13 Bankers: The Wall Street Takeover and the Next Financial Meltdown (34 page)

DISMANTLING THE WALL STREET MODEL

For Wall Street’s megabanks, business as usual now means inventing tradable, high-margin products; using their market power to capture fees based on trading volume; taking advantage of their privileged market position to place bets in their proprietary trading accounts; and borrowing as much money as possible (in part by engineering their way around capital requirements) to maximize their profits. Before 2008, they benefited from the general expectation that the government would step in if necessary to prevent a catastrophic failure. That expectation did not save Lehman Brothers. But since then, the idea that certain banks are “too big to fail” has virtually become government policy; as a result, they can take on more risk than their competitors, since creditors and counterparties know that the government will clean up after them.

Subprime lending, mortgage-backed securities, collateralized debt obligations (CDOs), and credit default swaps all flowed naturally from this business model, and absent fundamental reform, there is no reason to believe bankers will refrain from inventing new toxic products and precipitating another crisis in the future. What’s more, given the growth in the size of the leading banks, the next crisis is likely to be even bigger. As
The Financial Times
’ Martin Wolf wrote in September 2009, “What is emerging is a slightly better capitalised financial sector, but one even more concentrated and benefiting from explicit state guarantees. This is not progress: it has to mean still more and bigger crises in the years ahead.”
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When the next crisis comes, either the government will ride to the rescue once again, costing taxpayers hundreds of billions of dollars, or popular revulsion at bailing out megabanks yet again will prevent Congress and the administration from saving the financial system—with potentially disastrous economic consequences.

The time for change is now. While the crisis was largely wasted in the short term, we have more than a single session of Congress or a single presidential term to fix our financial system. After the Panic of 1907, six years passed before the Federal Reserve was created, and it took another two decades (and the Great Depression) to put the financial system on a sound footing.

Public anger at Wall Street remains high. In an October 2009 poll, only 7 percent of respondents thought that major financial institutions were doing a good job at avoiding another crisis, 75 percent thought that Wall Street would “return to business as usual,” 58 percent thought Wall Street had too much influence over government policy, and 59 percent favored more government regulation.
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But that anger remains diffuse, in part because it is spread across the political spectrum, shared by progressives and conservatives who disagree on the solution. Financial regulation remains a complex topic that many people, including Washington insiders, think should be left to the experts—most of whom were formed on Wall Street or in the Wall Street–friendly climate of the past few decades. Real change will take years, and it will only happen when the conventional wisdom in Washington changes—from the idea that financial innovation and free financial markets are necessarily good, to the idea that concentrated economic and political power can have devastating effects on society.

There are many regulatory policies that could be beneficial, and some of them are included in the various proposals put forward by the Obama administration. But effective reform must address the two basic elements that created the last crisis and, absent change, will create the next one. The first is reckless borrowing and lending, which create a debt bubble that must eventually burst; the second is financial institutions that are so big or systemically important that, when the bubble bursts, they must be bailed out by the government to prevent economic disaster. The first objective should be to protect individual participants in the real economy, both households and businesses, from the potentially abusive behavior of powerful banks. But this is not sufficient to ward off a future crisis, since banks are free to load up on risky assets overseas, out of reach of U.S. protections. Therefore, the second and most important objective must be to protect the economy as a whole from the systemic risk created by enormous banks. Excess optimism, debt bubbles, and overextended banks will likely be with us forever; our goal must be a financial system where those banks can fail without being able to hold up the entire economy.

“RIPPING THE FACE OFF” THE CUSTOMER

Basic microeconomic models assume that the world is made up of rational actors who make accurate decisions, based on perfect information, to maximize their expected utility (benefits to themselves). Given these assumptions, regulation is unnecessary because parties will only engage in transactions that are good for them.

Because lawmakers have long recognized that information available in the market may not be perfect, the consumer protection regime that existed prior to the financial crisis was based on
disclosure.
The Securities Act of 1933 and the Securities Exchange Act of 1934 require companies that sell securities to the public to disclose material information in periodic reports. The Truth in Lending Act of 1968 requires lenders to disclose loan information in standardized form, such as the annual percentage rate, in order to facilitate comparison by borrowers. However, in both cases the legislation does not attempt to determine whether a given financial product is harmful to the consumer; that is left to the market. This is why, for example, there have been no interest rate caps for first mortgages since the Depository Institutions Deregulation and Monetary Control Act of 1980.

The recent financial crisis has exposed the danger of relying on markets to protect consumers. Exotic subprime loans with artificially low initial payments became a vehicle for mortgage brokers to get families into houses they had no realistic hope of affording. While some homebuyers may have consciously used these mortgages to speculate on housing prices, mortgage brokers and lenders also pushed borrowers into unnecessarily high-cost loans. The Center for Responsible Lending found that subprime borrowers ended up paying the equivalent of 1.3 percentage points of interest more for loans obtained through mortgage brokers than they would have paid borrowing directly from a retail lender.
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The city of Baltimore sued Wells Fargo, alleging that the company systematically targeted minority borrowers through such policies as offering bonuses for steering borrowers who would have qualified for prime loans into subprime loans instead.
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According to Shaun Donovan, secretary of housing and urban development, 33 percent of subprime mortgages in New York City went to borrowers who could have qualified for conventional loans.
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These examples demonstrate that unscrupulous brokers and lenders, armed with dense fine print, can induce consumers to choose products that are not in their best interest.

