The current crisis is not merely a failure of the US housing bubble, that is but a symptom of a much wider and far-reaching problem. The nations of the world are mired in exorbitant debt loads, as the sovereign debt crisis spreads across the globe, entire economies will crumble, and currencies will collapse while the banks consolidate and grow. The result will be to properly implement and construct the apparatus of a global government structure. A central facet of this is the formation of a global central bank and a global currency.
The people of the world have been lulled into a false sense of security and complacency, living under the illusion of an economic recovery. The fact remains: it is only an illusion, and eventually, it will come tumbling down. The people have been conned into handing their governments over to the banks, and the banks have been looting and pillaging the treasuries and wealth of nations, and all the while, and making the people pay for it.
There never was a story of more woe, than that of human kind, and their monied foe.
Truly, the people of the world do need a new world order, but not one determined and constructed by and for those who have created the past failed world orders. It must be a world order directed and determined by the people of the world, not the powerful. But to do this, the people must take back the power.
The way to achieving a stable economy is along the path of peace. War and economic crises play off of one another, and are systematically linked. Imperialism is the driver of this system, and behind it, the banking establishment as the financier.
Peace is the only way forward, in both political and economic realms. Peace is the pre-requisite for social sustainability and for a truly great civilization.
The people of the world must pursue and work for peace and justice on a global scale: economically, politically, socially, scientifically, artistically, and personally. It’s asking a lot, but it’s our only option. We need to have ‘hope’, a word often strewn around with little intent to the point where it has come to represent failed expectations. We need hope in ourselves, in our ability to throw off the shackles that bind us and in our diversity and creativity construct a new world that will benefit all.
No one knows what this world would look like, or how exactly to get there, least of all myself. What we do know is what it doesn’t look like, and what road to steer clear of. The time has come to retake our rightful place as the commanders of our own lives. It must be freedom for all, or freedom for none. This is our world, and we have been given the gift of the human mind and critical thought, which no other living being can rightfully boast; what a shame it would be to waste it.
He was a poor Scottish farmer. One day, while trying to make a living for his family, he heard a cry for help coming from a nearby bog. He dropped his tools and ran to the bog.
There, mired to his waist in black muck, was a terrified boy, screaming and struggling to free himself. Farmer Fleming saved the lad from what could have been a slow and terrifying death.
The next day, a fancy carriage pulled up to the Scotsman's sparse surroundings. An elegantly dressed nobleman stepped out and introduced himself as the father of the boy Farmer Fleming had saved.
'I want to repay you,' said the nobleman. 'You saved my son's life.'
'No, I can't accept payment for what I did,' the Scottish farmer replied waving off the offer. At that moment, the farmer's own son came to the door of the family hovel.
'Is that your son?' the nobleman asked.
'Yes,' the farmer replied proudly.
'I'll make you a deal. Let me provide him with the level of education my own son will enjoy If the lad is anything like his father, he'll no doubt grow to be a man we both will be proud of.' And that he did.
Farmer Fleming's son attended the very best schools and in time, graduated from St. Mary's Hospital Medical School in London, and went on to become known throughout the world as the noted Sir Alexander Fleming, the discoverer of Penicillin.
Years afterward, the same nobleman's son who was saved from the bog was stricken with pneumonia.
What saved his life this time? Penicillin.
The name of the nobleman? Lord Randolph Churchill .. His son's name?
Buddhist contemplatives throughout Asia have taken special interest in the possible diff erences between the way mental processes appear and the way they exist, a concern raised more recently in Western research by Gilbert Ryle. 16 Specifi cally, they have found that although mental states and processes often appear to be relatively static, upon close examination, all the immediate contents of the mind as well as our awareness of them are constantly in fl ux, arising and passing many times per second. A relatively homogenous continuum of a mental state, such as depression, may endure for seconds or even minutes, but that stream of emotion consists of discrete pulses of awareness, each of fi nite duration. There is nothing static in the human psyche, though habits may become deeply ingrained over the course of a lifetime. A second discrepancy between appearances and reality is that certain mental states, such as joy and elation, may appear to be intrinsically satisfying, but upon more careful examination are found to be misleading. No
mental state that arises from moment to moment in dependence upon sensory or intellectual stimuli is inherently satisfying. Every aff ective state is experienced as pleasant, unpleasant, or neutral only in relation to a complex of attitudes and desires. When these aff ective states of mind are passively observed from the wider perspective of the space of awareness, without identifying with them, they have no absolute, independent attributes of either pleasure or pain. A third disparity between mental appearances and reality pertains to the fact that thoughts, emotions, and other mental phenomena seem to have an inherent personal quality. When strong identifi cation with these processes occurs, one may feel that one’s very identity has become fused with them, and momentarily have the sense “I am angry, “ or “I am elated.” But with some skill in observing the contents of the mind, one fi nds that thoughts and mental images arise by themselves, with no voluntary intervention or control by a separate agent or self. Psychophysiological causes and conditions come together to generate these mental events, but there is no evidence that a separate “I” is among those causal infl uences. To be sure, some thoughts and desires do appear to be under the control of an autonomous self, but as expertise is gained in this practice, this illusion fades away, and everything that arises in the mind is seen to be a natural event, dependent upon impersonal causes and conditions, like everything else in nature. As noted previously, all usual kinds of experience, both sensory and introspective, are structured by memories, language, beliefs, and expectations, which cause us to assimilate even novel experiences, whether we want to or not. One of the names for the meditative practice I am describing here is “settling the mind in its natural state,” which implies a radical deconstruction of the ways we habitually classify, evaluate, and interpret experience. The Buddhist hypothesis in this regard is that it is possible to so profoundly settle the mind that virtually all thoughts and other mental constructs eventually become dormant. The result is not a trancelike, vegetative, or comatose state. On the contrary, it is a luminous, discerningly intelligent awareness in which the physical senses are withdrawn and the normal activities of the mind have subsided. 17 The culmination of this meditative process is the experience of the substrate consciousness ( ālaya-vijñāna ), which is characterized by three essential traits: bliss, luminosity, and nonconceptuality. The quality of bliss does not arise in response to any sensory stimulus, for the physical senses are dormant, as if one were deep asleep. Nor does it arise in dependence upon a pleasant thought or mental image, for such mental features have become subdued. Rather, it appears to be an innate quality of the mind when set- OBSERVING THE SPACE OF THE MIND 45 tled in its natural state, beyond the disturbing infl uences of conscious and unconscious mental activity. 18 A person who has achieved this state of attentional balance can remain eff ortlessly in it for at least four hours, with physical senses fully withdrawn and mental awareness highly stable and alert. The quality of luminosity is not any kind of interior light similar to what we see with the eyes. Rather, it is an intense vigilance that has the capacity to illuminate, or make consciously manifest, anything that may arise within the space of the mind. To get some idea of what this is like, imagine being wide awake as you are immersed in a perfect sensory deprivation tank so that you have no experience of any of the fi ve senses, or even of your own body. Then imagine that all your thought processes involving memory and imagination are put on hold, so that you are vigilantly aware of nothing but your own experience of being conscious. This is also analogous to “lucid dreamless sleep,” in which one is keenly aware of being deep asleep, in a kind of wakeful vacuum state of consciousness. 19 The empty space of the mind of which one is aware, once the mind has been settled in its natural state, is called the substrate ( ālaya ). 20 Due to the relatively nonconceptual nature of this state of consciousness, there is no distinct experience of a division between subject and object, self and other. Relatively speaking, the subjective substrate consciousness is nondually aware of the objective substrate, an experiential vacuum into which all mental contents have temporarily subsided. The mind may now be likened to a luminously transparent snow globe in which all the normally agitated particles of mental activities have come to rest. To draw an analogy from classical physics, virtually all the kinetic energy of the human psyche has been turned into potential energy, stored in this nondual experience of the substrate. This natural, or relatively unstructured, state is permeated with an extraordinary amount of “creative energy” that has the capacity to generate alternative realities, such as whole dreamscapes that emerge from a state of deep sleep. To draw another analogy from contemporary physics, the substrate may be likened to the zero-point fi eld, a background sea of luminosity permeated by an enormous amount of energy. This is the lowest possible energy state of the mind that can be achieved through such straightforward calming practices, and the energy of all kinds of mental activity is over and above that zero-point state. For the normal mind, enmeshed in a myriad of thoughts and emotions, this zero-point fi eld—substrate—of consciousness is unobservable, for we see things by way of contrast. Our attention is normally drawn to appearances that arise to the physical senses and mental perception, and they
