Inside Job

by Charles Ferguson

  And then there were the S&Ls, small, usually local firms in the sole business of taking savings deposits and selling fixed-rate long-term residential mortgages. As late as 1980, most S&Ls were trusts—they had no shareholders, but rather were cooperatively owned by their local “passbook” depositors. (The same was true of credit unions and most large insurance companies.) Like banks, the S&Ls were tightly regulated, and their retail deposits were insured. They were explicitly permitted by regulators to pay slightly higher interest rates on savings accounts than commercial banks, in order to encourage mortgage lending.

  The world on the other side of the Glass-Steagall wall—the securities industry—was divided between retail brokerages and investment banks. Brokerage firms, the largest of which was Merrill Lynch, sold stocks and bonds to wealthy individual customers. Merrill Lynch was a large firm for this period. It was also one of the first to go public, in 1971.

  True investment banks, such as Goldman Sachs, Morgan Stanley, Bear Stearns, Dillon Read, and Lehman Brothers, provided financial advice to big companies and managed and distributed new issues of stocks and bonds. It was a fragmented but still clubby industry, informally divided between Protestant and Jewish firms, with women and minorities welcomed by neither. There were dozens of firms, all of them small but very stable, with low personnel turnover. In 1980 Goldman Sachs, the largest, had a total of 2,000 employees (versus 34,000 in 2011); most of the others had only a few hundred, some only a few dozen. They were all private partnerships, and the capital they used was their own. If they underwrote (guaranteed the sale of) a new issue of stock, the partners were literally risking their own personal money, which constituted the entire capital base of the firm. Their franchises depended on reputation and trust—though also, realistically, on golf, squash at the Harvard Club, and old-school ties.

  Regulation, Bankers’ Pay, and Financial Stability

  BANKERS’ PAY HAD reached stratospheric levels in the 1920s but then contracted sharply with the Depression and, even more importantly, with the tightening of regulation in its wake. After passage of the New Deal reforms, pay in the American financial sector settled down. For forty years, average financial sector pay stayed at about double the average worker’s income. Executive compensation, while comfortable, was hardly exorbitant; nobody had private planes or gigantic yachts.3

  Equally important was the structure of financial sector pay. Most commercial bankers were paid straight salaries. Investment bankers lived well and received annual bonuses, but through deliberate policy practised universally within the industry, most of the partners’ total wealth was required to remain invested in their firm, usually for decades. Partners could only take their money out when they retired, so partners and their firms exhibited very long time horizons and a healthy aversion to catastrophic risk taking.

  All of this—the industry structure, regulation, culture, and compensation practices—remained in place until the early 1980s. Then the wheels came off.

  Drivers of Change

  IN THE EARLY 1980s, three forces converged in a perfect storm of pressure and opportunity: the upheavals of the 1970s, which destabilized and devastated the financial markets, forcing bankers to seek new forms of income; the information technology revolution, which integrated previously separate markets and vastly increased the complexity and velocity of financial flows; and deregulation, which placed the inmates in charge of the asylum.

  The first driver of change was severe financial pressure. In the wake of the 1973 and 1979 oil shocks, the stock market and all financial institutions suffered badly. Inflation grew so severe that in 1981 three-month US Treasury bills briefly paid 16 percent interest.

  The second driver of change was technology. The US financial sector did need some deregulation, or more accurately, different and modernized regulation, in the computer age. The tight control over interest rates on consumer deposits, the somewhat artificial division between banks and S&Ls, and the prohibition on interstate banking caused significant inefficiencies. Information technology and the rise of electronic financial transactions created opportunities for productivity gains through nationwide and global integration of previously distinct markets.

  At the same time, however, information technology posed dangers that required tighter regulation in some areas. The advent of frictionless, instant electronic transactions introduced new volatility and market instability. Information technology also made it easy to construct and trade increasingly complicated and opaque financial products, through increasingly complex financial supply chains. But that same complexity also made it easier to hide things—things like risk, or fraud, or who really stood to gain and lose.

