The agencies should not be exposed to these pressures, and there are indeed discussions afoot about ways to decouple the decisions of the ratings agencies from the decisionmaking processes of the central banks and other major official bodies active in the financial markets. But these discussions have borne no fruit yet, and may indeed never do so.11 In the meantime, the agencies are left to do their impossible job, burdened with inadequate resources, excessive expectations, inappropriate incentives, and political opprobrium. But they’ve no right to complain. Truthtellers on Planet Ponzi were never likely to be popular.
The regulators
As I write, the SEC is conducting a major investigation into a highly controversial mortgage security sale led by Goldman Sachs. The joint chief counsel for the SEC is a former partner of Linklaters, Adam Glass. When he was at Linklaters, Glass advised Paulson & Company, a major hedge fund firm. The most notorious incident in that firm’s record is its role in constructing the controversial mortgage security created by Goldman Sachs. So, to summarize, at the head of the SEC’s legal staff is a man closely associated with the very transactions that the SEC is now investigating (though he is not himself on the investigation team).12
Suspiciously minded readers will instantly want to draw the obvious conclusion: there’s a huge conspiracy here; rich people are bound to protect their own interests; no major fraudster will ever be brought to justice. I don’t agree. For one thing, some very important fraudsters have been brought to justice recently—Bernie Madoff, Raj Rajaratnam—and sentenced to some swingeing jail time.13 For another thing, Glass isn’t accused of having done anything wrong, either when he was at Linklaters or now at the SEC. And for yet another thing, Glass has done something that few of us would ever do. He gave up a partnership at Linklaters (average salary: $2.3 million) to work for the government (maximum salary: $233,000). That makes him, in my eyes, a man of honor.
What, in fact, the Glass story draws attention to is the almost impossible position in which we place our regulators. Their salaries are so low in comparison with their private sector counterparts that they have an almost irresistible temptation to serve their two or three years at the SEC, then return to the lavish remuneration available outside. And when they do return to the private sector, they have a wonderful new skill to offer: insight into the workings of the principal financial regulator. According to a study conducted by the Project on Government Oversight:
Between 2006 and 2010, 219 former SEC employees filed 789 post-employment statements indicating their intent to represent an outside client before the Commission
Some former SEC employees filed statements within days of leaving the Commission, with one employee filing within 2 days of leaving
Some former SEC employees filed numerous statements during this time period, with one former employee filing 20 statements14
To put it bluntly, the SEC is seen by many of its employees as a training ground which will qualify them for lucrative private sector work in the future. The SEC is, in effect, training its employees to play the system. Even when it works the other way—that is, when private sector employees choose to become regulators—you are almost inevitably recruiting people strongly in sympathy with the goals and methods of the private sector. Those aren’t necessarily the folks best placed to get tough if they have to.
Although I’ve singled out the SEC in these paragraphs, I do so only to illustrate a broader issue. All the financial regulators in every major market suffer from these problems. Sometimes they are so blatant as to take your breath away. The chair of the Commodities Futures Trading Commission under President George H. W. Bush was Wendy Gramm. A few days before leaving office, she granted an order allowing Enron to trade certain derivatives without CFTC supervision. A few weeks after that, she was given a seat on Enron’s board—and we all know how successful that board went on to be.
These conflicts of interest are so gross as to seem almost criminal, yet it’s wrong to focus on individual malfeasance when the problem is systemic. Bluntly put, our regulators face impossible odds. We saw, in an earlier chapter, the extraordinary extent and effectiveness of corporate lobbying in Washington. Government regulators—however idealistic, capable, and tough they may be—are fighting an enemy with infinitely greater resources and infinitely more at stake than themselves. Arthur Levitt, a former chairman of the SEC, recalled in his wise and hard-hitting book Take on the Street:
During my seven and a half years in Washington … nothing astonished me more than witnessing the powerful special interest groups in full swing when they thought a proposed rule or a piece of legislation might hurt them, giving nary a thought to how the proposal might help the investing public. With laserlike precision, groups representing Wall Street firms, mutual fund companies, accounting firms, or corporate managers would quickly set about to defeat even minor threats. Individual investors, with no organized labor or trade association to represent their views in Washington, never knew what hit them.15
That last phrase is particularly telling: ‘never knew what hit them.’ It’s precisely right. Individual investors aren’t even aware of the battles that they’re losing, of what’s at stake, of the cumulative damage being done.