alone are real for us. But all such appearances originate from this zeropoint fi eld, which permeates all our experience. We are eff ectively blind to it, while the world of appearance arises over and above it. When sensory and mental appearances naturally cease, as in deep sleep, the mind is normally so dull that we are incapable of ascertaining the substrate consciousness that manifests. The experience of the substrate is imbued with a relative degree of symmetry, and in this vacuum state reality does not appear in a structured form, either as a human psyche or as matter. This unstable equilibrium is perturbed by the activation of the conceptual mind, which creates the bifurcations of subject and object, mind and matter, which may be regarded as broken symmetries . When the fundamental symmetry of the substrate manifests in dreamless sleep, it is generally unobservable, and can only be retrospectively inferred on the basis of the broken symmetries of waking experience. But as mentioned before, as a result of continuous training in developing increasing stages of mental and physical relaxation, together with attentional stability and vividness, it is said that one may directly vividly ascertain this relative ground state of consciousness and observe how mental and sensory phenomena emerge from it in dependence upon a wide range of psychological and physical infl uences. The mind gradually settles into the substrate consciousness as mental activities gradually subside, without suppression, throughout the course of this training. And in this process, memories, fantasies, and emotions of all kinds come to the surface of awareness. Our usual experience of our mental states is heavily edited and processed by the habitual structuring of the mind, so we tend to experience them in a way we regard as “normal.” But in this training, the light of consciousness, like a probe into deep space, illuminates bizarre mental phenomena that seem utterly alien to one’s past experience and sense of personal identity. As an analogy from contemporary astronomy, recall the million-second-long exposure of the Hubble Ultra Deep Field. Astronomers discovered in that region of deep space a zoo of oddball galaxies, in contrast to the classic images of spiral and elliptical galaxies. Some look like toothpicks, others like links on a bracelet, and a few of them appear to be interacting. These bizarre galaxies chronicle a period when the universe was more chaotic, when order and structure were just beginning to emerge. Likewise, consciously exposing the deep space of the mind to thousands of hours of observation reveals normally hidden dimensions that are more chaotic, where the order and structure of the human psyche are just beginning to emerge. Strata upon strata of mental phenomena previously concealed within the subconscious are made manifest, until fi nally the mind OBSERVING THE SPACE OF THE MIND 47 comes to rest in its natural state, from which both conscious and normally subconscious events arise. This is an exercise in true depth psychology, in which one observes deep core samples of the subconscious mind, penetrating many layers of accumulated conceptual structuring. Just as scientists expect that observations of the Hubble Ultra Deep Field will off er new insights into the birth and evolution of galaxies, so do Tibetan contemplatives believe that the experience of the substrate consciousness off ers insights into the birth and evolution of the human psyche. Drawing on an analogy from modern biology, this may be portrayed as a kind of “stem consciousness.” Much as a stem cell diff erentiates itself in relation to specifi c biochemical environments, such as a brain or a liver, the substrate consciousness becomes diff erentiated with respect to specifi c living organisms. This is the earliest state of consciousness of a human embryo, and it gradually takes on the distinctive characteristics of a specifi c human psyche as it is conditioned and structured by a wide range of physiological and, later, cultural infl uences. The substrate consciousness is not inherently human, for this is also the ground state of consciousness of all other sentient animals. Contrary to the hypothesis that consciousness ultimately emerges from complex confi gurations of neuronal activity, according to the Great Perfection (Dzogchen) tradition of Tibetan Buddhism, the human mind emerges from the unitary experience of the zero-point fi eld of the substrate, which is prior to and more fundamental than the human, conceptual duality of mind and matter. 21 This luminous space is undiff erentiated in terms of any distinct sense of subject and object. So this hypothesis rejects both Cartesian dualism and materialistic monism, and it may be put to the test of experience, regardless of one’s ideological commitments and theoretical assumptions. While resting in the substrate consciousness, one may deliberately direct attention to the past, gradually exercising memory until one can vividly and accurately recall events. Some Buddhists claim that within the distilled, luminous space of deep concentration, one may direct the attention back in time even before conception in this life and recall events in the distant past. 22 As far-fetched as this hypothesis may seem, it can be tested with carefully controlled experiments, assuming that the subjects involved are highly expert in this practice. By such rigorous examination, it should be a fairly straightforward process to determine whether such adepts’ “memories” are accurate recollections from the past or mere fantasies. Open-minded skepticism toward these claims—specifi cally, the kind of skepticism that inspires testing hypotheses in the most rigorous way possible— is healthy and appropriate for the scientifi c community. To the great detriment of science, however, the ideal of skepticism in the twentieth cen-
tury has often degenerated into a kind of complacent closed-mindedness about any theory or method of inquiry that deviates from current mainstream science. Richard Feynman reminded us of the true ideal of scientific skepticism when he encouraged experimenters to search most diligently in precisely those areas where it seems most likely they can prove their own theories wrong. 23 Heraclitus, the sixth-century b.c.e. Greek philosopher known for his belief that the nature of everything is change itself, encouraged this open-minded attentiveness to novelty: “If you do not expect the unexpected, you will not fi nd it, since it is trackless and unexplored.” 24
Eliot Spitzer and William Black call for an immediate Congressional investigation of Lehman’s accounting deception and the release of relevant emails and internal documents.
In December, we argued the urgent need to make public A.I.G.’s emails and “key internal accounting documents and financial models.” A.I.G.’s schemes were at the center of the economic meltdown. Three months later, a year-long report by court-appointed bank examiner Anton Valukas makes it abundantly clear why such investigations are critical to the recovery of our financial system. Every time someone takes a serious look, a new scandal emerges.
The damning 2,200-page report, released last Friday, examines the reasons behind Lehman’s failure in September 2008. It reveals on and off balance-sheet accounting practices the firm’s managers used to deceive the public about Lehman’s true financial condition. Our investigations have shown for years that accounting is the “weapon of choice” for financial deception. Valukas’s findings reveal how Lehman used $50 billion in “repo” loans to fool investors into thinking that it was on sound financial footing. As our December co-author Frank Partnoy recently explained as part of a major report of the Roosevelt Institute, “Make Markets Be Markets“, such abusive off-balance accounting was and is endemic. It was a major cause of the financial crisis, and it will lead to future crises.
According to emails described in the report, CEO Richard Fuld and other senior Lehman executives were aware of the games being played and yet signed off on quarterly and annual reports. Lehman’s auditor Ernst & Young knew and kept quiet.
The Valukas report also exposes the dysfunctional relationship between the country’s main regulatory bodies and the systemically dangerous institutions (SDIs) they are supposed to be policing. The NY Fed, the regulatory agency led by then FRBNY President Geithner, has a clear statutory mission to promote the safety and soundness of the banking system and compliance with the law. Yet it stood by while Lehman deceived the public through a scheme that FRBNY officials likened to a “three card monte routine” (p. 1470). The report states:
“The FRBNY discounted the value of Lehman’s pool to account for these collateral transfers. However, the FRBNY did not request that Lehman exclude this collateral from its reported liquidity pool. In the words of one of the FRBNY’s on-site monitors: ‘how Lehman reports its liquidity is between Lehman, the SEC, and the world’” (p. 1472).
Translation: The FRBNY knew that Lehman was engaged in smoke and mirrors designed to overstate its liquidity and, therefore, was unwilling to lend as much money to Lehman. The FRBNY did not, however, inform the SEC, the public, or the OTS (which regulated an S&L that Lehman owned) of what should have been viewed by all as ongoing misrepresentations.
The Fed’s behavior made it clear that officials didn’t believe they needed to do more with this information. The FRBNY remained willing to lend to an institution with misleading accounting and neither remedied the accounting nor notified other regulators who may have had the opportunity to do so.
The Fed wanted to maintain a fiction that toxic mortgage products were simply misunderstood assets, so it allowed Lehman to maintain the false pretense of its accounting. We now know from Valukas and from former Treasury Secretary Paulson that the Treasury and the Fed knew that Lehman was massively overstating its on-book asset values: “According to Paulson, Lehman had liquidity problems and no hard assets against which to lend” (p. 1530). We know from Valukas’ interview of Geithner (p. 1502):
The challenge for the government, and for troubled firms like Lehman, was to reduce risk exposure, and the act of reducing risk by selling assets could result in “collateral damage” by demonstrating weakness and exposing “air” in the marks.
Or, in plain English, the Fed didn’t want Lehman and other SDIs to sell their toxic assets because the sales prices would reveal that the values Lehman (and all the other SDIs) placed on their toxic assets (the “marks”) were inflated with worthless hot air. Lehman claimed its toxic assets were worth “par” (no losses) (p. 1159), but Citicorp called them “bottom of the barrel” and “junk” (p. 1218). JPMorgan concluded: “the emperor had no clothes” (p. 1140). The FRBNY acted shamefully in covering up Lehman’s inflated asset values and liquidity. It constructed three, progressively weaker, stress tests — Lehman failed even the weakest test. The FRBNY then allowed Lehman to administer its own stress test. Need we tell you the results?
We believe that the Valukas report cries out for an immediate Congressional investigation. As we did with A.I.G., we demand the release of the e-mails and internal documents from the New York Fed and Lehman executives that pertain to analyses of Lehman’s financial soundness. What downside can there possibly be in making these records available for public analysis and scrutiny?
Three years since the collapse of the secondary market in toxic mortgage product, we have yet to see significant prosecutions of the kind of fraud exposed in the Valukas report. The SDIs, with Bernanke’s open support, exorted the accounting standards board (FASB) to change the rules so that banks no longer need to recognize their losses. This has made the SDIs appear profitable and allows them to pay their executives massive, unearned bonuses based on fictional profits.
If we are to prevent another, potentially more devastating financial crisis, we must understand what happened and who knew what. Many SDIs are hiding debt and losses and presenting deceptive portraits of their soundness. We must stop the three card monte accounting practices that create the potential and reality of fundamental misrepresentation.
A.I.G.’s CEO, its board of directors, and the trustees that are supposed to represent the interests of the American people have failed to respond to our December letter calling on them to release to the public the AIG documents that would be the treasure trove (along with other SDI documents) that would allow our nation to uncover and end the gamesmanship that caused this financial crisis and will bring us recurrent crises. We call on them to act.
Eliot Spitzer is a former attorney general and governor of New York.
Michael Lewis' new book, The Big Short, is released today, and it's the latest bravura effort from the financial journalist. (You can read an excerpt in TBM by clicking here.) Author of Liar's Poker, The Blind Side, and many other books and long-form magazine pieces, Lewis is arguably the finest financial journalist in the country. In February 2009, Chadwick Matlin argued just that in an assessment of Lewis' work. Because of The Big Short's publication, TBM has reprinted that piece below.
When I was hired to work for The Big Money, the first question a colleague asked was whether I had read Liar's Poker. Coming from political journalism, I had an average American's amount of business knowledge. That is to say, I didn't have any. So I bought Michael Lewis' Liar's Poker, a book written in the late ’80's about the late ’80's, and it was there that I first learned about derivatives. Twenty years after the book’s events, some of the very same derivatives that Lewis described would end up disemboweling the financial system from within. On Sept. 15, 2008, I was thankful I’d read the book.