  In this context—oil shocks, recession, inflation, new technologies and financial products—much of the staid, rigid financial sector performed badly. In particular, by the early 1980s US regulators were faced with the potential collapse of the entire S&L industry.

  The S&Ls had been destroyed by the interest-rate volatility and inflation caused by the second oil shock. Their business of collecting deposits and financing long-term, fixed-rate mortgages assumed an environment of steady, low interest rates. By the early 1980s, depositors fled low-interest S&L accounts for money market funds. At the same time, the value of the S&Ls’ low-interest, fixed-rate mortgage loans declined sharply as a result of inflation and higher interest rates.

  The Reagan administration’s publicly stated response to the S&L problem was to make the S&L industry a star test case for deregulation. But what really happened was that deregulatory economic ideology was used as political cover for a highly corrupt process of letting the S&Ls, and their investment bankers, run wild. What followed was a film we’ve been watching ever since.

  Deregulatory Fiasco at the S&Ls

  HAD THE GOVERNMENT simply shut down the S&L industry, the cost to taxpayers would have been in the range of $10 billion. But the industry was politically well connected, and was one of the first to make aggressive use of political campaign contributions and lobbying. Senator William Proxmire, chairman of the US Senate Banking Committee, later called it “sheer bribery” on national television. But it worked. With bipartisan support, a supposed “rescue” bill, the Garn–St. Germain Act, was quickly passed by the Congress and signed by Reagan.

  The real killer was the appointment of Richard Pratt, an industry lobbyist, as head of the Federal Home Loan Bank Board, the S&Ls’ regulator. Pratt proceeded to gut the regulations against self-dealing. For the first time, an S&L could be controlled by a single shareholder, could have an unlimited number of subsidiaries in multiple businesses, and could lend to its own subsidiaries. Loans could be made against almost any asset. S&Ls could now raise money by selling government insured certificates of deposit (CDs) through Wall Street brokers. The shakier the S&L, the higher the interest rates paid by their CDs, and the larger the investment banking fees.

  It was a licence to steal. The people running S&Ls started to play massively with other people’s money. They loaned money to themselves, they loaned money to gigantic property development projects that they owned, they loaned money to their relatives, they bought cars, planes, mansions, and assorted other toys.

  From 1980 through mid-1983, an operator named Charles Knapp ballooned a California S&L’s assets from $1.7 billion to $10.2 billion, and then kept going at an annual rate of about $20 billion until he finally hit the wall in 1985. When the government moved in, the assets were worth about $500 million. The Vernon Savings Bank in Texas ran its assets from $82 million to $1.8 billion in about a year. The owner bought six Learjets, and when the Feds finally looked, they found that 96 percent of its loans were delinquent. As late as 1988, 132 insolvent Texas S&Ls were still growing rapidly.

  Charles Keating was another S&L pioneer—an expert hypocrite, famous for being an antipornography crusader. He claimed that pornography was part of “the Communist conspiracy”, and made really awful films about the horrors of perversion for profit. The SEC had charged him with f
raud in the 1970s, but Keating was still allowed to take over a relatively healthy S&L in 1984. He quickly racked up $1 billion-plus in costs to the government, while making (or rather, taking) a fortune for himself. Keating played Congress and the regulators like a violin, fending off investigators with eighty law firms and the famous Keating Five—the five US senators he persuaded to help him, via $300,000 in campaign contributions. (They were Alan Cranston, John Glenn, John McCain, Donald Riegle, and Dennis DeConcini.) For $40,000, Keating hired Alan Greenspan, then a private economist, to write letters and walk around Washington, DC, with him, telling regulators about Keating’s good character and solid business methods. Noting Greenspan’s excellent judgement, Reagan later appointed Greenspan to be chairman of the Federal Reserve Bank. Keating was eventually sent to prison.

