13 Bankers: The Wall Street Takeover and the Next Financial Meltdown (39 page)

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Raising equity capital makes a bank safer, since it increases the cushion of losses it can absorb before going bankrupt. However, bank shareholders do not like raising additional capital, since that reduces leverage and profits. Contingent capital is debt, so it increases leverage, but in the event of a crisis, the holders of the contingent capital can be forced to exchange it for equity capital—increasing the bank’s safety cushion when it needs it most, while diluting existing shareholders’ claim on profits.

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A capital ratio is a bank’s capital divided by its assets. Tier 1 capital is one common regulatory definition of capital. Eleven percent was considered a healthy amount of Tier 1 capital prior to the crisis.

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The most commonly discussed alternative basis for a size cap is a fraction of total financial assets in the economy. However, this number can rise dramatically in a bubble. In addition, as financial development progresses, financial assets tend to rise relative to GDP and relative to the government’s budget, which ultimately bears the brunt of any bailout.

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Risk-based size limits would require an approach similar to risk-weighting of assets. This is already a common feature of existing capital regulations, which prescribe different amounts of capital based on the riskiness of different types of assets. We propose using a similar approach to calculate the maximum allowable size for a given bank, based on its risk profile.

EPILOGUE
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The success of this landmark reform effort will ultimately depend on the individuals who become the regulators. The key lesson of the last decade is that financial regulators must use their powers, rather than coddle industry interests.

—Congressman Paul Kanjorski, June 30, 2010
¹

On July 21, 2010, President Barack Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act—Washington’s answer to the financial crisis.
²
Standing in the Ronald Reagan Building, President Obama said,

These reforms represent the strongest consumer financial protections in history.… Reform will also rein in the abuse and excess that nearly brought down our financial system. It will finally bring transparency to the kinds of complex and risky transactions that helped trigger the financial crisis. Shareholders will also have a greater say on the pay of CEOs and other executives, so they can reward success instead of failure. And finally, because of this law, the American people will never again be asked to foot the bill for Wall Street’s mistakes.
³

The Dodd-Frank Act was the culmination of the bitter, yearlong political battle that we described in
chapter 7
, ultimately passing in the Senate by the thinnest of possible margins. As the bill moved through the Senate in the spring, the lobbying campaign by the financial sector only intensified as the big banks dropped any pretense of supporting reform and chose all-out war instead, hiring fifty-four lobbying firms to do their bidding.
⁴
In private, Wall Street executives called President Obama—whose Treasury Department had pushed for a moderate reform package to begin with—“hostile to business,” “antiwealth,” “anticapitalism,” a “redistributionist,” a “vilifier,” and a “thug.”
⁵
On the record, even Jamie Dimon, who only a year before had been the toast of both Wall Street and Washington, was reduced to complaining that banks needed
more
influence on politicians so they could give them the “right facts.”
⁶
And a JPMorgan Chase managing director lashed out at Congress for “an unnerving ignorance of fundamental principles of market economics” and said it was “time for the grown-ups to step in.”
⁷

But a curious thing happened. Instead of getting weaker in the face of a full-court lobbying press, the financial reform bill actually got modestly
stronger
during the Senate debate, carried along by a cresting wave of anger and frustration aimed at the big banks that were reporting resurgent profits and compensation even as the country as a whole remained mired in high unemployment and a fitful economic recovery. That wave was fueled by the release in March of the report by the examiner in the Lehman bankruptcy documenting how the bank had used highly questionable accounting techniques to massage its financial statements in the months prior to its collapse.
⁸
But it became impossible to ignore the following month, when the Securities and Exchange Commission filed a civil suit against Goldman Sachs, the informal godfather of the markets, for misleading investors in a complicated subprime-backed synthetic CDO that the bank had concocted just as the subprime market was beginning to collapse.
⁹
The CDO in question had been designed with considerable input by John Paulson, a hedge fund manager who intended to bet
against
the CDO; the SEC alleged, in short, that Goldman had misled investors in the CDO by failing to disclose Paulson’s role. (When the subprime market collapsed, Paulson’s fund cleared a $1 billion profit on the deal.) The central character in the SEC’s suit was Goldman vice president Fabrice Tourre, who had the misfortune to write in a January 2007 e-mail, “The whole building is about to collapse anytime now.… Only potential survivor, the fabulous Fab[rice Tourre] … standing in the middle of all these complex, highly leveraged, exotic trades he created without necessarily understanding all of the implications of those monstruosities [
sic
]!!!”
¹⁰

The SEC-Goldman lawsuit followed closely on the heels of an investigative report by
ProPublica
into Magnetar, a hedge fund that made phenomenal profits by betting that the subprime mortgage market was on the verge of collapse.
¹¹
The
ProPublica
report went national as the main story on the radio show
This American Life.
¹²
Both the Magnetar story and the Goldman-Paulson story seemed to encapsulate everything that was wrong with the financial system. On the one hand, hedge funds were pushing investment banks to create highly toxic CDOs precisely so they could bet against them, thereby actually increasing the flow of capital into subprime lending and increasing the eventual costs of collapse. On the other hand, the investment banks were so eager for the up-front fees available that not only did they allegedly mislead their clients, but they sometimes held on to the toxic waste they should have known they were creating; in one transaction, JPMorgan Chase earned a fee of $20 million but ended up losing $880 million when the CDO collapsed.
¹³
The problem wasn’t just that fund managers and bankers wanted to make a lot of money; the problem was that the banks’ own internal incentive structures and risk management “systems” had allowed short-term profits to become completely unmoored from any kind of long-term economic value.