The book’s prescience—and Wall Street's stubborn refusal to change—has left Lewis uniquely situated to comment on our current disaster. Don't think that Lewis and business editors are unaware. In his October 2008 (post-Lehman, AIG, and Merrill) Portfolio essay, he writes that "there was an umbilical cord running from the belly of the exploded beast back to the financial 1980s." In his and David Einhorn's mammoth op-ed from January 2009, his regulation suggestions are grounded in the kind of alarms he sounded in the late '80s. And in a stroke of professional luck that often seems to follow Lewis, his newly edited anthology Panic arrived on bookshelves this year, promising a retrospective look at—surprise—20 years of financial catastrophe, including the subprime meltdown. Thanks to the meltdown, he's now working on a new book, tentatively called The Big Short, that seems certain to land on best-seller lists in November.
Put simply, this financial crisis has solidified Michael Lewis' position as America’s money laureate. And it's not just because he happened—as some critics would construe it—to be in the right place at the right time. Nor is it because he's sold a ton of books—1.2 million copies since 2001, to be precise. It's because Michael Lewis is by far the best business journalist in the country. His assessment of the country's economic situation—and thus the country's economic mood—has provided some of the finest, most accessible prose available. Lewis serves as translator for the confused, financially illiterate masses. Which makes his secret to success all the more intriguing: His writing isn't actually about money.
Above all, Michael Lewis is a man obsessed with characters. Business journalists are often left with a false choice between writing about inanimate objects—collateralized debt obligations are always a hit—or about stuffy corporations and CEOs—scions, Pfizer, and Bear Stearns, oh my! Lewis has managed to chart a third course. Instead of detailing financial instruments, he finds characters within the underbelly of the market and lets them do the hard work for him. At least hundreds, often thousands, of words in his magazine pieces are spent describing Lewis' characters to set some type of financial and psychological scene. For Lewis, stakes are established by outlining a character's motivations and then detailing the reactions when the principles and artifacts of Wall Street interact with those desires. This process allows his subjects to become emblems of broader economic themes. In other fields, this technique is the norm; it's called storytelling. In business, however, Lewis' type of narrative yarn is rarely pulled off deftly.
Take that New York Times op-ed I mentioned earlier. Almost immediately Lewis (and Einhorn) launch into an anecdote about then-little-known, now-infamous Madoff whistle-blower Harry Markopolos. Markopolos' futile plight becomes a microcosm of all that's wrong with the regulatory system in the country and serves as a narrative catalyst to discuss all of Lewis' proposed fixes. Then there's the piece on Lewis' old colleague John Meriwether and the decline of his hedge fund, Long-Term Capital Management. By profiling Meriwether and LTCM's strategists, Lewis manages to summarize a fraught and decaying economic era—without really leaving the walls of LTCM. Oh, and don't forget about his New York Times Magazine missive on Google, which is really about the effect of shareholders on the eternal tension between profits and social good. There's an entire NYT Magazine essay about Lewis' disbelief that so few people in Washington actually get access to their subjects. The point: Lewis would rarely write a piece like this one—in which its principal subject is purposefully never contacted nor heard from.
At times, Lewis' lust for character backfires. In his tech book, The New New Thing, Lewis gets swept up in Netscape founder Jim Clark's utopian visions of the future. By allowing Clark to muscle the narrative, the book and its author get swept away into the very tech bubble that Lewis would later cover after the dot-com crash. It's a fact that Lewis admits in Panic, where he includes a New New Thing passage as an artifact of journalism that was too idealistic, too fast. Consider it an occupational hazard for the character-dependent writer.
That Lewis is so devoted to profile-driven journalism is surprising considering his influences (which, it should be said, are influences that I—and The Big Money—share). Lewis’ career owes much to the tutelage of Michael Kinsley, co-founder of Slate and a man who once said that profiles are "encrusted with useless anecdotes." That quote appears in Slate's collection of assessments, the column that this piece is closely emulating. Lewis has written for Slate, which Kinsley cofounded and my boss, Jacob Weisberg, has edited. Kinsley and Weisberg both make an appearance in the acknowledgement section of Lewis' upcoming book Home Game, which is essentially a collection of his Slate columns. Kinsley is credited as the godfather of Lewis' first child, and Lewis says lovingly of Weisberg, "If he's never matched my self-pity he has often encouraged it." This would also probably be a good time to mention that The Big Money routinely syndicates Lewis' Bloomberg News columns.
For the record, I've never met the guy.
When market news is too aggregated and abstract to produce compelling characters, Lewis takes the opportunity to talk about himself. This, presumably, is to yet again distract the reader and the writer from focusing too intently on business. Lewis' devotion to the first-person singular is prolific. His two most famous books—Liar's Poker and Moneyball—begin with the word I. Three of his books—Liar's Poker, Coach, and the upcoming Home Game—have been memoirs in one way or another. The ones that aren't—New New Thing, Losers, and Moneyball, namely—may as well be, as Lewis' voice is so present that he not only serves as the narrator, but as one of the central characters, ready to propel the narrative forward. Every book is an artifact of the years spent researching and working on the title; Lewis is comfortable laying that bare through his writing. J.D. Salinger this man is not.
Through all of these advertisements for himself, Lewis has created his own public persona. On the page, Lewis is a reformed slacker who stumbled into an industry and onto the story of a lifetime. But when it comes to his own life story, Lewis is an inherently biased storyteller. It's not unlike the way a politician—Barack Obama, say—crafts his own image by choosing what his personality will be. Not all believe the image, of course. The late Marjorie Williams (who is also closely intertwined with Slate, having contributed to the site and been married to Slate senior writer Tim Noah) wrote a blistering profile of Lewis in Vanity Fair back in 1997, taking issue with Lewis' love life. (Unfortunately, the profile is not available online.) Lewis was reportedly miffed; and since then, Williams' thesis—that Lewis was an antsy Lothario—now appears to have been disproven by Lewis' current, long-standing marriage.
But Lewis' actual personality doesn't matter for our purposes. Just as politicians interact with the public through their carefully managed handlers, the money laureate projects himself through his writing. And it's through his writing that Lewis is so atypically intelligible on financial matters. Much of his success is attributable to the way he writes about himself as a conduit for an unknowing audience.
Lewis' origin story is first sketched in Liar's Poker. Our unwitting hero has stumbled into the world of Wall Street through a chance encounter at a dinner party. He gets a job at Salomon* Bros. but is amazed that he is trusted with a client's money. In a recent piece, he claims that "to this day, the willingness of a Wall Street investment bank to pay me hundreds of thousands of dollars to dispense investment advice to grownups remains a mystery to me."
Nevertheless, he has the job, and he's not afraid to tell us just how incomprehensible it all is at first. In Liar's Poker, he holds our hand as he screws up repeatedly, overwhelmed with jargon, cultural mores, and Salomon* protocols. He learns on the job and keeps a sense of humor about the absurdity of it all.
It's both a useful and purposeful story arc since his experience, give or take a few details, mirrors Americans' own experience with the economy. In every crisis, we are thrown in unexpectedly and forced to grapple with our own illiteracy in a sea of data, information, and prognoses. Eventually, we stumble out, survive the trauma, and some among us go on to make money in the aftermath. He is our boy-wonder proxy.
If his story resembles the American experience, he himself is a conduit for the average American. Repeatedly, he makes clear that he is as lingo averse as the rest of us. His step-by-step description of mortgage derivative pools in Liar’s Poker still guides my understanding. (The explanation is too lengthy to reprint here, but you can read it at Amazon.com.) In a 1999 magazine piece, he bluntly tells the reader that "there is no reason anyone should feel obliged to understand interest-rate-swap arbitrage." (He then goes on to explain what actually is important about it.) He provides a glossary in Panic, introducing it with this footnote: "Some of Wall Street's private language is necessary and useful, but a lot of it seems designed to mystify outsiders." That Lewis even thinks of the outsider dovetails with his desire to be seen as the average American's stand-in.
Perhaps most importantly, Lewis' first-person musings allow him to discuss socioeconomic class. Underneath all business journalism lies an implicit power dynamic—the subject is almost always more wealthy than both the journalist and the audience. Lewis recognizes this disparity and takes the side of the audience, forming a populist union with his readers. And when you're writing about really rich people, the more populism the better. He begins his introduction to Panic by pointing out that "the striking thing about the seemingly endless collapse of the subprime-mortgage market is how egalitarian it has been." Much of Liar's Poker and Lewis' Silicon Valley book, The New New Thing, are devoted to the question of what one really does with all that money. He wrote a satirical Bloomberg News column posing as a hedge fund trader who blamed the poor for taking too much subprime money they could never afford. His mini-memoir Coach is about high school baseball—not business—yet is still dominated by the lessons Lewis learned about class, and therefore about money. The moral of the story is delivered by Lewis' high-school baseball coach: "Privilege corrupts. [The rich] were always doing what money could buy instead of what duty demanded." Some version of that vignette makes an appearance in almost every piece of Lewis' writing, no matter the topic.
His Portfolio piece on living in an entirely too-large mansion is the ultimate synthesis of Lewis' first-person narrative skills. The conceit is simple: The Lewis family rents out a mansion it can't afford in New Orleans. What follows is a comedy of bourgeois maladies: The house is so big Lewis can't hear his kids scream; the rent doesn't include exorbitant utility costs, like running the estate's fountain; his children get trapped in the house's elevator. The piece provides fertile ground for Lewis to reflect on subprime America, Americans' never-ending desires for higher status, and Lewis' childhood realizations that some people have money and some people don't. This is only tangentially a piece about money. It's really about American society.
So the reality is that Michael Lewis is a money laureate who doesn't write about money that often. Remember, he has arguably been as—if not more—successful writing about politics, sports, technology, and family. And it's likely that if everything hadn't melted down, Lewis wouldn't have re-emerged in business publications so prominently. Before the crisis, his next two books were slated to be Home Game, a compilation of his writing on family due in June, and a sequel to Moneyball, his blockbuster story of how statistical eggheads were changing the market for baseball players. But now his new book about this crisis will push back the Moneyball sequel.
As Lewis himself says in a Panic introductory passage, "Crashes and panics make for interesting stories and, once I'd become a full-time journalist, I found myself pulled back to write about them." It's only the car accidents that draw Lewis back to the fold; routine traffic no longer intrigues him.
