We Can All Do Better (9 page)

The arrangement flourished for many years. But by the 1980s, banks had begun to chafe at the limitations of the law. Hadn't floating interest rates on loans and deregulated interest rates on deposits guaranteed the spread for banks and reduced their worry about quality in loans? Why shouldn't commercial banks own insurance companies? Why shouldn't commercial banks make investments for their own benefit and use leverage to turbocharge their returns? Why shouldn't investment banks take deposits, too, and get the federal insurance? How could U.S. banks compete with the big Japanese, German, British, and Swiss banks without these new powers? Bankers maintained that it was ultimately a question of competitiveness. Their lips said it was all about the national interest, but their eyes blazed with dollar signs. When the Glass–Steagall provisions
that had reined them in were repealed in 1999, huge integrated financial institutions arose to speculate with depositors' money in relatively unaccountable ways. The share of financial assets held by the ten largest financial institutions went from 10 percent in 1990 to 75 percent twenty years later.
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All the upside was with the bank. All the downside was with the taxpayer. Heads I win. Tails you lose. The stage had been set for disaster.

2. The failure to regulate derivatives
. In the 1990s, executives at the new megabanks found ways to bundle together real assets, like mortgages, slicing and dicing them into new financial instruments that symbolized a real thing but were just numbers on a screen. The daisy chain began with a tangible asset—a house, say, and someone who borrowed money to buy it. The buyer got a mortgage from a bank, which put a thousand such obligations, of varying quality, together into one security and sold it to the public, including other financial institutions. The bank no longer owned these mortgages or bore any responsibility for the loan payments or the mortgages' quality. The investor who bought the security held the risk; the bank became simply a conduit. The derivatives team of the purchasing financial institution then took a thousand of these so-called mortgage-backed securities and packaged them into a financial instrument called a CDO (for “collateralized debt obligation”), which they in turn proceeded to sell to the public and other institutions. This was the second sale of the same asset. But it didn't stop there. A thousand of these CDOs would then be packaged into a CDO-Squared, which was also sold by the latest institutional buyer. The same real asset—a house and its mortgage—had now been sold three times. The financial institutions that packaged each level of derivatives had essentially created money, and the suckers were on the other side of the trade.

Many policymakers and way too many bank CEOs had not the foggiest idea of what was going on. Those who did lacked the strength or vision to call off the party. As Charles O. Prince, the former CEO of Citigroup, said when asked why his corporation bought and sold derivatives, “It bears emphasis that Citi was by no means alone in the view and that everyone, including our risk managers, government regulators and other banks all believed that these securities held virtually no risk.”
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Finally, to take this process to an absurdity, the daisy chain of selling the same asset over and over was insured by something called a CDS (for “credit default swap”), a kind of insurance that promised to pay someone who bought the CDO if the entities involved couldn't pay them. But this kind of insurance wasn't backed by reserves to assure payment in a crunch. The CDS was nothing more than a fourth sale—all resting on the initial sale of one house. With so much money at stake, the only thing that could rain on the parade was government regulation. So in the last year of his administration, President Bill Clinton signed a law, passed by a Republican Congress, which specifically prohibited the government from regulating the trading of derivatives.

3. The loosening of regulations for Fannie Mae and Freddie Mac
. It used to be that if you were a president who wanted low-income people to have homes, you had two choices: You could either subsidize their purchase of a home or build housing for them. But in the 1990s, there emerged a third alternative. You could instruct Fannie Mae and Freddie Mac to take on greater risk by investing in subprime mortgages given to people who, by traditional standards, would never have qualified for a loan. The relaxed underwriting standards quickly spread to private lenders, and housing speculation exploded. Prudent capital requirements were jettisoned, and profits soared.
Mortgages were given by banks that never checked the income of applicants. These loans were quickly packaged and sold, and Fannie and Freddie were the biggest purchasers. Their breakdown was only a matter of time.

4. The increase in leverage
. This occurred on George W. Bush's watch. In 2004, financial institutions, no longer satisfied with selling the same asset four times, wanted to turbocharge their returns, so they petitioned the Securities & Exchange Commission to allow them to increase what they could borrow for a trade from ten times their capital to thirty or forty times. Warren Buffett has said that leverage is “like driving a car down the road and placing a dagger on the steering wheel pointed at your heart.”
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Everything goes fine until you slam on the brakes. In 2008, the brakes brought the economy to a screeching halt as the speculative frenzy produced a near-death experience for the global economy. Thanks to the government (i.e., taxpayer) underwriting, the dagger didn't reach the heart of the drivers, who were “too big to fail.” It was the hapless passengers in the backseat who got hurt—and they didn't even know who was driving the car or how recklessly it was being driven. They just rolled out onto the street to find their houses underwater and their retirement in peril. The quotable Chuck Prince commented about the leveraged lending practices of Citi: “As long as the music is playing, you've got to get up and dance,” he told the
Financial Times
back in July 2007. “We're still dancing.”
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5. The Federal Reserve's demurral
. Underlying and abetting the four mistakes listed above was the Fed's ideological view that it had no responsibility for asset inflation, be it a stock market fueled on cheap credit or a housing bubble. Unlike William McChesney Martin Jr., the Fed chairman from 1951 to 1970, who said that his job was to “take away the punch bowl as the party gets going,” Alan
Greenspan cheered the party on by keeping interest rates near zero.
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Who couldn't make money by borrowing at near zero and investing the money in practically anything? And that was before you were permitted to borrow thirty times your capital. Noted financial economist Henry Kaufman likens the proper relationship between the Federal Reserve and banks to that of parent and child: “As guardian, the parents' role is to set out standards of behavior and hold the child to them. A parent should not play the role of friend in his or her relationship with the child. Similarly, the central bank should define and enforce standards of behavior. It should never become a folk hero of the marketplace.”
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The financial crisis of 2008–2009 was caused by these specific policy blunders, which benefited a few in the financial world, even as they undermined the financial stability essential for economic growth and raising standards of living. Middle-class Americans participated in this fiasco by borrowing money for homes and consumer goods they couldn't afford. But their recklessness was encouraged by liberal credit—and, of course, by the mortgage industry, which gave them mortgages beyond their means because the banks got paid for selling mortgages, not for making sure they were repaid. Besides, the dicey mortgages would probably end up in the coffers of Fannie or Freddie. Your taxpayer dollars at work.

