In a recent private conversation, a senior financial executive observed to me that Goldman Sachs executives have a decidedly mixed record when operating outside of Goldman Sachs. Referencing Jon Corzine at MF Global, Robert Rubin at Citigroup, and John Thain at Merrill Lynch as well as Mr Paulson, this executive commented that these men were trained to be traders and managers in a tightly structured universe, but not to think about large-scale structural and conceptual issues, or to deal with organizations far messier than Goldman. Whether this accounts for Paulson’s complacency, I do not know. But even in private meetings with his counterparts, and as late as mid-2008, Paulson was stunningly complacent about the oncoming crisis.
Paulson and Bernanke have thus far largely escaped the condemnation they deserve, perhaps out of gratitude for their unquestioned nerve and commitment once the acute crisis period began in September 2008. For the most part, I would not presume to second-guess the majority of their actions during those chaotic, psychotic, terrifying weeks of September and October 2008. But their prior and subsequent conduct is another matter. And even some of the decisions taken during the crisis period reveal an ability to be cool and careful when investment bankers’ interests, or their own, were at stake.
Bernanke was a lifelong academic who had never done anything else until appointed to the Federal Reserve Board in 2002. He clearly has excellent diplomatic and political skills, but he had never had any experience either as a banker or as a regulator prior to joining the Fed. He became chairman of the Federal Reserve Board only in early 2006, just as the bubble was peaking. During the crisis, Bernanke appears to have deferred to Paulson, and obeyed his orders, almost without exception.
Paulson certainly had very impressive experience, but also a slightly peculiar and somewhat unsavory career. He had a wholesome, all-American youth in small-town Illinois; he was an Eagle Scout, a football player, and a devout Christian Scientist. (In his frequently selective and self-serving memoir On the Brink, Paulson goes out of his way to defend his religion’s attitude towards medical care.) But in 1972–73, Paulson served as the personal assistant of White House counsel and domestic affairs assistant John Ehrlichman, another devout Christian Scientist, during the period when Erhlichman was working intensively to cover up his highly criminal activities in the Watergate affair. We don’t know what Paulson saw or heard at the office, but by early 1973 there was already clear public evidence that Ehrlichman had done some very nasty things, including running covert burglary and political sabotage operations and assisting in the Watergate coverup. Yet Paulson stayed in Ehrlichman’s employ. Under mounting pressure, Nixon forced his aide to resign in April 1973, and Ehrlichman was convicted of conspiracy, obstruction of justice, and perjury in 1975.
Paulson joined Goldman Sachs in 1974, worked very hard, and rose fast, becoming chief operating officer and then CEO in 1999, mounting a coup that forced out his predecessor Jon Corzine. Given Paulson’s background, it seems very difficult to believe that he had no sense of the increasingly dishonest, unsound nature of Goldman’s mortgage CDOs in 2004–2006, the height of the bubble. By the time Paulson left Goldman in May 2006, it had issued tens of billions of dollars of increasingly toxic mortgage securities, and had extensive dealings with several of the worst originators. It was only seven months after Paulson’s departure that Goldman started its Big Short.
Paulson also appears to have fully supported and in several cases championed Goldman’s, and his industry’s, many deregulatory efforts throughout the 1990s and the 2000s. These included repealing Glass-Steagall, banning the regulation of OTC derivatives, relaxing disclosure requirements for mortgage CDOs (via a joint letter to the SEC signed by Goldman and Morgan Stanley executives in 2004), relaxing the SEC’s leverage restrictions on investment banks in 2004, and continuing the Federal Reserve’s long-standing refusal to regulate the mortgage industry. As Treasury secretary, Paulson also lobbied to reduce the power and funding of the SEC.
