13 Bankers: The Wall Street Takeover and the Next Financial Meltdown (24 page)

A major test of Wall Street’s power was regulation of derivatives. Because they did not directly involve either deposits or traditional securities, and because they defied conventional treatment on an accounting balance sheet, customized derivatives posed a new challenge to the existing regulatory framework. The first threat to this new profit center arose in 1994 because of the major derivatives losses suffered by Orange County, Procter & Gamble, and Gibson Greetings, among others.

In response, Congress took up the issue of derivatives regulation. The House Banking and Financial Services Committee conducted a major investigation, and several bills to regulate derivatives were proposed. The industry countered with a major lobbying effort coordinated by the International Swaps and Derivatives Association (ISDA), which was received sympathetically by Alan Greenspan and by the Wall Street–friendly Clinton administration. Treasury Undersecretary Frank Newman urged Congress not to regulate derivatives;
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Treasury Secretary Lloyd Bentsen also backed the industry, saying, “Derivatives are perfectly legitimate tools to manage risk. Derivatives are not a dirty word. We need to be careful about interfering in markets in too heavy-handed a way.”
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The Group of Thirty, an international advocacy group largely composed of private sector bank executives, central bankers, and sympathetic academics, chimed in with a study concluding that no new regulation was required and that the industry could be trusted to regulate itself.
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The study was overseen by Dennis Weatherstone, then chair of J.P. Morgan.
The New York Times
reported at the time, “Many of those people conducting the study work at businesses that have a stake in assuring the market’s continued prosperity. They were trying to head off calls for greater regulation and supervision by addressing these concerns.”
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And they were entirely successful. By the end of 1994, the lobbying effort had killed off all congressional efforts at regulation. Some customers who had been burned by derivatives were able to win settlements from their derivatives brokers, but these isolated cases did little to stem the growth of the industry.
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This was only one of several high-profile battles over regulation in the last two decades (but perhaps the only one that Wall Street had any chance of losing). Another struggle was precipitated by Brooksley Born’s campaign as chair of the Commodity Futures Trading Commission (CFTC) to
think about
regulating over-the-counter derivatives. Born was concerned that the buildup of large derivatives positions invisible to regulatory oversight could create risks for the financial system as a whole.
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She was opposed not only by Greenspan, Rubin, and Summers, but also by Securities and Exchange Commission chair Arthur Levitt and House Banking Committee chair Jim Leach. On May 7, 1998, the same day that Born’s “concept release” was published, Rubin, Greenspan, and Levitt went public with their “grave concerns … about reports that the CFTC’s action may increase the legal uncertainty concerning certain types of OTC derivatives.”
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In June, they proposed draft legislation imposing a moratorium on regulatory action by Born’s agency.

In July 1998, before the House Banking Committee, representatives from Treasury, the SEC, and the major banking regulators lined up with Greenspan and executives from several major banks to oppose Born and testify that derivatives markets were functioning effectively without additional regulation. Greenspan said, “professional counterparties to privately negotiated contracts also have demonstrated their ability to protect themselves from losses, from fraud, and counterparty insolvencies”; he concluded, “aside from safety and soundness regulation of derivative dealers under the banking or securities laws, regulation of derivatives transactions that are privately negotiated by professionals is unnecessary. Regulation that serves no useful purpose hinders the efficiency of markets to enlarge standards of living.”
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In October, the moratorium was approved. The next year, Born decided not to seek reappointment.

From the perspective of the derivatives industry, however, winning the battle was not enough. Not satisfied that derivatives were unregulated, the industry used its influence to ensure that derivatives would never be regulated. In November 1999, the President’s Working Group on Financial Markets produced a report, “Over-the-Counter Derivatives Markets and the Commodity Exchange Act,” signed by Summers (then treasury secretary), Greenspan, Levitt, and new CFTC chair William Rainer. That report concluded that, in order “to promote innovation, competition, efficiency, and transparency in OTC derivatives markets, to reduce systemic risk, and to allow the United States to maintain leadership in these rapidly developing markets,” those derivatives should be exempted from federal regulation.
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The financial sector’s supporters in Congress complied by passing the Commodity Futures Modernization Act (CFMA), introduced in May 2000 but held up in the Senate due to Senator Phil Gramm’s desire for even stricter deregulatory language.
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Ultimately, Gramm succeeded in foreclosing any possibility of regulation by the CFTC or the SEC; in the middle of December, the bill was inserted into the Consolidated Appropriations Act for Fiscal Year 2001, passed by a lame-duck Congress, and signed by a lame-duck president. The financial sector had succeeded in sealing off one of its profit-making engines from the possibility of government interference.

Another key goal of the Wall Street banks was to maximize their leverage, and structured finance was a key to their strategy. Leverage is an easy way to increase profits. If you invest $10 of your money at a 10 percent return, you will gain $1 in profits; but if you invest $10 of your money and $90 of borrowed money at a 10 percent return, your profits will be $10. Conversely, however, leverage increases the chances that you will be wiped out; a 10 percent loss on $10 of your own money is only $1, but a 10 percent loss on $10 of your money and $90 of borrowed money leaves you with nothing.