The question asked was never “What is right?” The operative question was “Can I get away with it?” That attitude is symptomatic of the wider cultural norm, which holds that if it's legal, it's OK. If you've ever seen the power of special interests at work in the writing of laws, you know that that's not the right answer.

The Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010 was supposed to prevent another financial meltdown. Instead it risked turning the financial sector into a government monolith. The bill punted on breaking up the too-big-to-fail banks. Far from
it, Dodd-Frank bolstered them against failure and encased the whole thing in a four-hundred-thousand-word web of complexity that will serve as a full employment act for many members of the Washington club. The act provided for an orderly dissolution when a too-big-to-fail institution got into real trouble. But no one knows how orderly dissolution will work. As Henry Kaufman pointed out in a speech to the Foreign Policy Association on December 6, 2011, “Untangling these credit relationships will affect prices and other market relationships. Who will take the losses? Who will take over the assets and liabilities as the dissolution proceeds? . . . [A] good portion of the assets and liabilities will be acquired by other institutions that are themselves deemed too big to fail. . . . Either way, the entire process will increase financial concentration.” There is only one answer to this dilemma: Shrink the big financial institutions. You could spin off the credit-card and consumer-loan divisions into a new company. You could do the same with the mortgage division or the insurance division. You could even put the investment banking and trading operation in a new company. After these behemoths have been downsized, they will no longer be a systemic risk. Small businesses will find easier financing. Conflicts of interest will end. Large corporations will no longer receive a privileged flow of funds. The economy will be more resilient and more stable. The only thing preventing this outcome is the role of money in politics.

There are ways to keep our sclerotic democracy from succumbing to the corruption of money. A constitutional amendment, stating that federal, state, and local governments can limit the total amount of money spent in a political campaign, should supersede
Buckley
and
Citizens United
. If that were combined with public financing for whatever amount was permitted by the campaign finance laws, we would have returned government to the people. The second way (either as a part of the constitutional amendment process or in a freestanding bill) is to establish public financing for all congressional
and senatorial campaigns. For roughly $3 billion a year out of a $3.5 trillion budget, we could shut special interests out of the legislative process entirely, and then legislation would be influenced more by argument and facts than by dollars. Absent the constitutional amendment, a candidate's acceptance of public financing would have to be voluntary. A wealthy candidate, not wishing to limit his spending, could always opt out of receiving public money, but his opponent would be assured enough money to make his case without begging the special interests for it. I know plenty of members of Congress who would rather not spend three hours a day calling strangers for money, but in a catch-22 they're afraid to support public-financing legislation for future elections because this might offend the interests, who then wouldn't contribute to the member's campaign in the pending election. Obama's failure to put campaign finance reform front and center in the first months of his presidency makes it more difficult than ever to achieve today.

Beyond the legislative route to diminish the role of money in politics lies the judicial one. People could flood the courts with cases that take the logic of
Citizens United
to its absurd conclusion. The Supreme Court based its decision on the theory that a corporation is a person—an idea that arose not with our Founders but with the robber barons' court of the late nineteenth century in
Santa Clara County vs. Southern Pacific Railroad Company
, which dealt with the railroad's claim to its right to due process. According to the theory dusted off by the Court in
Citizens United
, a corporation can't be denied its right to free speech since it's legally a person. The absurdity of the ruling is made manifest if one asks, “When was the last time you saw a corporation get married?” or, better yet, “go to jail?” But for corporations there's a downside to being labeled a person. Might the executives of BP, for instance, be charged with murder because, through their position and their neglect, eleven people died in the explosion of the Deepwater Horizon?

When members no longer have to beg for special-interest money, Congress's time could be spent on passing legislation. The reforms I've suggested would build into the structure of politics a force against special-interest deals. When legislators don't have to spend time raising money, they'll have more time to study the issues and talk to their constituents. Evenhanded laws will pass, making America a better country. Politics will once again be a vehicle to improve people's lives—and people will feel the change. Their voices will be heard, online and in person. Their confidence in their own power and their trust in the power of government will grow. And our democracy will be strengthened.