  Then there was Silverado, on whose board of directors sat Neil Bush, son of George H. W. Bush and brother of George W. Bush. Bush approved $100 million in loans to Silverado executives, and loans to himself too. Silverado’s collapse cost the taxpayers $1.3 billion. Neil Bush was sued by two US government regulators; he paid fines and was banned from banking but avoided criminal prosecution.

  There were many others. The US government established the Resolution Trust Corporation to take over bankrupt S&Ls and sell off their assets. The cost to the taxpayers was about $100 billion, which seemed like an enormous amount at the time.

  But there was one important regard in which the US system had not yet been completely corrupted. Although many perpetrators got away with it—particularly those who worked for major investment banks, law firms, and accounting firms—many did not. As a result of the S&L scandals, several thousand financial executives were criminally prosecuted, and hundreds were sent to prison. Altogether, the episode was a pointed, but in retrospect very mild, foreshadowing of the outbreak of massive financial criminality in subsequent decades.

  But it wasn’t just the S&Ls who partied hard in the 1980s. The investment bankers, leveraged buyout firms, lawyers, accountants, and insider trading people had a good time too.

  Indeed the first truly disturbing signal about deregulation was that the proudest names in American investment banking, law, and accounting had eagerly participated in the S&Ls’ looting. Merrill Lynch earned a quick $5 million by shovelling more than a quarter billion dollars in high-rate deposits into two S&Ls in the six months before they were shut down. The law firms that later paid multimillion-dollar settlements included Jones, Day, Reavis, and Pogue; Paul, Weiss, Rifkind; and Kaye Scholer. The accounting profession was just as bad. Ernst & Young and Arthur Andersen (later of Enron fame) paid especially big settlements for having allowed the S&Ls to fake their books; Ernst & Young alone paid more than $300 million. The total taxpayer cost, of course, was many, many times the recoveries.4

  But the real party was with the boys who played with junk bonds.

  Junk Bonds, Leveraged Buyouts, and the Rise of Predatory Investment Banking

  PRIOR TO THE 1980s, only a very few highly rated companies could raise capital by issuing corporate bonds. But years of research convinced an ambitious young man named Michael Milken that ordinary companies could also do so, and in 1977 he and his employer, the investment bank Drexel Burnham Lambert, began to underwrite bond issues for previously unrated companies. Interest rates were higher than in the blue-chip bond market but compared favourably with bank loans. Initially, the availability of so-called junk bonds was a useful service to midsize companies that needed capital for growth. But then things went crazy.

  What happened first was that predatory investment firms started to use junk bonds to buy companies. This often made financial sense, for two reasons. First, the stock market had fallen so severely, and often irrationally, that many public companies were cheap to acquire—if you had the cash, which the junk bond market provided. But the second reason for the junk bond boom was that many companies were grotesquely mismanaged by complacent, entrenched executives. Until junk bonds, they had nothing to fear, because they were supported by their equally complacent, entrenched boards of directors.

  But then, suddenly, there was a way to get rid of entrenched management, even if the board supported them. Someone could go to Michael Milken and, nearly instantly, raise billions of dollars on the junk bond market to finance a hostile takeover. In some early cases, this produced real efficiencies as incompetent managers were forced out by new owners. But then the financiers noticed two important things. The first was that once they took over a company, they could do anything they wanted. They could break the company up, sell off its pieces, cut employee benefits, pay themselves huge fees, and, quite often, loot whatever remained. They could also “flip” the company. Early in the leveraged buyout (LBO) cycle, the stock market was severely depressed. But as the market started to recover in the 1980s, it became almost trivial to buy a company in an LBO, cut some expenses, and take it public a few years later.

  William Simon, Treasury secretary in the Nixon and Ford governments, put up $1 million of his own money and borrowed another $80 million to buy Gibson Greeting Cards in 1982. Less than a year and a half later, with a stock market recovery under way, he took the company public at a value of $290 million. Ted Forstmann’s firm even more spectacularly bought and flipped Dr Pepper. The simplicity and profitability of the early deals led to a bubble, one that Michael Milken and his friends then perpetuated, of which more shortly.