As disgust with Wall Street mounted, senators responded with amendments that were more far-reaching than anything put forward by the Treasury Department or passed by the House of Representatives, including proposals to prohibit banks from engaging in proprietary trading, to force them to spin off their derivatives trading operations, and even to break up the largest banks.
¹⁴
This placed the Obama administration and the Treasury Department in particular in the slightly awkward position of having to work, largely behind the scenes, to defeat or water down measures they feared would be too restrictive or onerous for the big banks.
¹⁵
Ultimately, however, this turned out to be ideal for the administration. The mounting pressure from reformers helped counterbalance the lobbying efforts of the banking industry, allowing the administration to claim the prized middle ground in the debate and ensuring that the final bill turned out roughly the way it wanted.

In the end, the Dodd-Frank Act was both a significant step forward and a missed opportunity. One of the bill’s most important achievements was the creation of a new, nearly independent Consumer Financial Protection Bureau (CFPB), largely similar to the agency that Elizabeth Warren had envisioned in 2007 and that we argued for in
chapter 7
. Any regulatory agency is only as effective as the people who staff it, and there is always the possibility that a future, pro-finance president will appoint a head of the CFPB who is opposed to consumer protection. But the creation of a new agency dedicated solely to consumer protection, with broad authority to prohibit abusive practices by all financial institutions, is an undoubted benefit for the ordinary people whom existing bank regulators had largely ignored over the previous decades. Abusive practices such as prepayment penalties (locking borrowers into expensive mortgages) and yield-spread premiums (providing incentives for steering borrowers into expensive mortgages) could become a thing of the past.

In many other areas, the bill is promising, although its ultimate impact is hard to gauge. The derivatives that Brooksley Born wanted to regulate in 1998—and that were sheltered by the Commodity Futures Modernization Act of 2000—have been brought under the regulatory umbrella. Most derivatives must be centrally cleared and traded either on exchanges or swap execution facilities—steps that should increase both competition and transparency, reducing prices for market participants and risk to the financial system. Derivatives dealers will face new capital requirements and will have new duties to treat their customers fairly, particularly if those customers are municipalities or pension funds. Existing regulatory agencies and the newly formed Financial Stability Oversight Council have new powers to monitor and take action against systemic risks, for example by subjecting important nonbank financial institutions to regulatory oversight. Resolution authority—a new system for taking over and liquidating failing financial institutions (briefly discussed in
chapter 7
)—should make it impossible to repeat some of the more egregious bailouts of the recent financial crisis. These are all important steps, and there are many others as well.

However, whether these new laws live up to their potential depends heavily on the same regulatory agencies that performed so poorly over the past decades. The Dodd-Frank Act, like most complex legislation, leaves a dizzying number of details to regulatory discretion. Simply putting these new laws into effect requires regulators to write hundreds of new rules, many of which offer opportunities for the financial sector to weaken or pervert the intent of Congress. (The law firm Davis Polk counted 243 new rules and 67 new studies required by the bill.)
¹⁶
For example, the new requirements for trading and clearing derivatives include an exemption for “commercial end users” (nonfinancial entities) that use derivatives for hedging purposes. How big that loophole turns out to be depends largely on the wording of the rule defining exempt transactions, an issue on which Wall Street is sure to have its say; ultimately, it could depend on how the courts rule on the eventual appeals by the banks or their clients. Another rule is necessary to define what qualifies as an evasive tactic to avoid regulation. Each of these rules will be the subject of a fight that will be repeated dozens of times as the details of financial reform are hammered out.

Wall Street is gearing up for battle; or, rather, Wall Street never stopped fighting. Lobbying organizations and law firms representing the financial sector have been recruiting former regulators to press their case with their former colleagues.
¹⁷
And in this phase, the banks have two advantages. For a brief few months, financial reform was front-page news, with Goldman Sachs providing the color; rule writing, by contrast, is unlikely to command popular attention and will be relegated to the back pages of the newspaper, if it is covered at all. In addition, rule writing is inherently complicated and full of legal technicalities—the natural home turf for the battalions of lawyers employed by Wall Street. And some of the most important rules—including those determining how much capital banks are required to hold, what qualifies as capital, and how capital requirements are measured—will be set in international negotiations where the rule of the least common denominator is likely to prevail. On the other hand, many of the regulators currently in place do genuinely want to do the right thing for the country, fulfilling the potential of the Dodd-Frank Act and constraining the excesses of the financial sector. But they will be under enormous pressure from an extremely well-funded campaign to undermine regulation at every turn. As Raghuram Rajan said, “There is a great amount of ambiguity about how the bill will evolve in practice. It has tremendous promise, but also tremendous scope for disappointment.”
¹⁸

The financial reform bill itself is also far from perfect. Unfortunately, Dodd-Frank does little to address a few of the more obvious problems that helped produce the financial crisis. The main executive compensation provisions include a requirement that board compensation committees be composed entirely of independent directors and a “say on pay” rule requiring shareholder votes on executive compensation packages—but those votes are nonbinding. Despite the central role of credit rating agencies in making the credit bubble and financial crisis possible, the conference committee that crafted the final version of the legislation stripped out the most significant provision aimed at the rating agencies: Senator Al Franken’s amendment, originally included in the Senate version, eliminating the ability of banks issuing new securities to decide who would rate those securities. (Instead, the final bill requires the SEC to study the issue of conflicts of interest.)
¹⁹
Finally, the bill makes virtually no mention of Fannie Mae, Freddie Mac, or the decades-old bipartisan policy of promoting homeownership and propping up housing prices.