On June 29, 2001, Rosner published a research piece that summed up his thinking, entitled, “A Home without Equity Is Just a Rental with Debt.” No one seemed to take much notice. He was working from home one day when the phone rang. On the other end was an elderly man. “I just read your paper and want to discuss it with you, but I can’t hear very well on the phone,” he said. “Would you be able to sit down with me in person?”
“Sure,” Rosner responded politely. “Are you in the city?”
“I’m in Lexington, Massachusetts,” the caller explained. Rosner, again being polite, said he’d call when he was next headed to Boston for meetings, and asked for the man’s name.
“My name is Charles Kindleberger,” the caller replied. Kindleberger was the author of Manias, Panics, and Crashes, which documented market crises through the ages and was widely viewed as a classic. Rosner had long admired it. The next morning, Rosner flew to Boston and spent the day with Kindleberger, who was ninety-one. Kindleberger told Rosner that if he published another edition of Manias, Panics, and Crashes, he would use “A Home without Equity” as the final chapter.
There was at least one bank regulator in Washington during this era who tried to do something to curb subprime lending abuses. Her name was Donna Tanoue, and from 1998 to 2001 she was the chair of the Federal Deposit Insurance Corporation. Her concern stemmed from the simple fact that subprime lenders were shutting down. When those lenders were banks, it was the FDIC, which insures deposits for the federal government, that had to pick up the pieces. Tanoue’s solution—an obvious one, really—was for the subprime companies to hold more capital against those loans. “Subprime lenders,” she said during one congressional hearing, “are twenty times more likely than other banks to be on the agency’s problem list and accounted for six of the last eleven failures.” By late 2000, she went even further, arguing that banking regulators needed to “sever the money chain that replenishes the capital of predatory lenders and allows them to stay in business.” She was talking about Wall Street’s purchase and securitization of subprime loans. The FDIC even issued draft guidelines instructing banks on how to avoid purchasing predatory loans for their securitizations.
The industry was apoplectic about the draft guidelines. Patricia Alberto, an executive at J.P. Morgan, wrote a letter in protest. “The regulatory agencies and the public, in their quest to eradicate predatory lending, have issued ‘guidelines’ that have the effect of imposing a large portion of the responsibility for ferreting out and eliminating predatory lending by others to the large banks in the industry, because they are in a position to provide liquidity to the marketplace,” she said. Well, yes: that was exactly what Tanoue was trying to do.
When Tanoue testified before the House banking committee, defending her plan to increase the capital that had to be held for subprime loans, Representative Carolyn Maloney, a Democrat from New York, replied bluntly, “I am concerned that adopting any arbitrarily high capital standard for subprime lending will unnecessarily reduce the number of subprime lenders.”
In early 2001, the banking regulators did issue “guidance” requiring institutions with heavy concentrations of subprime loans to hold more capital against those loans. But the definition of what constituted subprime lending was vague. And “guidance” was only guidance, which lenders could adopt or ignore as they saw fit, depending on how zealously the regulators enforced it. No antipredatory lending bill was ever passed; no strictures against most of the practices were ever enforced; no serious effort was ever made to make financial institutions pay more attention to the loans they were buying and securitizing.
Yet even the guidance, as weak as it was, met with a firestorm of criticism. John Reich, a new member of the FDIC board, told the American Banker that the regulators were in the wrong, and that “we should have done it right the first time.” He clarified that “doing it right” meant consulting with the banking industry. James Gilleran, who became the head of the Office of Thrift Supervision in late 2001, would later say of his agency, “Our goal is to allow thrifts to operate with a wide breadth of freedom from regulatory intrusion.” A few years later, a picture was taken of Gilleran and Reich with the representatives of three bank lobbying groups. They were taking a chain saw to the red tape of excessive regulation. In 2005, Reich replaced Gilleran as the director of the OTS.