Which, when you think about it, is a pretty good way to sum up the American interest in business as well. It's always there in the background, but even when we do pay attention, we care much more about the characters and class implications than the fiscal specifics. Thus, the question is: Do we model ourselves after our laureate, or does our laureate model himself after us?
Nice to see you up on your soap box, Mr. Ritholtz. You wear it well.
You can make money in these markets. You can make money in Las Vegas playing craps, blackjack or roulette. For joe six pack, which has better odds. The financial markets are now completely and totally a shame. You can most certainly make a trade and profit from it. Your profits are going to be someone else's losses. How long do we think a system that is so broken, corrupt and disgusting is going to last? A year, ten years? When this mess comes to a dramatic conclusion I hope that what ever money we "won" is enough to protect us from the screaming starving hordes.
If we are not part of the solution we are part of the problem. Just because you can do something, just because everyone else is doing it and just because there is no law against it - Does Not Make It Right. Pay back is a bitch and pay back is always just around the next corner.
When the French had their revolution it was not pretty. This 30 year old massive explosion of "greed is good" mind set and philosophy which has a strangle hold on our society will need to be put to rest. In my opinion when the inevitable happens, it too will not be a very pretty sight to see.
Barry Ritholtz says:
The bankruptcy report on Lehman is both revealing and damning. Once again, the investing public learns — after the fact — the basic truisms of modern markets:
-Major accounting firms are worthless to investors. They were either unable or unwilling to detect fraud amounting to 50 billion dollars. The incompetents at Ernst & Young deserve the same fiery death as Arthur Anderson; Whether they are hired guns or paid whores, they — like the rating agencies — are worthless to investors.
-Corporate management engages in fraud all too regularly: Am I reading this correctly — that Dick Fuld’s defense will be “I didn’t know that Lehman was a giant Ponzi scheme, and I was unaware we were hiding billions in bad debt and leverage off balance sheet?”
Based on the release of the bankruptcy court report, LEH was technically insolvent perhaps years before it collapsed;
-The Shortsellers turn out to be the good guys. Consider the absurdity fraud of “protecting” the bankster frauds — fromt he truth, as revelaed by Einhorn et. al.
-The SEC is utterly incapable of comprehending how markets function. They believe the criminals who commit the fraud, and ignore the whistleblowers who uncover it;
-The ban on short selling is an indictment of the inability of the SEC to understand WTF is going on, and a reward tot he criminal corporate management teams;
-The Media did a terrible job uncovering the fraud as well. Some media folk were used by CEOs. Some of the TV press who relied on access to their subjects, actually rallied to the defense of these CEOs, including Fuld, and trashed the short sellers. Most notably Charlie Gasparino from his CNBC days, but their were others as well.
-The Analyst community, for the most part, failed as well. The few who publicly acknowledged the debacle were notable for being so far outside of the herd. 95% of them were wrong.
All in all, the entire system failed. The situation is utterly disgusting, and if the investing public pulls its money out of the completely corrupt public markets for a generation or more, it would not surprise me . . .
You forget the most important bullet:
Armani wearing crime does pay! None of these people will be ever charge with any thing or lose any of their fraudulent gotten money. So my advice to thugs out there is join an IB to get away with it
dead hobo Says:
Who exactly is the “Analyst Community?” At one point many years ago I respected the idea of them as people who were smarter than me and it probably was good to at least pay attention to what ‘The Analysts” said.
Today, the word “analysts” makes me think of sell side shills who always always undershoot on their predictions so that the sell siders can shout “IT BEAT EXPECTATIONS!!!!”. Has there ever been a time when “analysts” weren’t optimistic or has there ever been a quarter where their expectations weren’t beat?
I suppose it ads credibility to an incompetent business reporter’s work when they can write “Analysts Said” to the headline the story being concocted,
Does anyone anymore actually think the phrase “analysts Said” has credibility with anyone anymore? People I talk to don’t believe government statistics any more. Is the phrase “Analysts Said” becoming an automatic dis-qualifier for anything that follows that phrase?
Julia Chestnut Says:
I’ve been out of the market for more than a year. I looked at the market then and the fundamentals were lacking – and the rally was being led by financials that I knew to be insolvent. I got out, and I haven’t looked back.
The problem is, we’re all stuck in 401(k)s that we can’t really control. I have a money market option in mine, and that is what I’m in. At what – zero interest? But government employees who have TSP? Their options are extremely limited – treasuries is the only out. Granted, when the US government defaults on its debt, you have bigger fish to fry than whether your TSP account just evaporated. Indeed, government employees are probably the least diversified for government default/crisis risk in the whole country: after ENRON, nobody else can have their entire pension fund in the company’s bonds/stock. But in effect, that is what government employees have their money in! TSP participants can either get into bonds, stocks, or treasuries. If all three of those markets are rigged/staring into the abyss? I find it depressing.
The penalties for pulling our money out of tax-deferred retirement plans and sitting in cash make it incredibly difficult to get safely away from the fraud being perpetrated with our money. And the people pulling the strings know that all too well. There are ways, but it is difficult and interest rates are at zero. Try convincing people that losing money on a zero interest rate is the only way to staunch that huge, flowing wound on their leg. . . .while they float in the middle of the Pacific Ocean surrounded by sharks. Lots of them can’t distinguish the bleeding from the surrounding water. Talking to my parents about this goes better when they don’t turn on their hearing aids, if that tells you anything.
Chief Tomahawk Says:
Charlie F-ing Gaspardrino strikes again!
And to think he was “rewarded” by FOX Business for his crap.
I hope he melts down and delivers a mea culpa which brings down (clawbacks anyone?!?) and cleans up the Street! Capitalism should’ve been protected by those who hold it most dear; they should’ve self-regulated to preserve the golden cow instead of whoreing it out in a Ponzi scheme.
I wonder what those who are buried in Arlington National Cemetary and died in service to their country would feel about the behavior by those who “inherited the flame”? Would the vets who charged up the beach on D-Day done so knowing there’d be such an ungrateful bunch of b*tch-ass punks in charge someday presiding over the lives of their children???
I started my career with PricewaterhouseCoopers in North Carolina, across the street from then Nationsbank, later to be Bank of America. we did their taxes until they hired away all the tax folks and paid them in-house. No real point to that except to say that I could easily see the conflict of interest back when I was 22-23-24, a new CPA and college grad. Think we wanted to do anything to lose that account? Millions that they paid us to do their taxes? Wine and cheese tasting events just because the Nasdaq was up that day?
The common denominator to all of this is greed. It was prevalent in 1999 and 2000 when I worked at PWC, and common in 2002 when my wife lost her job at Arthur Andersen, as Enron brought them to their knees. And “greed is still good” today. Nothing has changed.
My full faith in capitalism as an economic philosophy is not blind to the constant grab for money and power that is taking place as I write this. The bigger question is “What am I doing to make myself more wealthy at anyone’s expense?” Why am I on a message board vilifying people for their greed and stupidity, even though they will be laughing all the way to or from the bank, to or from the prison, while I get up and shill away every day, with “honor”?
I don’t think the system failed at all. The system was corrupted to achieve pretty much exactly the ends which we are seeing. Huge bonuses and salaries for Ponzi schemes. Wall Street jobs for government employees who toe the line while working for the Fed, Sec, etc. Bribes and kickbacks for politicians in the form of campaign contributions and lobbyist payments. Fees and insider tips for analysts who lie and cheat for their clients. Ditto for accounting firms that structure the schemes, hide the debt, and confuscate the books.
CNBC and Bloomberg are “media” in the sense that Gilligan’s Island is media. If the producers of Gilligan were engineers or ex-SAS, the show would have lasted two episodes, the time needed to repair a very small hole in the Minnow. CNBC made money because they sold “money sex” and “credit dreams”.
The system was a stunning success for everyone, even individual investors who have seen their bacon (house prices and stock prices) saved by the same mechanisms which bailed out the bankers.
So, who pays? Well, we all do a bit now and a lot later…except for the rich and powerful who will not suffer…ever. At least until we storm the palace gates and start sticking heads on pikes.
Wall Street Reform That Will Prevent The Next Financial Crisis
March 11, 2010
Introduction: Where the Burden of Proof Lies
Financial regulatory reform is perhaps the most important legislation that the Congress will address for many years to come. Because if we don't get it right, the consequences of another financial meltdown could truly be devastating.
In the Senate, as we continue to move closer to consideration of a landmark bill, however, we are still far short of addressing some of the fundamental problems – particularly that of “too big to fail” – that caused the last crisis and already have planted the seeds for the next one. And this is happening after months of careful deliberation and negotiations, and just a year and a half after the virtual meltdown of our entire financial system.
Following the Great Depression, the Congress built a legal and regulatory edifice that endured for decades. One of the cornerstones of that edifice was the Glass-Steagall Act, which established a firewall between commercial and investment banking activities. Another was a federally guaranteed insurance fund to back up bank deposits. Other rules were imposed on investors to tamp down rampant speculation, like margin requirements and the uptick rule on short selling.
That edifice worked well to ensure financial stability for decades. But in the past thirty years, the financial industry, like so many others, went through a process of deregulation. Bit by bit, many of the protections and standards put in place by the New Deal were methodically removed. And while the seminal moment came in 1999 with the repeal of Glass-Steagall, that formal rollback was primarily the confirmation of a lengthy process already underway.
Indeed, after 1999, the process only accelerated. Financial conglomerates that combined commercial and investment banking consolidated, becoming more leveraged and interconnected through ever more complex transactions and structures, all of which made our financial system more vulnerable to collapse. A shadow banking industry grew to larger proportions than even the banking industry itself, virtually unshackled by any regulation. By lifting basic restraints on financial markets and institutions, and more importantly, failing to put in place new rules as complex innovations arose and became widespread, this deregulatory philosophy unleashed the forces that would cause our financial crisis.
I start by asking a simple question: Given that deregulation caused the crisis, why don’t we go back to the statutory and regulatory frameworks of the past that were proven successes in ensuring financial stability?