Subprime loans are hardly the only example of the market’s inability to prevent malfeasance. In 2005, the Federal Reserve ruled that overdraft “protection” is not covered by the Truth in Lending Act, allowing banks to charge overdraft fees without their customers’ permission and without disclosing the effective interest rate (although the existence of the programs is typically included in fine-print disclosure statements). In 2009, banks were expected to earn $27 billion in overdraft fees—amounting, on average, to a $34 fee for a $20 transaction.
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Credit card issuers have also become increasingly adept at maximizing revenues by adopting complex pricing structures that are hard for consumers to understand. For example, universal cross-default provisions (failing to pay one bill to a different company can count as a “default” on your credit card bill) can cause your interest rate to jump up to the “penalty” rate—even retroactively, thanks to two-cycle billing.
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Universal cross-default and two-cycle billing policies are included in the disclosure statements that card issuers slip into monthly bills, but are often difficult to understand.

Even those who do read the fine print often fail to understand the impact it will have on them individually, due to cognitive biases that lead people to underestimate their usage of credit and the price of credit. For example, 58 percent of people say that they usually pay off their credit cards each month—but only 37–42 percent actually do.
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The result is that people take on more debt than they intend to and pay a higher price for it than they realize. These errors are by no means confined to low-income, supposedly less sophisticated consumers. The reverse convertibles discussed in
chapter 4
were largely sold to relatively affluent investors, for the simple reason that complex financial products have to be sold (few people wake up in the morning suddenly wanting to buy complex structured notes), and larger transactions translate into larger commissions. And the harm caused by deceptive pricing structures goes beyond damage to individual consumers. When it is difficult to assess the likely cost of financial products, even a competitive market does not lead to lower prices for everyone; instead, financial institutions compete by thinking of new tricks to ensnare consumers, and those that refuse to take advantage of their customers lose market share.

Ultimately, simple microeconomic models break down for a few basic reasons. First, innovation leads to financial products that are too complex for even an intelligent, financially savvy person to understand. As former Federal Reserve governor Edward Gramlich wrote of subprime lending, “[I]t is complicated and confusing for borrowers to search out all their available options, to understand all the terms of the loans, and to avoid getting misallocated into a lower credit category than may be appropriate.”
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Second, people are not rational actors, and financial institutions are more than willing to prey on this weakness. A simple cognitive fallacy such as optimism bias—the tendency to think that you won’t miss a payment on your credit card or overdraw your checking account—causes people to choose financial products that are bad for them. As Shailesh Mehta, former CEO of Providian, said in an interview, “When people make the buying decision, they don’t look at the penalty fees, because they never believe they’ll be late. They never believe they’ll be over limit.”
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Third, the negotiating table is tilted in favor of financial services providers, not consumers. Individuals have no ability to negotiate the terms of their mortgages or their credit cards. And the people that they turn to for help with these confusing products, such as mortgage brokers, do not necessarily have their best interests in mind.

These problems were exacerbated by the regulatory structure in place prior to the financial crisis. Enforcement of consumer protection statutes was entrusted to the Federal Reserve, whose priorities have historically been managing the overall economy and ensuring the soundness of bank holding companies. Banks were also subject to various federal bank regulators—the OCC, the OTS, and the Federal Deposit Insurance Corporation—but their primary mission was to prevent banks from failing, not to protect consumers. The patchwork nature of financial regulation, particularly the limited oversight of nonbank lenders, made it possible for financial institutions to engage in their most questionable practices through their least regulated subsidiaries. And with regulators competing for fees from the banks they regulated, consumers’ interests were often an afterthought.

The need for stronger consumer protection in the financial arena motivated law professor Elizabeth Warren’s 2007 article “Unsafe at Any Rate.” Warren began:

It is impossible to buy a toaster that has a one-in-five chance of bursting into flames and burning down your house. But it is possible to refinance an existing home with a mortgage that has the same one-in-five chance of putting the family out on the street—and the mortgage won’t even carry a disclosure of that fact to the homeowner.
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Warren called for the creation of a Financial Product Safety Commission, modeled on the Consumer Product Safety Commission, with the power not only to establish disclosure requirements but also to study financial products, review them for safety, and require that dangerous products be modified before being made available to the public.

In 2009, Warren’s idea became the Obama administration’s proposed Consumer Financial Protection Agency. In its original form, the CFPA would have jurisdiction over almost any financial product sold to individuals, and would have the power to regulate “unfair, deceptive, or abusive acts or practices for all credit, savings, and payment products,” including the ability to ban specific practices such as prepayment penalties or yield-spread premiums (the practice of paying mortgage originators higher commissions for generating higher-cost mortgages). The CFPA would also be able to demand that financial service providers offer “plain-vanilla” versions of products, such as a thirty-year fixed rate mortgage, alongside whatever more complicated products they chose, so that consumers could buy a product that they knew was free of hidden traps.
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The banking lobby and its defenders closed ranks against the CFPA. Peter Wallison of the American Enterprise Institute claimed that some consumers would be “denied the opportunity to buy products and services that are available to others,” restating the textbook assumption that free choice is always good and restrictions on choice are always bad—but neglecting to ask whether meaningful choice exists when it comes to complicated products offered by a handful of oligopolists, such as credit cards.
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Small community savings banks joined forces with Wall Street, fearful that new regulations would increase their cost of doing business.
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The incumbent regulators also took a united stand against ceding any authority to a new agency, with Ben Bernanke of the Federal Reserve, John Dugan of the OCC, and Sheila Bair of the FDIC all taking aim at the CFPA before Congress.
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