As darkness gathered in 2007 and 2008, there was no serious attempt by Paulson or Bernanke to create a systematic monitoring process for the financial system—which, of course, would have been fiercely resisted by Mr Paulson’s former employer and others in the industry. In fairness to Paulson and Bernanke, they inherited a badly outdated and weakened regulatory system. But in significant measure, this was the result of their own deliberate actions to cripple it—Bernanke while on the Federal Reserve Board, then the Bush White House staff, and then finally as chairman of the Fed, and Paulson when he was running Goldman Sachs, which lobbied fiercely and continuously for ever more deregulation.
The combination of the industry’s incentives for secrecy or even disinformation, weak disclosure requirements, the progressive crippling of the regulatory system, and Bernanke’s and Paulson’s own ignorance and/or dishonesty was an extremely destructive cocktail. Indeed, one clear lesson from the crisis is that almost nobody in the financial sector had incentives to be honest or to warn the regulators—not those gaming the system, not most of those betting on its collapse, not even those who were about to collapse themselves. As 2008 progressed Paulson, Bernanke, and the whole world were repeatedly blindsided by developments that could have been predicted, and which in some cases (e.g., the collapse of the CDO market and of AIG) actually were predicted—especially by Goldman Sachs, the hedge funds betting against the mortgage market, and various economists. But precise assessment and management of these developments depended upon facts that Paulson and Bernanke never seemed to have. As the various narratives of the crisis make clear, Paulson and Bernanke generally had no more than two to three days’ advance notice of the impending collapse of major financial institutions including Bear Stearns, Lehman Brothers, Merrill Lynch, AIG, Washington Mutual, and Citigroup. The same was true of upheavals in the commercial paper market and money market funds. In most cases, these events could have been foreseen substantially earlier.
The further consequence of Paulson and Bernanke’s willful information vacuum was that they did virtually no planning for, or analysis of, what would happen if major firms did fail. For example, when Lehman Brothers went bankrupt, neither Paulson nor Bernanke was aware that British and Japanese law required that the assets of Lehman’s local subsidiaries be frozen, preventing Lehman’s clients from retrieving their money. Nor did they understand that Lehman’s bankruptcy would have immediate, major effects on commercial paper markets and money market funds that held large amounts of Lehman’s short-term debt.
Their lack of preparedness was worsened by the utter incompetence or inexperience of many senior administration personnel. Christopher Cox, the chairman of the SEC, was a former corporate attorney and Republican congressman with no previous experience either in financial services or as a regulator. He also had significant health problems during the late bubble period, having undergone cancer surgery in January 2006. Cox had gutted the SEC’s risk monitoring and enforcement organizations, which did not file a single lawsuit related to the mortgage bubble under his chairmanship. But he was far from alone.
In my film I show selections from my interview with Frederic Mishkin, who was one of the seven members of the Federal Reserve Board from September 2006 through August 2008. (Or rather, one of the few members of the board; during much of the crisis period, two and sometimes three of the Fed Board seats remained vacant.) Mishkin resigned effective 31 August 2008, two weeks before the collapse of Lehman, Merrill Lynch, and AIG, and one doesn’t know whether to be outraged or grateful. His record is a stunning litany of judgement errors and occasional hocus-pocus, ranging from his paid boosting of Icelandic banks in 2006 to his being unaware of the high credit ratings still enjoyed by major banks on the brink of their collapse in September 2008.
In July 2007 Paulson recruited David McCormick, whom I also interviewed for my film, from the White House staff to become the Treasury Department’s undersecretary for international affairs. It was a very odd choice, perhaps designed to ensure that Paulson faced no competition in the int
ernational arena. I have known David McCormick, slightly, for a long time, although we haven’t talked since the release of my film Inside Job (which doubtless made him quite unhappy). David is an intelligent, accomplished man who studied engineering at West Point, served in the first Persian Gulf War, and then had a very successful business career, first in consulting and then in the software industry. In the Bush administration he likely spent too much energy averting his eyes from everything in front of him, but I think that David is basically a decent, thoughtful guy.