And what response do I hear when I raise this rather obvious question? That we have moved beyond the old frameworks, that the eggs are too scrambled, that the financial industry has become too sophisticated and modernized and that it was not this or that piece of deregulation that caused the crisis in the first place.
Mind you, this is a financial crisis that necessitated a $2.5 trillion bailout. And that amount includes neither the many trillions of dollars more that were committed as guarantees for toxic debt nor the de facto bailout that banks received through the Federal Reserve’s easing of monetary policy. The crisis triggered a Great Recession that has thrown millions out of work, caused millions to lose their homes, and caused everyone to suffer in an American economy that has been knocked off its stride for more than two years.
Given the high costs of our policy and regulatory failures, as well as the reckless behavior on Wall Street, why should those of us who propose going back to the proven statutory and regulatory ideas of the past bear the burden of proof? The burden of proof should be upon those who would only tinker at the edges of our current system of financial regulation. After a crisis of this magnitude, it amazes me that some of our reform proposals effectively maintain the status quo in so many critical areas, whether it is allowing multi-trillion-dollar financial conglomerates that house traditional banking and speculative activities to continue to exist and pose threats to our financial system, permitting banks to continue to determine their own capital standards, or allowing a significant portion of the derivatives market to remain opaque and lightly regulated.
To address these problems, Congress needs to draw hard lines that provide fundamental systemic reforms, the very kind of protections we had under Glass-Steagall. We need to rebuild the wall between the government-guaranteed part of the financial system and those financial entities that remain free to take on greater risk. We need limits on the size of systemically significant non-bank players. And we need to regulate effectively the derivatives market that caused so much widespread financial ruin. It is my sincere hope that we don’t enact compromise measures that give only the illusion of change and a false sense of accomplishment. If we do, then we will only have set in place the prelude to the next financial crisis.
The Steady Removal of Glass-Steagall Protections
First, however, let us examine the origins – both obscure and well-known – of the Great Recession of 2008. As I have already noted, the regulators began tearing down the walls between commercial banking and investment banking long before the repeal of Glass-Steagall. Through a series of decisions in the 1980s and 1990s, the Federal Reserve liberalized prudential limitations placed upon commercial banks, allowing them to engage in securities underwriting and trading activities, which had traditionally been the particular province of investment banks. One fateful decision in 1987 to relax Glass-Steagall restrictions passed over the objections of then Federal Reserve Chairman Paul Volcker, the man who is today leading the charge to restrict government-backed banks from engaging in proprietary trading and other speculative activities.
With the steady erosion of these protections by the Federal Reserve, the repeal of Glass-Steagall had become a fait accompli even before the passage of the Gramm Leach Bliley Act (GLBA) in 1999. In effect, by passing GLBA, Congress was acknowledging the reality in the marketplace that commercial banks were already engaging in investment banking. As the business of finance moved from bank loans to bonds and other forms of capital provided by investors, commercial banks pushed the Federal Reserve to relax Glass-Steagall standards to allow them to underwrite bonds and make markets in new products like derivatives. Even before GLBA was passed, J.P. Morgan, Citigroup, Bank of America and their predecessor organizations had all become leaders in those businesses.
After Glass-Steagall’s Repeal: The Opening of the Floodgates
If the changes in the financial marketplace that led to the repeal of Glass-Steagall took place over many years, the market’s transformation after 1999 was swift and profound.
The Emergence of Mega Banks
First, there was frenzied merger activity in the banking sector, as financial supermarkets that had bank and nonbank franchises under the umbrella of a single holding company bought out smaller rivals to gain an ever-increasing national and international footprint. While the Riegle-Neal Banking of Act of 1994, which established a 10% cap nationally on any particular bank’s share of federally-insured deposits, should have been a barrier for at least some of these mergers, regulatory forbearance permitted them to go through anyway. In fact, then Citicorp’s proposed merger with Travelers Insurance was actually a major rationale behind the Glass-Steagall Act. Most of the largest banks are products of serial mergers. For example, J.P. Morgan Chase is a product of J.P. Morgan, Chase Bank, Chemical Bank, Manufacturers Hanover, Banc One, Bear Stearns, and Washington Mutual. Meanwhile, Bank of America is an amalgam of that predecessor bank, Nation’s Bank, Barnett Banks, Continental Illinois, MBNA, Fleet Bank, and finally Merrill Lynch.
Financial Disintermediation and the Rise of Shadow Banking
Second, the business of finance was changing. Disintermediation, the process by which investors directly fund businesses and individuals through securities markets, was already in full bloom by the time of the repeal of Glass-Steagall. This was demonstrated by the dramatic growth in money market fund and mutual fund assets and by the fact that corporate bonds actually exceeded non-mortgage bank loans by the middle of the 1990s.
The subsequent boom in structured finance took this process to ever greater heights. Securitization, whereby pools of illiquid loans and other assets are structured, converted and marketed into asset-backed securities (ABS), is in principle a valuable process that facilitates the flow of credit and the dispersion of risk beyond the banking system. Regulatory neglect, however, permitted a good model to mutate and grow into a sad farce.
On one end of the securitization supply chain, regulators allowed underwriting standards to erode precipitously without strengthening mortgage origination regulations or sounding the alarm bells on harmful nonbank actors (not even those within bank holding companies over which the regulators had jurisdiction). On the other, securities backed by risky loans were transformed into securities deemed “hi-grade” by credit rating agencies, only after a dizzying array of steps where securities were packaged and repackaged into many layers of senior tranches, which had high claims to interest and principal payments, and subordinate tranches.
The non-banking actors – investment banks, hedge funds, money market funds, off-balance-sheet investment funds – that powered structured finance came to be known as the shadow banking market. Of course, the shadow banking market could only have grown to surpass by trillions of dollars the actual banking market with the consent of regulators.
In fact, one of the primary purposes behind the securitization market was to arbitrage bank capital standards. Banks that could show regulators that they could offload risks through asset securitizations or through guarantees on their assets in the form of derivatives called credit default swaps (CDS) received more favorable regulatory capital treatment, allowing them to build their balance sheets to more and more stratospheric levels.
With the completion of the Basel II Capital Accord, determinations on capital adequacy became dependent on the judgments of rating agencies and, increasingly, the banks’ own internal models. While this was a recipe for disaster, it reflected in part the extent to which the size and complexity of this new era of quantitative finance exceeded the regulators’ own comprehension. When Basel II was effectively applied to investment banks like Lehman Brothers and Goldman Sachs, which had far more precarious and potentially explosive business models that utilized overnight funding to finance illiquid inventories of assets, the results were even worse. The SEC, which had no track record to speak of with respect to ensuring the safety and soundness of financial institutions, allowed these investment banks to leverage a small base of capital over 40 times into asset holdings that, in some cases, exceeded $1 trillion.
Third, little more than a year after repealing Glass-Steagall, Congress passed legislation – the Commodity Futures Modernization Act of 2000 (CFMA) – to allow over-the-counter (OTC) derivatives to essentially remain unregulated. Following the collapse of the hedge fund Long Term Capital Management (LTCM) in 1998, then Commodities Futures Trading Commission (CFTC) Chairwoman Brooksley Born began to warn of problems in this market. Unfortunately, her calls for stronger regulation of the derivatives market clashed with the uncompromising free-market philosophies of Federal Reserve Chairman Alan Greenspan, then Treasury Secretary Robert Rubin and later Treasury Secretary Larry Summers. To head off any attempt by the CFTC or another agency from regulating this market, they successfully convinced Congress to pass the CFMA.
The explosive growth of the OTC derivatives market following the passage of the CFMA was stunning – the size of the OTC derivatives market grew from just over $95 trillion at the end of 2000 to over $600 trillion in 2009. This growth had profound implications for the overall risk profile of the financial system. While derivatives can be used as a valuable tool to mitigate or hedge risk, they can also be used as an inexpensive way to take on leverage and risk. As I noted before, certain OTC derivatives called credit default swaps were crucial in allowing banks to evade their regulatory capital requirements. In other contexts, CDS contracts have been used to speculate on the credit worthiness of a particular company or asset.
But they pose other problems as well. Since derivatives represent contingent liabilities or assets, the risks associated with them are imperfectly accounted for on company balance sheets. And they have concentrated risk in the banking sector, since even before the repeal of Glass-Steagall, large commercial banks like J.P. Morgan were major derivatives dealers. Finally, the proliferation of derivatives has significantly increased the interdependence of financial actors while also overwhelming their back-office infrastructure. Hence, while the growth of derivatives greatly increased counterparty credit risks between financial institutions — the risk, that is, that the other party will default at some point during the life of the derivative contract — those entities had little ability to quantify those risks, let alone manage them.
Therefore, on the eve of what was arguably the biggest economic crisis since the Great Depression, which was caused in large part by the confluence of all the forces and trends that I have just described, the financial industry was larger, more concentrated, more complex, more leveraged and more interconnected than ever before. Once the sub-prime crisis hit, it spread like a contagion, causing a collapse in confidence throughout virtually the entire financial industry. And without clear walls between those institutions the government insures and those that are free to take on excessive leverage and risk, the American taxpayer was called upon to step forward into the breach.
The Crisis and the Response: Expanding the Safety Net
Unfortunately, the government’s response to the financial meltdown has only made the industry bigger, more concentrated and more complex. As the entire financial system was imploding following the bankruptcy filing by Lehman Brothers, the Treasury and the Federal Reserve hastily arranged mergers between commercial banks (which had a stable source of funding in insured deposits) and investment banks (whose business model depended on market confidence to roll over short-term debt).
Before the Lehman bankruptcy, Bear Stearns had been merged into J.P. Morgan. After the Lehman collapse, one of the biggest mergers to occur was between Bank of America and Merrill Lynch. And Ken Lewis, the CEO of Bank of America at the time, alleges that it was consummated only following pressure he received from Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke.