As for the regulators, Congress and Wall Street can conspire to render them toothless simply by depriving them of the funds needed to do their job. The Commodities Futures Trading Commission has, for example, recently halted a technology program designed to identify patterns of suspicious trading because of budget restrictions forcing cuts in its $11 million technology budget.16 Worse still, the panel set up to dissect the causes of the financial crisis—the Financial Crisis Inquiry Commission—has been given a budget of just $8 million.17 That compares with $38 million spent by a federal bankruptcy trustee looking at the Lehman collapse.18 It compares with $30 million spent investigating the Monica Lewinsky ‘scandal.’19 It compares with at least $130 million spent investigating the accident to the space shuttle Columbia.20
Forgive my heartlessness, but when space shuttles explode they do not threaten the entire fabric of Western capitalism. When the financial system explodes, it does. And forgive my political naivety, but when an American president stains an intern’s dress, he causes damage that can be remedied by an ordinary dry-cleaner for about $15. When the American financial system sprays toxic waste over the entire economy, the damage totals so many trillions of dollars it’s hard to know quite how to count them. The IMF estimated the fiscal impact of the crisis of 2007–8 on the US at 35% of GDP, or about $4.5 trillion.21 The crisis caused a similar degree of destruction to government finances in Italy, Japan, Spain, and France. It caused a whole lot more in the UK. It caused a lot, but slightly less, in Germany. And that’s only the fiscal impact. The cost in lost output is so large it pretty much burns the calculator up to start figuring it out. But if you reckon the cost of lost output at a permanent 5% of global GDP, the present value of that loss soars to easily more than $100 trillion, even on quite conservative assumptions about discount rates and the like. A Bank of England paper guesstimated the cost of lost output at between $60 trillion and $200 trillion.22 And yet the committee set up to investigate these things was given about one-quarter of the budget of the Monica Lewinsky one. It’s beyond outrageous. The solution is as plain as sunshine. We need to give the regulators real cash and real teeth. One of the eye-watering aspects of the current crisis is encapsulated in a few simple statistics:23
Number of bankers in jail in the US 0
Number of bankers in jail in the UK 0
Number of bankers in jail elsewhere in Europe 0
Number of bankers in jail in Japan 0
Total number of bankers in jail 0
These data don’t include the imprisonment of Bernie Madoff, because his fraud had no direct connection with the financial crisis (except inasmuch as the failure to catch and jail him earlier reveals extensive flaws in Wall Street’s culture and supervision). And
the simple truth—so howlingly obvious it should hardly need spelling out—is that very many more bankers should have been jailed for their role in the catastrophe. Don’t take my word for it. Former chairman of the Federal Reserve Alan Greenspan is on the record as saying:
There are two fundamental reforms that we need. [One], to get adequate levels of capital [in the banking system] and two, to get far higher levels of enforcement of fraud statutes—the existing ones, I’m not even talking about new ones. Things were being done which were certainly illegal and clearly criminal in certain cases … Fraud creates very considerable instability in competitive markets. If you cannot trust your counterparties, it won’t work. And indeed we saw that it didn’t.24
I’m not about to start listing those firms and individuals who committed criminal acts. I don’t fancy spending the rest of my life being sued for libel. In any case, I don’t personally know enough of the detail to be sure which transactions may have constituted criminal fraud and which were merely pushing—but legally pushing—the boundaries of acceptable market practice. On the other hand, you only need to look at the torrent of lawsuits and out-of-court settlements being conducted between banks, regulators, and other governmental or quasi-governmental agencies to realize that the boundaries of acceptable practice were given a real pasting. For example, recent news stories have reported:
Settlement for mishandled foreclosures: ‘The 14 largest U.S. mortgage servicers must pay back homeowners for losses from foreclosures or loans that were mishandled in the wake of the housing collapse, the first of a set of sanctions regulators are seeking against the companies.’25
Lawsuits filed by FHFA: ‘Bank of America Corp. and JP Morgan Chase & Co. (JPM) were among 17 banks sued by the U.S. to recoup $196 billion spent on mortgage-backed securities bought by Fannie Mae and Freddie Mac.’26
Mortgage-bond fraud settlement: ‘U.S. securities regulators are expected to reach a settlement with major banks as soon as this week over mortgage-bond fraud, which contributed to the financial crisis.’27
Fraudulent lending charges against BoA: ‘Nevada’s attorney general on Tuesday accused the bank of repeatedly violating its $8.4 billion agreement with that state and others to address fraudulent lending charges involving its Countrywide unit, which it bought in 2008.’ Bank of America is contesting the charges.28
Goldman Sachs settlement with SEC: ‘Goldman Sachs agreed on Thursday to pay a lower-than-expected $550m fine to settle US regulators’ accusations that it misled investors in a mortgage-backed security—a move that ends the highest profile regulatory case since the crisis.’29
Morgan Stanley sued by Allstate: ‘Morgan Stanley (MS) was sued for fraud by Allstate Insurance Co. over residential mortgage-backed securities in which the insurer invested, according to a complaint filed in New York.’30
Madoff trustee sues JP Morgan: ‘“The bankruptcy code allows the trustee to stand in the shoes of a judgment creditor and assert common-law claims against JPMC,” [Trustee Irving Picard] said in a court filing yesterday. JP Morgan, as Madoff’s primary banker, was central to the fraud and “complicit” in it, he said.’31
Let me repeat, I am categorically not alleging that all, or even any, of these suits and claims and settlements revolve around criminality. Nor am I suggesting that any of the fine (and litigious) firms named above have a systemic problem with criminality. What I do say, however, is that the sheer volume of legal activity indicates something crucially significant about the culture that has come into being on Wall Street. Like Alan Greenspan, I consider it inconceivable that the credit crisis of 2008–9 arose without there being extensive deception and criminality. Naturally it’s important that federal regulators, and authorities such as the FHFA, do all they can to recover money where they believe they have the legal scope to do so. But it is also important to launch criminal investigations against individuals wherever charges could credibly stick. It’s important to prosecute those charges in court, to push for the severest possible sentences, and not to be distracted by the possibility of securing some multimillion or multibillion out-of-court settlement instead.