But was David McCormick the right guy to be the Treasury Department’s undersecretary for international affairs during the worst financial crisis since the Great Depression? No way. David had no experience with international finance, very little international experience of any kind (outside of the Persian Gulf), and had never worked either in a financial institution or at a financial regulator. Here are some excerpts from our exchanges about Lehman and various international issues related to the crisis.
CF: I have to say that I was rather surprised when Christine Lagarde told me that she didn’t learn about Lehman’s bankruptcy until after the fact.
MCCORMICK: That’s probably right. She probably learned about it Monday, or maybe Sunday night. So, typically, it’s typically not the case that, when you’re debating the pros and cons of different policy options within one government, that you necessarily are going out and sharing the internal thinking with another government.
CF: Were you aware at the time that bankruptcy laws were different in other parts of the world, and that in other parts of the world, in particular in England, Lehman’s bankruptcy meant that London accounts would be frozen and people wouldn’t be able to trade?
MCCORMICK: You know, there may have been people involved in the specifics of the transaction that were aware of that; I was not aware of that.
It also seems that Paulson kept McCormick out of the loop:
CF: My understanding . . . is that Barclays was willing to do the transaction [to purchase Lehman Brothers], but only if it first of all got approval from British regulators, and secondly got a guarantee for something on the order of $30 billion worth of Lehman debt, that was, Lehman assets, which were thought to be very questionable, and in fact proved so, and that the FSA [UK Financial Services Authority] declined to approve the transaction because Secretary Paulson and Chairman Bernanke would not provide the guarantee for the Lehman assets. Correct?
MCCORMICK: I don’t know the facts on that.
CF: You were not involved in that.
MCCORMICK: I was not involved in that.
CF: So even though you were the international guy—
MCCORMICK: I was not the intermediary to Barclays.
CF: Or to the FSA?
MCCORMICK: Or to the FSA on that.
CF: Oh, really?
MCCORMICK: No. I’m sorry, I just don’t know factually what the answer is.
But whatever their shortcomings, at least Paulson and Bernanke were completely focused on avoiding the collapse of the system once the crisis began. The same cannot be said for everyone else. Consider, for example, John Thain, someone else I have known slightly for many years. Thain had been Goldman Sachs’s president and co-COO until 2004, then CEO of the New York Stock Exchange. Thain became CEO of Merrill Lynch in November 2007, replacing Stan O’Neal after O’Neal took his $161 million in severance payments.
While making my film, I spoke frequently and in detail with Thain, who agreed to talk to me on the condition that our conversations remained off the record. Without going into details, I can say that John was not big on accepting personal responsibility—not for Goldman Sachs’s behaviour in the Internet bubble, not for Goldman’s massive lobbying for deregulation, and not for the failure of FINRA (which until 2007 was under contract with the New York Stock Exchange, of which Thain was then CEO) to do anything whatsoever about investment banks’ conduct during the bubble. But it was John’s behaviour at Merrill that was perhaps most revealing, not just about him but about banking culture generally. Before starting at Merrill, Thain obtained a $15 million cash sign-on bonus and a first-year compensation package that would have given him over $80 million if Merrill’s share price had recovered. But, of course, Merrill’s stock didn’t recover, since Merrill proceeded to lose almost $80 billion during the crisis.
John was one of the CEOs summoned by Paulson to meet at the New York Fed over the weekend of 12–14 September 2008—the meetings at which Paulson tried and failed to find a rescuer for Lehman. There were two potential buyers: Barclays and Bank of America. But with Lehman’s obvious collapse, and with Paulson telling him directly to look for a buyer, John saw the handwriting on the wall. By accounts, he excused himself from the meeting to make a phone call—without telling Paulson what he was doing. John’s phone call was to the CEO of Bank of America, and pretty soon BofA was no longer interested in Lehman. This may have sealed Lehman’s fate, since Barclays was prevented from buying without the approval of British regulators—who refused it.