As merger plans for the remaining two investment banks, Goldman Sachs and Morgan Stanley, faltered, another plan was hatched. Both Goldman Sachs and Morgan Stanley – neither of which had anything even close to traditional banking franchises – were both given special dispensations from the Federal Reserve to become bank holding companies. This provided them with permanent borrowing privileges at the Federal Reserve’s discount window – without having to dispose of risky assets. In a sense, it was an official confirmation that they were covered by the government safety net because they were literally “too big to fail.”
Following the crisis, the U.S. mega banks left standing have even more dominant positions. Take the multi-trillion-dollar market for OTC derivatives. The five largest banks control 95 percent of that market. With such strong pricing power, these firms could afford to expand dramatically their margins. The Federal Reserve estimated that those five banks made $35 billion from trading in the first half of 2009 alone. Of course, they used these outsized profits from trading activities in derivatives and other securities not only to replenish their capital, but also to pay billions of dollars in bonuses.
The New Financial Order
Large and complex institutions like Citigroup dominate our financial industry and our economy. MIT professor Simon Johnson and James Kwak, a researcher at Yale Law School, estimate that the six largest U.S. banks now have total assets in excess of 63 percent of our overall GDP. Only 15 years ago, the six largest U.S. banks had assets equal to 17 percent of GDP. We haven’t seen such concentration of financial power since the days of Morgan, Rockefeller and Carnegie.
As I stated at the outset, I am extremely concerned that our reform efforts to date do little, if anything, to address this most serious of problems. By expanding the safety net — as we did in response to the last crisis — to cover ever larger and more complex institutions heavily engaged in speculative activities, I fear that we may be sowing the seeds for an even bigger crisis in only a few years or a decade.
Unfortunately, the current reform proposals focus more on reorganizing and consolidating our regulatory infrastructure, which does nothing to address the most basic issue in the banking industry: that we still have gigantic banks capable of causing the very financial shocks that they themselves cannot withstand.
The Need for Fundamental Reform
Rather than pass the buck to a reshuffled regulatory deck, which will still be forced to oversee banks that former FDIC Chairman Bill Isaac describes as “too big to manage, and too big to regulate,” we must draw hard statutory lines between banks and investment houses.
We must eliminate the problem of “too big to fail” by reinstituting the spirit of Glass-Steagall, a modern version that separates commercial from investment banking activities and imposes strict size and leverage limits on financial institutions.
We must also establish clear and enforceable rules of the road for our securities markets in the interest of making them less fragmented, opaque and prone to collapse. The over-the-counter derivatives market must be tightly regulated, as originally proposed by Brooksley Born – and rejected by Congress – in the late 1990s.
Finally, I believe the myriad conflicts of interest on Wall Street must be addressed through greater protection and empowerment of individual investors. Our anti-fraud provisions, as represented for example by Rule 10(b)5, under the 1934 Securities Act, need to be strengthened.
Eliminating “Too Big to Fail”
The Insufficiency of Resolution Authority
One key reform that has been proposed to address the “too big to fail” problem is resolution authority. The existing mechanism whereby the FDIC resolves failing depository institutions has, by and large, worked well. After the experiences of Bear Stearns and Lehman Brothers in 2008, it is clear that a similar process should be applied to entire bank holding companies and large nonbank institutions.
While no doubt necessary, this is no panacea. No matter how well Congress crafts a resolution mechanism, there can never be an orderly wind-down, particularly during periods of serious stress, of a $2-trillion institution like Citigroup that had hundreds of billions of off-balance-sheet assets, relies heavily on wholesale funding, and has more than a toehold in over 100 countries.
There is no cross-border resolution authority now, nor will there be for the foreseeable future. In the days and weeks following the collapse of Lehman Brothers, there was an intense and disruptive dispute between regulators in the U.S. and U.K. regarding how to handle customer claims and liabilities more generally. Yet experts in the private sector and governments agree – national interests make any viable international agreement on how financial failures are resolved difficult to achieve. A resolution authority based on U.S. law will do precisely nothing to address this issue.
While some believe market discipline would be reimposed by refining the bankruptcy process, Lehman Brothers demonstrates that the very concept of market discipline is illusory with institutions like investment banks, which used funds that they borrowed in the repo market to finance their own inventories of securities, as well as their own book of repurchase agreements, which they provided to hedge funds through their prime brokerage business.
Investment banks, the fulcrum of these institutional arrangements, found themselves in a classic squeeze. On one side, their hedge fund clients and counterparties withdrew funds and securities in their prime brokerage accounts, drew down credit lines and closed out derivative positions, all of which caused a massive cash drain on the bank. On the other side, the repo lenders, concerned about the value of their collateral as well as the effect of the cash drain on the banks’ credit worthiness, refused to roll over their loans without the posting of substantial additional collateral. These circumstances quickly prompted a vicious cycle of deleveraging that brought our financial system to the brink. With such large, complex and combustible institutions like these, there can be no orderly process of winding them down. The rush to the exits happens much too quickly.
That is why we need to directly address the size, the structure and the concentration of our financial system.
The Volcker Rule: A Good Beginning
The Volcker Rule, which would prohibit commercial banks from owning or sponsoring “hedge funds, private equity funds, and purely proprietary trading in securities, derivatives or commodity markets,” is a great start, and I applaud Chairman Volcker for proposing that purely speculative activities should be moved out of banks. That is why I joined yesterday with Senators Jeff Merkeley (D-OR) and Carl Levin (D-MI) to introduce a strong version of the Volcker Rule. But I think we must go further still. Massive institutions that combine traditional commercial banking and investment banking are rife with conflicts and are too large and complex to be effectively managed.
Glass-Steagall for the 21st Century
We can address these problems by reimposing the kind of protections we had under Glass-Steagall. To those who say "repealing Glass-Steagall did not cause the crisis, that it began at Bear Stearns, Lehman Brothers and AIG," I say that the large commercial banks were engaged in exactly the same behavior as Bear Stearns, Lehman and AIG – and would have collapsed had the federal government not stepped in and taken extraordinary measures. Moreover, in response to the last crisis, we increased the safety net that covers these behemoth institutions. The result: they will continue to grow unchecked, using insured deposits for speculative activities without running any real risk of failure on account of their size.
We need to reinstate Glass-Steagall – in an updated form – to prevent or at least severely moderate the next crisis.
By statutorily splitting apart massive financial institutions that house both banking and securities operations, we will both cut these firms down to more reasonable and manageable sizes and rightfully limit the safety net only to traditional banks. President of the Federal Reserve Bank of Dallas Richard Fisher recently stated: “I think the disagreeable but sound thing to do regarding institutions that are [‘too big to fail’] is to dismantle them over time into institutions that can be prudently managed and regulated across borders. And this should be done before the next financial crisis, because it surely cannot be done in the middle of a crisis.”
A growing number of people are calling for this change. They include former FDIC Chairman Bill Isaac, former Citigroup Chairman John Reed, famed investor George Soros, Nobel-Prize-winning-economist Joseph Stiglitz, President of the Federal Reserve Bank of Kansas City Thomas Hoenig, and Bank of England Governor Mervyn King, among others. A chastened Alan Greenspan also adds to that chorus, noting: “If they’re too big to fail, they’re too big. In 1911 we broke up Standard Oil -- so what happened? The individual parts became more valuable than the whole. Maybe that’s what we need to do.”
Size and Leverage Constraints: Cutting the Mega Banks and Shadow Banking System Down to Size
But even this extraordinary step of splitting these institutions apart is not sufficient. Cleaving investment banking from traditional commercial banking will still leave us with massive investment banks, some with balance sheets that exceed $1 trillion in assets.
For that reason, Glass-Steagall would need to be supplemented with strict size and leverage constraints. The size limit should focus on constraining the amount of non-deposit liabilities at large investment banks, which rely heavily on short-term financing like repos and commercial paper.
The growth of those funding markets in the run-up to the crisis was staggering. One report by researchers at the Bank of International Settlements estimated that the size of the overall repo market in the U.S., Euro region and the U.K. totaled approximately $11 trillion at the end of 2007. Incredibly, the size was more than $5 trillion more than the total value of domestic bank deposits at that time, which was less than $7 trillion.
The overreliance on such wholesale financing made the entire financial system vulnerable to a classic bank run, the type that we had before we instituted a system of deposit insurance and strong bank supervision. Remarkably, while there is a prudential cap on the amount of deposits a bank can have (even though deposits are already federally insured), there is no limit of any kind on liabilities like repos that need to be rolled over every day. With a sensible limit on these liabilities at each financial institution (for example, as a percentage of GDP), we can ensure that never again will the so-called shadow banking system eclipse the real banking system.
In addition, institutions that rely upon market confidence every day to finance their balance sheet and market prices to determine the worth of their assets should not be leveraged to stratospheric levels. To ensure that regulatory forbearance does not permit another Lehman Brothers, we should institute a simple statutory leverage requirement, that is, a limit on how much firms can borrow relative to how much their shareholders have on the line. As I have said in a previous speech, a statutory leverage requirement that is based upon banks’ core capital — i.e. their common stock plus retained earnings — could supplement regulators’ more highly-calibrated risk-based assessments, providing a sorely-needed gut check that ensures that regulators don’t miss the forest for the trees when assessing the capital adequacy of a financial institution.
This would push firms back towards the levels of effective capital they had in the “pre-bailout” days – like in the post World War II period when our financial system generally functioned well. To be sure, this would move our core banks from being predominantly debt financed to being substantially capitalized by equity. But other parts of our financial system already operate well on this basis – with venture capital being the most notable example. The return on equity relative to debt would need to rise to accommodate this change, but – as long as we preserve a credible monetary policy – this is consistent with low interest rates in real terms.
I would also stress that a leverage limit without breaking up the biggest banks will have little effect. Because of their implicit guarantee, “too big to fail” banks enjoy a major funding advantage – and leverage caps by themselves do not address that. Our biggest banks and financial institutions have to become significantly smaller if we are to make any progress at all.