And yet, and yet. Even though the bank supervisors refused to take steps to curb subprime lending, the smarter ones—the Office of the Comptroller of the Currency, in particular—also didn’t want its institutions to make these loans. Via the examination process, which isn’t public, the OCC quietly started making life difficult for any national bank that had a big subprime business. Early on, in August 2001, Bank of America announced it was selling its ninety-six subprime lending branches and its $26 billion loan portfolio. Four years later, in a decision that every bank noticed, the OCC forced Laredo National Bank, in Texas, to make restitution to every borrower who had gotten a loan without the bank taking care to “adequately consider creditworthiness.” “OCC ran every national bank out of the business,” says a former Treasury official.
Admirable though this effort may have seemed, it was both problematic and a little perverse. Because the OCC’s effort was not matched by the Office of Thrift Supervision, thrifts began grabbing the subprime market share the big banks were abandoning. Subprime lending also began to migrate into state-regulated institutions, where, as Gramlich once put it, federal regulators have “no obvious way to monitor the lending behavior of independent mortgage companies.”
And one other thing. What the OCC forgot was that even if the big banks were no longer making the majority of subprime loans, those loans were still finding their way into the banking system. All the big banks were also in the securities business, and they were all making fortunes securitizing subprime loans originated by others. And big and small banks alike continued to hold mortgage-backed securities on their balance sheets. But no one, not the banking supervisors, nor the Securities and Exchange Commission, nor the Federal Reserve, was bothering to track this. That risk was supposed to be gone.
7
The Committee to Save the World
In February 1999, Time magazine put a photograph of Alan Greenspan, Robert Rubin, and Larry Summers on its cover. Greenspan by then was the most famous economic policy maker in the country, and probably the world, but Rubin, the Treasury secretary, and Summers, his deputy—who would become Treasury secretary himself five months later—weren’t far behind. On the cover, Greenspan stood front and center, flanked by a smiling Rubin and a stern-faced Summers, the three of them looking both smug and heroic. Then again, they had a lot to be smug about. Ever since Rubin had become Treasury secretary in January 1995, the three men had successfully fended off one major financial crisis after another.
First came the 1994 Mexican crisis, which had Mexico’s creditors bracing for a default of its sovereign debt, an event that would have sent tremors through the global economy. The crisis was averted when the Treasury Department and the Fed, after weeks of around-the-clock effort, maneuvered to have the Exchange Stabilization Fund loan Mexico $20 billion, guaranteed by the United States. That was followed, in short order, by full-blown crises in Russia (which did default), Asia, and Latin America, as well as near crises in Egypt, South Africa, the Ukraine, and elsewhere. Each time, the three men helped contain the crisis while keeping it walled off from the U.S. economy. They did the same in the fall of 1998, when a giant hedge fund, Long-Term Capital Management, collapsed. An LTCM bankruptcy could have been devastating for Wall Street, since the big firms were all on the hook for tens of billions of dollars of LTCM’s losses, both as lenders and as counterparties.
“In late-night phone calls, in marathon meetings and over bagels, orange juice, and quiche, these three men … are working to stop what has become a plague of economic panic,” Time wrote breathlessly. “By fighting off one collapse after another—and defending their economic policy from po
litical meddling—the three men have so far protected American growth, making investors deliriously, perhaps delusionally, happy in the process.” Who wouldn’t be smug after being described in such terms? Time called them “The Committee to Save the World.”
One thing the article glided over, though, was why these crises kept taking place. To the extent the Committee to Save the World had answers, they were as smug as that cover photo. The developing world, they said, was new to this business of trusting in markets. They didn’t act enough like, well, us, with our supremely efficient market-driven economy. “A Thai banker who breaks the rules by passing $100,000 to his brother-in-law puts the whole system at risk,” is how the author of the article, Joshua Cooper Ramo, characterized their thinking.