Less than forty-eight hours later, John had signed a definitive contract for the sale of Merrill Lynch to Bank of America. That contract, even though negotiated and drafted faster than any comparable acquisition in history, was very carefully constructed so that Merrill, and John Thain, retained control over the payment of bonuses until the acquisition closed in January 2009. Then, one month after Merrill’s acquisition and Lehman’s bankruptcy, on 13 October 2008, Henry Paulson summoned the CEOs of America’s nine largest banks, once again including John Thain, to a secret meeting in Washington, DC. Paulson ordered them to accept $250 billion in emergency capital funding, both to strengthen them in reality and to reassure the public. Thain had only one concern, and he asked Paulson about it: would this affect their freedom to award bonuses? The answer was no.
Then, in December, Thain actually awarded those bonuses—two months early, in order to guarantee that they would be paid before Bank of America took control. Despite the fact that Merrill had already lost about $50 billion, the bonuses totalled nearly $4 billion in cash, heavily concentrated at the top. Over seven hundred people received bonuses exceeding $1 million each, and several were in the tens of millions. John had asked for a $10 million bonus for himself, which was refused. The bonuses could not have been paid without the kind assistance of Mr Paulson, because without US government aid, Merrill (and Bank of America, for that matter) would have been bankrupt. I asked John about the ethics of awarding such bonuses to people who had just caused tens of billions of dollars in losses, not to mention a world-historical financial crisis. His answer did not impress me.
A month later—in January, as usual—the rest of the investment banks announced their bonuses, which totalled about $19 billion. Paulson and Bernanke had neglected to attach any conditions or compensation limitations to their assistance to the financial sector, which by that point totalled hundreds of billions of dollars. They also had neglected to take any steps to address the rapidly rising tide of mortgage defaults, foreclosures, home repossessions, and unemployment. Their job was banks, not people.
CHAPTER 6
* * *
CRIME AND PUNISHMENT: BANKING AND THE BUBBLE AS CRIMINAL ENTERPRISES
AS ALL BANKERS (INCLUDING crooked ones) will readily tell you, there is nothing more important to the health of the financial system than trust and confidence.
It is therefore all the more disturbing that, since deregulation, no other major industry has broken the law so often and so seriously—behaviour, moreover, that is now rarely punished. For the last quarter century even highly criminal behaviour has typically resulted at most in civil settlements in which the institution admits nothing, promises not to do it again, pays a fine—and then promptly does it again. Rarely are individual executives even sued, or fined, much less criminally prosecuted. The fines are generally trivial, a minor cost of doing business, paid by the institution, or frequently, by insurance. Thus, while the housing bubble and financial crisis contain the
largest and most recent episodes of financial sector misbehaviour, they are far from isolated.
Obviously there are many honest bankers, and even through the bubble and crisis the majority of all banking transactions were performed properly. People still deposited their salary, paid their bills, used their credit cards; companies issued shares and bonds. At the same time, however, there has been a sharp increase in organized, high-level fraudulent behaviour across a wide array of financial markets, ranging from consumer lending to high-end institutional trading. This now occurs on such a large scale, and with such frequency, that it can no longer be dismissed as aberrant or exceptional. It is no exaggeration to say that since the 1980s, much of the American (and global) financial sector has become criminalized, creating an industry culture that tolerates or even encourages systematic fraud. The behaviour that caused the mortgage bubble and financial crisis was a natural outcome and continuation of this pattern, rather than some kind of economic accident.
It is also important to understand that this behaviour really is criminal. We are not talking about walking out of a store absentmindedly and forgetting to pay, or littering, or neglecting some bureaucratic formality. We are talking about deliberate concealment of financial transactions that aided terrorism, nuclear weapons proliferation, and large-scale tax evasion; assisting in major financial frauds and in concealment of criminal assets; and committing frauds that substantially worsened the worst financial bubbles and crises since the Depression.
Inside Job Page 17