This is why regulators place limits on the amount of leverage a bank can take on, in the form of minimum capital requirements. Capital is the amount of money put up by the bank’s owners (shareholders), and acts as a safety cushion in times of stress; the more capital, the more money the bank can lose before it becomes unable to return money to its depositors and repay its debts. Capital requirements are set as a percentage of the bank’s assets. For every $100 in assets, a bank might have to hold $10 in capital, which means it can borrow only up to $90; this is the same as saying its leverage cannot be more than nine to one. Therefore, to maximize profits per dollar invested (capital), banks want to maximize their leverage; put another way, for the same assets, they want to hold as little capital as possible.

One motivation for securitization was to exploit a loophole in existing regulatory capital requirements. The amount of capital a bank had to hold depended on the type of assets it held; in theory, the riskier the asset, the more capital was required. The loophole was that these requirements were set somewhat arbitrarily—4 percent for home mortgages, 8 percent for unsecured commercial loans, and so on. As a result, a bank could take $100 of assets that required, say, $8 in capital; put them into a securitization pool; and, through the magic of structured finance, convert them into $100 of new securities that were treated differently by capital regulations and therefore required only $5 in capital. The true risk of the assets hadn’t changed, since the probability of default hadn’t changed. But because financial engineers could create securities with just the right characteristics needed to get just the right credit ratings, they could control the amount of capital that was required. So a bank could use securitization to
keep
the economic risk of its loans while reducing its capital requirements (so it could go and make more loans).

In addition to securitization, credit default swaps could be used to reduce capital requirements and increase leverage. The same J.P. Morgan team that pioneered the synthetic CDO also first lobbied federal regulators for permission to use credit default swaps to reduce their capital requirements. In 1996, the Federal Reserve Board of Governors obliged.
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With both securitization and credit default swaps in their arsenal, Wall Street’s financial engineers could concoct increasingly elaborate mechanisms for repackaging risk in ways that reduced its regulatory footprint.

Federal regulators were well aware of these practices. In 2000, for example, Federal Reserve economist David Jones published a paper with detailed examples of how banks could engage in regulatory capital arbitrage (RCA). “[R]egulatory capital standards seem destined to become increasingly distorted by financial innovation and improved methods of RCA,” he wrote, “at least for those large, sophisticated banks having the resources to exploit such opportunities.” Jones argued that this could actually be a good thing: “Against the backdrop of regulatory capital requirements that are often quite arbitrary, in some circumstances RCA actually may improve a bank’s financial condition and the overall efficiency of the financial system. Indeed, RCA is widely perceived as a ‘safety valve’ for mitigating the adverse effects of regulatory capital requirements.”
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Instead of attempting to crack down on banks’ attempts to get around minimal capital requirements, federal regulators went in the other direction and loosened those requirements. In 2001, the federal bank regulators issued a new rule standardizing the capital requirements for securitizations.
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If the bank creating the securitization retained some of the risk of the assets involved (which it often did in order to attract investors), the new rule calculated the bank’s capital requirements based on ratings set by credit rating agencies (or, in some cases, the banks’ own internal models). The goal of this rule was to align capital requirements with the degree of economic risk taken on by the bank, which was supposedly measured by the rating agencies. Instead, however, it meant that banks could get away with anything, so long as they could convince a rating agency to approve it.
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Not surprisingly, “shopping for ratings” became a standard part of securitizations. Banks would tweak their models until they got the ratings that they needed in order to sell some of the tranches to investors and keep some tranches for themselves. Rating agencies—who were being paid by the banks to rate these securities—complied, granting AAA ratings to thousands of securities at a time when only a handful of companies enjoyed AAA ratings for their bonds.
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According to Jim Finkel of Dynamic Credit, which created structured products, “Wall Street said, ‘Hey, if you don’t [give me the rating I want], the guy across the street will. And we’ll get them all the business.’ And they just played the rating agencies off one another.” One investment banker who worked on these securitizations said, “It makes me feel really bad actually, it’s very hard for me to acknowledge.… I knew I was doing things to get around the rules. I wasn’t proud of it but I did it anyway.”
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The rating agencies were hardly passive victims. A McClatchy investigation found that even as the housing market was starting to crumble, Moody’s was forcing out executives who questioned the agency’s high ratings of structured products and filling its compliance department with people who had specialized in giving those ratings.
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By making capital requirements dependent on credit ratings, the regulators put this critical aspect of oversight in the hands of a small number of rating agencies that themselves depended on the banks for their revenues. With limited competition and little ability for investors to understand the rating process, the agencies had little incentive to give accurate ratings; by contrast, they had a lot of incentive to keep their key clients—the investment banks—happy. In 2004 and 2005, some rating agencies modified their rating models in ways that made it easier to give higher ratings to CDOs, helping extend the structured finance boom. But when the bubble finally burst, they ended up downgrading over 75 percent of asset-backed CDOs that had gotten AAA ratings in 2006 and 2007.
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Regulators went even further and outsourced control over minimum capital requirements to the banks they were regulating. On April 28, 2004, the Securities and Exchange Commission agreed to a request by the five large investment banks—Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Stearns—to use their own internal models, based on historical data, to calculate the “net capital” in their broker-dealer operations. The rule was explicitly intended to reduce the regulatory burden on the major investment banks by increasing their net capital, thereby enabling them to expand their business:

These amendments are intended to reduce regulatory costs for broker-dealers by allowing very highly capitalized firms that have developed robust internal risk management practices to use those risk management practices, such as mathematical risk measurement models, for regulatory purposes. A broker-dealer’s deductions for market and credit risk probably will be lower under the alternative method of computing net capital than under the standard net capital rule.
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