Even the Long-Term Capital Management disaster didn’t dent their enthusiasm for the way our own markets had evolved. LTCM was a firm that relied entirely on the tools of modern finance, chief among them derivatives, risk models, and debt. Its leverage ratio was a staggering 250 to 1, meaning that it had borrowed $250 for every $1 of equity on its balance sheet. The notional value of its derivatives book was more than $1.25 trillion, and the fact that LTCM traded almost exclusively in derivatives was the central reason it had been able to accumulate so much debt. Derivatives didn’t come with capital requirements. Derivatives transactions could be done entirely with borrowed money. And derivatives positions housed in secretive hedge funds—even massive, bring-down-the-system positions—didn’t have to be disclosed to anyone.
Yet when Greenspan was asked about the Long-Term Capital Management crisis, he shrugged it off as the price of modernity. Faster markets, he told Ramo, gave rise to “the increased productivity of mistakes”—whatever that meant. Added Ramo, paraphrasing Greenspan: “Computers make it possible to push a button and destroy a billion dollars of wealth.” Clearly, the staggering increase in the number of derivatives contracts, with notional value topping $50 trillion by early 1999, didn’t cost Greenspan any sleep. He liked derivatives. He especially liked the fact that they were unregulated. As one former Capitol Hill aide later put it, Greenspan viewed the derivatives market as akin to “the way the Europeans once viewed the New World. It was a virgin market. A beautiful, unregulated, free market.” Summers felt likewise.
But Rubin was different. Derivatives made Rubin nervous. During his years as a trader and manager at Goldman Sachs, he had seen derivatives trades spiral out of control. He knew that if something went seriously awry they had the potential to create immense damage. “I thought both derivatives and leverage could pose problems,” he wrote in his 2003 memoir, In an Uncertain World. And yet at the same time LTCM was collapsing, Rubin was standing arm in arm with his fellow Committee members, blocking the last serious attempt anyone in government would make to oversee derivatives prior to the financial crisis of 2008.
In this misguided stance, Greenspan was blinded, as ever, by ideology. Summers was blinded by his deep-seated need to be viewed as a brilliant man, which in this case meant embracing, uncritically, the complexities of modern finance. As for Rubin, he was blinded by pride.
The Goldman Sachs that Bob Rubin joined in 1966, a young man just a few years removed from Yale Law School, was not the Wall Street juggernaut we know today. Not even close. Though nearly a century old, with a noble history, Goldman had nonetheless spent most of that century struggling to become an elite firm. During the Depression, Goldman was nearly brought to ruin by an excitable senior partner named Waddill Catchings, who had made a series of disastrous investments during the roaring twenties that dragged the firm down for the next decade plus. According to The Partnership , a history of Goldman Sachs written by Charles Ellis, it was saved in part by the forbearance of the ruling Sachs family, which covered its losses for the next twenty years, and in part by the savvy senior partner Sidney Weinberg, who had joined the firm as a janitor in 1907, took it over after Catchings was ousted, and ruled it until his death in 1969.
Weinberg was a Wall Street giant—Mr. Wall Street, the press called him. He rebuilt Goldman as a place where the relationship between a corporate client and its Goldman Sachs investment banker was paramount. More often than not, that investment banker was Weinberg himself. As late as 1956, when he was sixty-five, Weinberg served as Ford’s investment banker when the automaker went public. At the time, it was the biggest IPO in history, and it finally catapulted Goldman Sachs into Wall Street’s top tier.
The senior partner who succeeded Weinberg was Gus Levy, a gruff, no-nonsense trader who had built the firm’s trading department more or less from scratch. In the early 1950s, Levy had been one of the innovators in risk arbitrage, and the firm had one of the leading “arb” desks on Wall Street.