Reforming Our Financial Markets
Turning now to derivatives reform, I have already noted how large dealer banks completely dominate the OTC marketplace for derivatives, an opaque market where these banks exert enormous pricing power. For over two decades, this market has existed with virtually no regulation whatsoever. Amazingly, it is a market where the dealers themselves actually set the rules for the amount of collateral and margin that needs to be posted by different counterparties on trades. Dealers never post collateral, while the rules they set for their counterparties are both lax and pro-cyclical, meaning that margin requirements tend to increase during periods of market turmoil when liquidity is at a premium. The complete lack of oversight of these markets has almost brought our financial system to its knees twice in ten years, first with the failure of LTCM in 1998, and then with the failure of Lehman Brothers in 2008. We have known about these problems for over a decade – yet we have so far done nothing to make this market better regulated.
That is why I applaud CFTC Chairman Gary Gensler’s efforts in pushing for centralized clearing and regulated electronic execution of standardized OTC derivatives contracts as well as more robust collateral and margin requirements. Clearinghouses have strong policies and procedures in place for managing both counterparty credit and operational risks. Chairman Gensler underscores that this would get directly at the problem of “too big to fail” by stating: “Central clearing would greatly reduce both the size of dealers as well as the interconnectedness between Wall Street banks, their customers and the economy.” Moreover, increased clearing and regulated electronic trading will make the market more transparent, which will ultimately give investors better pricing.
A strong clearing requirement, however, should not be swallowed by large exemptions that circumvent the rules. While I am sympathetic to concerns about increased costs raised by non-financial corporations that use interest rate and currency swaps for hedging purposes, any exemption of this sort should be narrowly crafted. For example, it might be limited to transactions where non-financial corporations use OTC derivatives in a way that qualifies for GAAP hedge accounting treatment. In any case, we should recognize more explicitly that when such derivatives contracts are provided by too big to fail banks, the end users are in effect splitting the hidden taxpayer subsidy with the big banks. And remember that this subsidy is not only hidden – it is also dangerous, because it is central to the incentives to become bigger and to take more risk once any financial firm is large.
Given that one of the key objectives behind increased clearing is to reduce counterparty credit risk, it also seems reasonable that derivatives legislation place meaningful constraints on the ownership of clearinghouses by large dealer banks.
Addressing Conflicts of Interest
Finally, we need to address the fundamental conflicts of interest on Wall Street. While separating commercial banking from investment banking is a critical step, there are still inherent conflicts within the modern investment banking model.
Better Addressing Securities Fraud
Let’s take the example of auction rate securities. Brokers at UBS and other firms marketed these products, which were issued by municipalities and not-for-profit entities, as “safe, liquid cash alternatives” to retail investors even though they were really long-term debt instruments whose interest rates would reset periodically based upon the results of Dutch auctions. In other words, these unsuspecting investors would be unable to sell their securities if new buyers didn’t enter the market, which is exactly what happened. As credit concerns by insurers who guaranteed these securities drained liquidity from the market, bankers continued to sell these securities to retail clients as safe, liquid investments. There was a blatant conflict of interest where the banks served as broker to their retail customers while also underwriting the securities and conducting the auctions.
There is an open issue of why such transactions did not constitute securities fraud, for example under Rule 10(b)5 – which prohibits the nondisclosure of material information. Civil actions are still in progress and perhaps we will learn more from the outcomes of particular cases. But no matter how these specific cases are resolved, we should move to strengthen the legal framework that enables both private parties and the SEC (both civil and criminal sides) to bring successful enforcement actions.
Individuals at Enron, Merrill Lynch, and Arthur Anderson were called to account for their participation in fraudulent activities – and at least one executive from Merrill went to prison for signing off on a deal that would help manipulate Enron’s earnings. But it is quite possible that no one will be held to account, either in terms of criminal or civil penalties, due to the deception and misrepresentation manifest in our most recent credit cycle. We must work hard to remove all the loopholes that helped create this unfair and unreasonable set of outcomes.
Strengthening Investor Protection
We can begin by strengthening investor protection. Currently, brokers are not subject to a fiduciary standard as financial advisors are, but only subject to a “suitability” requirement when selling securities products to investors. Hence, brokers don’t have to be guided by their customers’ best interest when recommending investment product offerings – they might instead be focused on increasing their compensation by pushing proprietary financial products. By harmonizing the standards that brokers and financial advisors face and by better disclosing broker compensation, retail investors will be able to make better, more informed investment decisions. Even Lloyd Blankfein, the CEO of Goldman Sachs, has stated that he “support[s] the extension of a fiduciary standard to broker/dealer registered representatives who provide advice to retail investors. The fiduciary standard puts the interests of the client first. The advice-giving functions of brokers who work with investors have become similar to that of investment advisers.”
It has also become known that some firms underwrite securities – promoting them to investors – and then short these same securities within a week and without disclosing this fact, which any reasonable investor would regard as adverse material information. In the structured finance arena, investment banks sold pieces of collateralized debt obligations — which were packages of different asset-backed securities divided into different risk classes — to their clients and then took proceeded to take short positions in those securities by purchasing credit default swaps. Some banks went further by shorting mortgage indexes tied to securities they were selling to clients and by shorting their counterparties in the CDS market. This is how a firm like Goldman Sachs could claim that they were effectively hedged to an AIG collapse.
Unfortunately, the use of products like CDS in this way allows the banks to become empty creditors who stand to make more money if people and companies default on their debts than if they actually paid them. These and other problematic practices that place financial firms’ interests against those of their clients need to be restricted. They also completely violate the spirit of our seminal legislation from the 1930s, which insisted – for the first time – that the sellers and underwriters of securities disclose all material information. This is nothing less than a return to the unregulated days of the 1920s; to be sure, those days were heady and exciting, but only for a while – such practices always end in a major crash, with the losses disproportionately incurred by small and unsuspecting investors.
Investors should also have greater recourse through our judicial system. For example, auditors, accountants, bankers and other professionals that are complicit in corporate fraud should be held accountable. That is why I worked on a bill with Senators Specter and Reed to allow for private civil actions against individuals who knowingly or recklessly aid or abet a violation of securities laws.
Conclusion: Hard Lines, Not Regulator Discretion
Admittedly, this is not an exhaustive list of financial reforms. I also believe we need to reconstitute our system of consumer financial protection, which was a major failure before our last crisis. We must have an independent Consumer Financial Protection Agency (CFPA) that has strong and autonomous rulemaking authority and the ability to enforce those rules at nonbanking entities like payday lenders and mortgage finance companies. Most importantly, the head of this agency must not be subject to the authority of any regulator responsible for the “safety and soundness” of the financial institutions. The CFPA must look out for the interests of consumers and for consumers alone.
Unfortunately, like the public option in healthcare, the CFPA issue has become something of a “shiny object” – though certainly an important one – that has distracted the focus of debate away from the core issues of “too big to fail.”
Beginning with the solutions for “too big to fail,” each of these challenges represents a crucial step along the way towards fixing a regulatory system that has permitted both large and small failures. Each is an important piece to the puzzle.
I know there are those who will disagree with some, and perhaps all of these proposals. They sincerely advocate a path of incrementalism, of achieving small reforms over time. They say that problems as complex as these need to be solved by the regulators, not by Congress. After all, they are the ones with the expertise.
I respectfully disagree.
Giving more authority to the regulators is not a complete solution. While I support having a systemic risk council and a consolidated bank regulator, these are necessary but not sufficient reforms – the President’s Working Group on Financial Markets has actually played a role in the past similar to that of the proposed council, but to no discernible effect. I do not see how these proposals alone will address the key issue of “too big to fail.”
In the brief history I outlined earlier, the regulators sat idly by as our financial institutions bulked up on short-term debt to finance large inventories of collateralized debt obligations backed by subprime loans and leveraged loans that financed speculative buyouts in the corporate sector.
They could have sounded the alarm bells and restricted this behavior, but they did not. They could have raised capital requirements, but instead farmed out this function to credit rating agencies and the banks themselves. They could have imposed consumer-related protections sooner and to a greater degree, but they did not. The sad reality is that regulators had substantial powers, but chose to abdicate their responsibilities.
What is more, regulators are almost completely dependent on the information, analysis and evidence as presented to them by those with whom they are charged with regulating. Last year, former Federal Reserve Chairman Alan Greenspan, once the paragon of laissez faire capitalism, stated that “it is clear that the levels of complexity to which market practitioners, at the height of their euphoria, carried risk management techniques and risk-product design were too much for even the most sophisticated market players to handle properly and prudently.” I submit that if these institutions that employ such techniques are too complex to manage, then they are surely too complex to regulate.
That is why I believe that reorganizing the regulators and giving them additional powers and responsibilities isn’t the answer. We cannot simply hope that chastened regulators or newly appointed ones will do a better job in the future, even if they try their hardest. Putting our hopes in a resolution authority is an illusion. It is like the harbor master in Southampton adding more lifeboats to the Titanic, rather than urging the ship to steer clear of the icebergs. We need to break up these institutions before they fail, not stand by with a plan waiting to catch them when they do fail.
Without drawing hard lines that reduce size and complexity, large financial institutions will continue to speculate confidently, knowing that they will eventually be funded by the taxpayer if necessary. As long as we have “too big to fail” institutions, we will continue to go through what Professor Johnson and Peter Boone of the London School of Economics have termed “doomsday” cycles of booms, busts and bailouts, a so-called “doom loop” as Andrew Haldane, who is responsible for financial stability at the Bank of England, describes it.
The notion that the most recent crisis was a “once in a century” event is a fiction. Former Treasury Secretary Paulson, National Economic Council Chairman Larry Summers, and J.P. Morgan CEO Jamie Dimon all concede that financial crises occur every five years or so.
Without clear and enforceable rules that address the unintended consequences of unchecked financial innovation and which adequately protect investors, our markets will remain subverted.
These solutions are among the cornerstones of fundamental and structural financial reform. With them we can build a regulatory system that will endure for generations instead of one that will be laid bare by an even bigger crisis in perhaps just a few years or a decade’s time. We built a lasting regulatory edifice in the midst of the Great Depression, and it lasted for nearly half a century. I only hope we have both the fortitude and the foresight to do so again.