Toward the end of this book I’ll suggest some possible solutions to some of the problems enumerated in this chapter; but for now, just take a note of the fundamental issue at stake. To be effective, financial regulators need to have guts, teeth, brains, and independence. They need to be able to kick ass, inflict losses, and override vested interests, and to do all these things despite the fact that those vested interests will be prepared to spend tens or hundreds of millions in lobbying against any adverse change in their conditions of business. And we want them to do these things for one-tenth of the remuneration that they could get elsewhere. What’s remarkable, in fact, is how well these guys do, given the circumstances. But they’re fighting their way uphill with the wind in the faces. And they mostly lose.
*
This survey of biased, asymmetric, and inappropriate incentives should really end with a study of politicians: the breed who ought to be in charge of sorting through all this muddle and instead have played such a huge part in creating it. For the past three decades, the record of government in the United States in particular has been atrocious. This current administration, like those that preceded it, has utterly failed to deliver long-awaited and essential change. The only fools worse than the fools in the White House are the ones in Congress. The only idiots worse than the idiots in the Senate are the ones in the House. And the only idiots worse than either are the rest of us, the dummies who choose to put up with them all.
We’ll get to all that, but not yet. We’ve studied how the theoretical perfection of the financial markets is a mirage; a mirage concealing a minefield. We’ve labeled some of the mines—the buried risks, the dangerous incentives—but that’s not the same as establishing the likely cost as they detonate. That’s our next task. We need to survey the housing market, the bond and equity markets. We need to test the solidity of bank balance sheets, consider the weight of accumulated household debt, review the situation in Europe and Japan, see if we can feel our way to some kind of likely damage appraisal.
Only once we’ve done all that will our rap sheet be complete. We’ll talk about politicians all right, but only at the end of the book, once we have a proper understanding of the swamp they’ve led us into. Next up: the roof over your head.
12
I’m short your house
On April 13, 2011, a Senate committee released a 635-page report on the financial crisis. Senator Carl Levin, the committee chairman, commented that
the report discloses how financial firms deliberately took advantage of their clients and investors, how credit rating agencies assigned AAA ratings to high risk securities, and how regulators sat on their hands instead of reining in the unsafe and unsound practices all around them. Rampant conflicts of interest are the threads that run through every chapter of this sordid story.1
Along with the report, some 5,800 pages of previously unseen documents were released, providing detailed support for Levin’s claims. Included in those 5,800 pages was the following email, written by Greg Lippmann, a trader at Deutsche Bank, to Michelle Borre, an investor at OppenheimerFunds, Inc. I presented the email here just as it was written: all caps, muddled spacing, and punctuation that your English teacher wouldn’t have liked.
A CLIENT THAT DID THE SAME TRADE AS U WITH US SENT ME A TSHIRT “IM SHORT YOUR HOUSE” … I JUST BOUGHT 20 OF EM TO GIVE TO CLIENT S THAT DO THE TRADE WITH US.DO U WANT 1 OR 2 ?2
It’s an interesting message. Let’s start by looking at its most obvious feature: its lack of even the most rudimentary effort at presentation. The transaction referred to involved a vast sum of money. Michelle Borre was not an in-house colleague, but an external client. Deutsche and Oppenheimer are both leading institutions whose standards were and are, presumably, as high as those of any of their peers. Yet the message has a kind of teenage quality to it. It calls to m
ind high-schoolers ‘starting a rock band’ in their garage, kids getting drunk or smoking weed for the first time. A culture which permits and encourages messages of that kind is a culture that has left ordinary professional standards a long way behind it. And those standards matter. They’re not the same as ethics, but they’re related.
(And, to digress for a moment, one could say something similar about the financial markets’ relationship with drugs. The British Guardian newspaper quoted one former addict:
‘It is absolutely rife in the City,’ Daniel [not his real name] says. ‘The cocaine dealers have not gone out of business because I’ve stopped. I could take you five minutes from here to 15 or 20 bars where you would be guaranteed to be able to buy cocaine.’
Daniel claims there are bars in the City where regular customers order bottles of wine that are not advertised. In fact, these vintages aren’t on sale, but are a code for ordering cocaine from bar staff.
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