For most of its modern life, Goldman Sachs has been a firm with two cultures—a genteel investment banking culture, represented by Weinberg, and a rough-and-tumble trading culture, exemplified by Levy. In many ways, the two men could not have been more different. Yet Levy, a college dropout who joined Goldman at the age of twenty-three, completely shared Weinberg’s beliefs in how Goldman Sachs should act as a firm. A Goldman man, whether banker or trader, worked impossibly hard, eschewed flashy cars and clothes, and was utterly devoted to the firm. He was maybe just a little smarter than his Wall Street peers, but he didn’t make a big show of it. His Goldman colleagues were his closest friends. He didn’t tell tales out of school. He took great pride in his work, but it was a quiet, understated pride. Senior executives at Goldman did not have palatial offices with private bathrooms. The rugs and furniture were a little shabby. The firm’s offices in lower Manhattan lacked so much as a single sign identifying it as Goldman’s headquarters.
Most of all, Levy subscribed to Weinberg’s lifelong belief that acting ethically on behalf of its clients was the single most important thing Goldman Sachs did. Anything that created even the appearance of a conflict with its clients was not just discouraged, but forbidden. That’s why, for instance, when corporate raiders like Carl Icahn and T. Boone Pickens began their takeover attempts in the late 1970s, Goldman refused to advise them, despite the substantial fees they were paying. The hostile takeover movement, the firm believed, was not in the best interest of its corporate clients. A few years after Levy died, in 1976, one of his successors, John Whitehead, set down a list of Goldman’s fourteen business principles. The first one began, “Our clients’ interests always come first.”
Levy was also Bob Rubin’s mentor. Rubin started his Goldman career on the risk arbitrage desk, which he quickly found he had an affinity for. Levy soon realized it as well, and began both encouraging Rubin—in his gruff, no-nonsense way—and talking him up with the other Goldman partners. Within five years, Rubin himself was named a partner.
Rubin had the rarest of skills: he could rise through the ranks of Goldman Sachs faster than just about anyone ever had before without arousing either jealousy or animosity. He was admired equally by superiors, peers, and underlings. On the surface, he appeared to be the opposite of prideful. In meetings—even meetings filled with important partners—he made a point of soliciting the opinion of the most junior associate, and then seeming to hang on his every word. He had a way of making his bosses want to see him do well. His colleagues were drawn to his almost preternatural calm. When a problem arose and he was asked his opinion, he invariably responded, “What do you think?”
“There is no one better at the humility shtick than Bob,” says one former colleague who remains a Rubin admirer. “The line ‘just one man’s opinion’ was something he would utter a dozen times a day.” He inspired intense loyalty.
He also delivered the goods. In 1981, when Goldman Sachs bought J. Aron, a commodities firm whose executives then included Goldman’s current CEO, Lloyd Blankfein, Rubin was put in charge of overseeing the new acquisition. With his help, the firm began to move its business in a direction that made it vastly more profitable. He pushed Goldman to begin trading options, which it had long shied away from, even hiring Fischer Black
, the MIT professor and coinventor of the famous Black-Scholes options pricing model. Goldman’s options trading desk soon became immensely profitable as well. As co-head of the fixed-income research department in the mid-1980s, Rubin helped transform the fixed-income division from a second-tier player into a worthy competitor to such bond strongholds as Salomon Brothers and First Boston. By 1990, he was the co-head of the entire firm. (He shared the title with Steve Friedman, who had also run the fixed-income department with him.) By the time Rubin left for the Clinton administration in 1993—where he spent two years as the head of the National Economic Council before becoming Treasury secretary—Goldman had become the envy of Wall Street. Rubin departed for Washington as the most admired man at the most admired firm.
In August 1996, a year and a half after Rubin became Treasury secretary, Bill Clinton appointed a lawyer named Brooksley Born to be the new chairman of the Commodity Futures Trading Commission. She was a formidable figure in Washington legal circles, a longtime partner at Arnold & Porter, with a practice that dealt with regulatory and financial services issues. She was also a player on the national legal scene, a co-founder of the National Women’s Law Center, a member of the board of governors of the American Bar Association, and an adjunct professor at the law schools of Georgetown and Catholic University. After Clinton won the presidency, she was rumored to be on the short list for attorney general.
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