On The Brink: Inside the Race to Stop the Collapse of the Global Finance System by Henry Paulson Jr.
SIMON JOHNSON on HENRY PAULSON'S MISLEADING, SELF-JUSTIFYING MEMOIR
Hank Paulson sounds tough. His gravelly delivery starts out strong. The voice is that of a seasoned and fair-minded cop sorting out the ruffians, and the hard-boiled dialogue is straight from Raymond Chandler. Speaking of his plans to act immediately against some specific financial sector CEOs and their boards of directors, he says “Mr. President, ... we’re going to move quickly and take them by surprise. The first sound they’ll hear is their heads hitting the floor.”
As I say, a great opening. This is exactly what we need—a top-tier Wall Street dealmaker and experienced executive who knows how to bring major-league pressure to good banks gone bad, and who uses that knowledge to depose miscreants while safeguarding the public purse. We might have opened his book worrying about the fact that its author, the man who was charged with confronting Wall Street about the damage it caused to the economy and the country, used to run Goldman Sachs, but immediately he sounds like a big-time poacher turned gamekeeper. We can all sleep that little bit easier.
Or can we? This is only three lines into the book and something already sounds wrong. Haven’t we heard far too much lately about Wall Street attitudes and behavior to take Paulson’s statements so readily at face value? One sentence later and all is clear: Paulson is talking about his takeover of Fannie Mae and Freddie Mac, an important episode for people working at those Government Sponsored Enterprises, but largely a sideshow to the main business of 2008, which was the complete collapse and the unconditional bailout of the purely private firms—and the people who run them—that dominate Wall Street. Or, rather, the way in which the most “pro-market” people in our economy all became Government Sponsored and made out like bandits along the way.
Paulson sounds tough throughout the book and he has many growling moments that add to the theater. But on the substance that matters—when it came to his friends, associates, and even long-term Street rivals—he was weak. He had a soft and gentle touch. In his mind, no one was really to blame, and (almost) everyone could and would be saved, and at no cost to them—and never mind what that meant to taxpayers and ordinary citizens.
On the Brink is Paulson’s story, or at least a heavily vetted spin on his story. (He keeps no notes and never uses email—this is a smart guy.) The book focuses primarily on the period from September 2008 through the end of the Bush administration. Its author comes across in its pages as honest, overtaken by events, and swamped by odds beyond his control. But in reality he is a prime constructor of modern Wall Street, a man who worked long and hard—alongside his competitors—to bring you the risk-taking and crazy gambling of the 2000s.
That Paulson was also in charge when the Street crashed has its potential ironies, of course. And there is still a chance to save his reputation—that is what this book is all about–with a sophisticated web of misdirection. He seeks to make three closely connected points. If you buy them all, then Hank Paulson is a hero of mythic proportions. If you question even one, the whole house of cards around his reputation—and our current financial sector—starts to tremble like an investment bank facing its creditors.
And if we seriously dispute his interpretation on all three dimensions, then we are looking at something quite different. Far from being a hero (his view), or an unfortunate victim of events beyond his control (the mainstream consensus view), or even a man who was compromised by his deep Wall Street background but tried hard to use this knowledge to turn things around (a position favored by some Democrats), Paulson is something else entirely. He is an integral, if somewhat un-self-aware, component in the mechanism that not only shook down the American taxpayer in 2008-2009, but also set us up for repeated crashes—perhaps with even worse consequences—in the future.
Here are the issues. First, Paulson portrays himself as the thoughtful Wall Street insider who knew—somehow—that a crisis was coming. As he told President Bush, “If you look at recent history, there is a disturbance in the capital markets every four to eight years.” And he confides in the reader, “I was convinced we were due for another disruption.” This is a sensible insight and, if true, would qualify as prescient—although it’s too bad that Paulson turns out to be a procrastinator.
But before we get there—what exactly did Paulson know and when did he know it? This memoir is thin regarding his time at Goldman Sachs. We learn that he pushed out Jon Corzine, and that he built up the firm and internationalized it, but not much else. He talks about the development of financial instruments in and around the housing market in a very detached way, as if he were only an observer. There is no first-person involvement, no sense of the risks being taken and the rewards harvested. Paulson’s line is that he knew enough to be helpful but not enough to have engaged in any fraudulent transactions. Alternatively, he had no idea what was coming. He was just as much in the dark as everyone else running big Wall Street firms. The crisis that hit us was based just as much on his ignorance as it was on yours.
There is also no mention of his own mega-payday. When Paulson joined the Bush administration in July 2006, he was exempted from paying capital-gains tax on the sale of his half-billion dollar holdings of Goldman stock, which presumably saved him (and cost the taxpayer), at least $100 million. Paulson has to be very careful here, of course, because our securities law is tough on anyone who withholds material information when selling securities. So his notions about a future crisis have to be expressed in vague language. If he is more precise, people will start going through his various statements as CEO about the likely future of Goldman or the overall market.
But even at this level, he has a big p.r. problem. There is no mention anywhere in his book of how the crisis was built on the backs of consumers—abused and trampled upon by a banking sector that brags about “ripping the faces off” its customers. And Paulson does not discuss the need for consumer protection vis-à-vis financial products. It’s almost as if he is on a different planet.
Second, Paulson wants to convince you that, once he became secretary of the treasury, he worked hard to head off the growing crisis and prepared for it as much as possible. This is exceedingly hard to believe. All of his policy initiatives were small and late (his programs for homeowners are the best example). Slight pressure was put on lenders and their agents to restructure troubled mortgages—but there was no serious arm-twisting and no real incentive to make progress. If you ask sharp-elbowed financial sector representatives to be nice, it turns out they just ignore you.
Paulson is from the deal-making side of investment banking. He deals with China by meeting lots of top policymakers, but there is no evidence this makes much difference, say, to China’s massively undervalued exchange rate. And there is also no evidence that Hank Paulson ever noticed. He likes to meet important people. His “best” ideas for financial policy and heading off a crisis are always about getting one firm to merge with another, and worrying about the “social issues” that ensue. Those issues are not really about society, of course; they are about who will rule in any merged board room. Still, house prices decline, financial firms enter into distress, and Paulson (and Geithner) fret mainly about whether Goldman can buy another firm or reasonably be bought up.
The prose is flat, the chronology well known—almost cliché by now—but weirdly enough all this is fascinating and somewhat disturbing reading, because you know where it ends. The shakedown, when it comes, is so beautiful that it takes your breath away—rather like watching Nueve Reinas (Nine Queens), the brilliant Argentine financial scam movie.
Here's the set up. The core of the world's financial system teeters. Paulson doesn't want to do another bailout, he thinks. The politics stink, the economics are appalling, and Dick Fuld (the CEO of Lehman) is a difficult fellow. So Paulson lets Lehman fail. But it turns out that the bankruptcy of a major financial firm is an unspeakably messy affair. Paulson had been warned about this, including by the International Monetary Fund (not an ordinary event)—but he was oblivious. We can handle it ourselves, thank you, was Treasury’s attitude.
But they couldn’t. They were absolutely and completely unprepared. This was not a team that was expecting the unexpected; they were asleep at the wheel. Paulson thinks he hired the best people—mostly from Goldman, naturally—and honed them into a sharp-edged tool. The alternative view is that he and his people were incompetent bumblers who had no idea what they were doing or how dangerous modern financial markets have become. So here are the possible interpretations: either the former head of Goldman Sachs saw it all coming and prepared assiduously, or an old-fashioned deals guy—most definitely not a trader—was hopelessly out of his depth and floundered his way to the greatest financial crisis since 1929.
Finally, Paulson really needs you to believe that once the crisis broke, he did what was necessary to save the world’s financial system. As Mrs. Thatcher liked to say, “there is no alternative.” This part of the story has been told much better by Andrew Ross Sorkin in Too Big To Fail. But the great conceit in Paulson’s book is still fascinating. He wants to convince you that the only way to save the American financial system and—by implication—the world’s economy was by keeping Wall Street essentially intact. To be sure, he says that “the Wall Street I knew had come to an end.” But what he means is that the remaining investment banks—including Goldman Sachs—became bank holding companies and therefore, for the first time in history, acquired effective government backing.
So leading financial institutions were saved, which is not by itself an unusual event in some countries. It happens with some regularity in places with serious governance issues and endemic corruption. But even in troubled middle-income countries, such as South Korea, Turkey, Argentina, or even Russia, it is extraordinary to keep management in place when providing such support. Perhaps a few financial executives might be deemed beyond reproach and unfortunate victims of a system-wide panic. But to keep them all, with their base pay and their bonuses and their pensions? That is essentially unheard of. Perhaps there is a poor and benighted country somewhere that saved its massively incompetent financial firms in this manner, but you can search the historical records long and hard for a parallel to what Paulson pulled off.
The fallacy here is complete. Since the entire system failed—in terms of the largest banks and quasi-banks—Paulson and his supporters, including his successor at Treasury, argued that we must treat everyone generously in order to have an economic recovery. But the United States always presses for a much harder approach toward failed bankers in other countries. And with good reason: when the whole system crashes due to reckless risk-taking, you should aim to re-boot with a different incentive structure and, immediately, with much more effective regulation.
It is not hard to save a financial system: you can just throw money at the problem, providing various kinds of unconditional guarantees. This is in effect what Paulson and his colleagues did. Banks will, of course, recover on that basis. If you put the balance sheet of the United States behind any group of firms, investors will stand up and salute. But the point is to save the financial system while not worsening the underlying problems. If “hubris” and “too big to fail” attitudes lurked before 2008, where are they now?
Paulson has the answer, and on this final point he has a moment of clarity, “The largest financial institutions [today] are so big and complex that they pose a dangerously large risk.” Exactly right. So On the Brink turns out to be an interesting and important book, but not at all for the reasons its author thinks. It is really a memoir of modern American power, an account of how we messed up and how our so-called leaders put it all back together—with the same underlying problems now made worse.
Simon Johnson is co-author of 13 Bankers, forthcoming March 30