  But the financiers’ next insight was much more fun. They realized that actually, they didn’t even need to buy the company, and then go through all the messy work of fixing it, running it, selling it. All they needed to do instead was to threaten to buy the company. In response, the company’s terrified, inept executives and board of directors would pay them enormous sums simply to go away. And thus was born “greenmail”. Michael Milken and Drexel’s junk bonds started to finance greenmail on a large scale, which was primarily conducted through specialized firms created by the likes of business magnates T. Boone Pickens, Ronald Perelman, and Carl Icahn.

  Milken and his junk bonds also financed a number of the most corrupt S&Ls, as well as the arbitrageurs, or “arbs”, who gambled on the existence and outcome of takeover battles. Of course, making money that way was a lot easier if you actually knew what was about to happen, so the rise of LBOs, greenmail, and speculative arbitrage also caused an epidemic of insider trading. People like Ivan Boesky developed networks of informants and paid serious bribe money for leaks; Boesky would then raise money through Milken, buy stock, and sell it as soon as the takeover was initiated or completed. Boesky made a fortune, but in 1986 the SEC and government prosecutors nailed him. He pled guilty, turned informant on Milken and others, and was sentenced to three years in prison.

  The first wave of junk-bond-backed LBOs was mostly good for the economy. But it didn’t take long for the early deals, plus recovery from the second oil shock, to push up share prices. This made the early LBOs look insanely profitable, which led to a new wave of LBOs, forcing share prices up even more. Then came greenmail and speculative arbitrage. In the rational, “efficient” world fantasized by academic economists, buyouts should have tapered off once share prices reached reasonable levels. In the real world, junk bonds created a bubble, both in the stock market and in the bonds themselves. The Decade of Greed, as it came to be called, lasted until the late 1980s. Once the hysteria broke, collapse rapidly followed. Milken tried to prolong the bubble by “parking” stock through secret side agreements, and by encouraging self-dealing. His clients would buy junk bonds for their company’s employee retirement plans, invest in junk bonds with money he raised for them, and so forth. Milken was indicted on more than ninety counts, pled guilty to six, and was sentenced to ten years in prison, fined $600 million, and banned from the securities industry for life. The fine left him still a billionaire, and he was released from prison after two years. He has since tried to rehabilitate himself through a series of charitable foundations, one of which is now a major source of funding for pro-
business academic economists.5

  The junk bond–LBO-takeover-greenmail-arbitrage craze of the 1980s was a key milestone in Wall Street’s metamorphosis from a tradition-bound enclave to the cocaine-fuelled, money-drugged, criminalized casino that wreaked global havoc in the 2000s. One major consequence of the LBO craze was to break down the traditional culture of investment banking. LBOs and related activities required lots of capital, particularly as the size of takeover deals increased to billions, even tens of billions, of dollars. They also were inherently driven by short-term, one-time transaction fees. So investment banks started to go public to raise capital, pay short-term cash bonuses, and abandon their quaint old notions of ethics and customer loyalty.

  The LBO boom also radically changed Wall Street’s compensation structures, in both structure and size. The bankers on LBO deals soon were paid a percentage of the deal, regardless of long-term results, and Wall Street salaries soared, as did incomes for the CEOs involved in LBOs, their law firms, their accountants, and their consulting firms. (For several years, Michael Milken was paid over $500 million per year.) It was the beginning of the shift towards the extraordinary inequality and financial sector wealth we know today.

  Financial Innovation, Derivatives, and the 1987 Market Crash

  THE BOOM ON Wall Street was accompanied by enormous growth in institutional stock portfolios and also by the first wave of the modern IT revolution, driven by powerful microprocessors and personal computers. The result was the rise of sophisticated computer-driven innovations in portfolio management.