartered (though largely privately owned) bank modeled on the Bank of England, which would manage the federal government’s money and provide an important source of credit to the government and the economy. Legislation to create the (First) Bank of the United States passed Congress easily in 1791. Jefferson lobbied hard for President Washington to veto it, however, arguing that the power to charter a bank was not expressly granted to Congress by the Constitution and therefore remained with the states under the Tenth Amendment (“The powers not delegated to the United States by the Constitution, nor prohibited by it to the States, are reserved to the States respectively, or to the people”).
*
Washington went so far as to request that James Madison (principal author of the Constitution and the Bill of Rights) draft a veto, but he also allowed Hamilton the opportunity to respond.
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Hamilton’s fifteen-thousand-word memo, largely written at the last minute, convinced Washington that a federal bank was a “necessary and proper” application of Congress’s power and responsibility to promote fiscal stability and regulate trade by supporting the broader commercial system.
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The president signed the legislation without allowing Jefferson a rebuttal.
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After all the furor and rhetoric, the immediate historical aftermath was rather dull. The Bank of the United States functioned broadly as advertised by Hamilton, managing the government’s incoming revenues and outgoing payments and facilitating payments across an otherwise small-scale and fragmented financial system.
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It won over many supporters, although not Jefferson and Madison (at least at first), who formed the Democratic-Republican Party to oppose Hamilton’s Federalist Party, in part because of the Bank of the United States.