Crashed

by Adam Tooze

  This was the script that the administration liked. A light-touch government intervention had enabled private business to take the lead. Nationalization had been avoided. As President Obama had promised, “[P]rivate capital” would be “fulfilling the core—core investment needs of this country.” But what this celebratory narrative glossed over were the more ambiguous implications of the exercise. The stress tests subjected the accounts of the commanding heights of American finance to intrusive scrutiny not by the public and the markets but by select teams of government bank supervisors. By the same token, they placed a seal of official approval on profit-driven private business activity. They were the model of a new regime of comprehensive, anticipatory oversight but also of entanglement between the American state apparatus and the big banks. This might be obtrusive and expensive in bureaucratic terms. It was onerous for those banks subjected to it. But it also conferred privileges, specifically the implicit promise that a bank that passed the stress test was deemed safe by the Fed and the Treasury. If it came to a crisis, a bank that had passed the test could hardly be denied assistance. Among this group of tightly regulated and closely supported entities, there could be no sudden and unforeseen failures. With that risk removed, it was significantly cheaper for such banks to issue shares and borrow money. One study estimated that in the wake of the crisis the advantage in funding costs enjoyed by the larger banks relative to their smaller peers had more than doubled, from 0.29 to 0.78 percent. For the largest eighteen US banks, this implied an annual subsidy of at least $34 billion.32

  III

  It was no surprise, therefore, that the markets liked the news. The banks were clearly in safe hands. With the implicit backing of the authorities, the banks finally stabilized. This bought time to think of longer-term solutions. The Obama administration could embark on the huge challenge of financial reform.

  The political stakes were high. By the summer of 2009 the White House badly needed a “win.” The stimulus was a dud in political terms. Health-care reform was facing relentless opposition. Financial reform as a political project was defined by the imperative to “get something done.” This forged an unholy alliance between Geithner’s Treasury and the West Wing’s political operatives headed by Rahm Emanuel. Apart from a pugilistic style and a shared fondness for the f-word, Emanuel’s and Geithner’s intensity and single-mindedness bent in opposite, but complementary, directions. For the political fixer Emanuel, all that mattered was getting “points on the board.” The content of financial reform was someone else’s problem. Conversely, for Geithner, with his suspicion of Congress, all that mattered was passing a piece of legislation that gave as little new power as possible to “populist” politicians and maximized the discretion and firepower of the expert regulators. To achieve this goal, however, the Treasury had to work through Congress, and in particular the two key committee chairs, Barney Frank in the House and Chris Dodd in the Senate. They also had to contend with key regulators like Sheila Bair of the FDIC. They had to channel the energy of campaigners, most notably Elizabeth Warren, the Harvard law professor and consumer rights activist, and fend off the ever present banking lobby.33

  The result was a sprawling piece of legislation running to 849 pages.34 Rather than offering a single coherent thesis, the Wall Street Reform and Consumer Protection Act, commonly known as Dodd-Frank, embodied a compendium of crisis diagnoses. Was the crisis due to mass predation of poorly informed borrowers? In which case what was needed was Elizabeth Warren’s Bureau of Consumer Financial Protection (Title X). Was it opaque over-the-counter derivatives that had blown up the system? In which case the fix was transparent, market-based trading of derivatives (Title VII—Wall Street Transparency and Accountability). Was it the breakdown of responsibility in the extended chains of mortgage securitization that poisoned the well? In which case securitizers should be required to have skin in the game (Title IX—Investor Protections). Was the sheer size of banks at the root of all the problems? Were they simply too big to fail? In which case the answer was to restrict bailouts and to make the industry pay for them (Title II—Orderly Liquidation Authority) and to cap banks’ further growth (Title VI, sections 622 and 623). Had investment banks used client money to gamble? If so, the thing to do was to reinstate 1930s-style divisions between commercial and investment banking by way of the so-called Volcker rule banning “proprietary trading” (Title VI, Volcker rule). All of these theories about the crisis of 2007–2009 had major political resonance. All of them made their way into the meandering text of Dodd-Frank. Many of them were sensible and worthwhile measures that redressed some of the grosser imbalances in the financial services industry. But in general they had little to do with the implosion of the wholesale-funded shadow banking system that actually brought down the house in 2008.

  The Treasury had a clearer view of the mechanics of the crisis. It wanted more capital, less leverage, more liquidity. And it wanted centralized powers in the Treasury and the Fed to deal with the next disaster. It spelled out this vision in a blueprint, which it issued in the summer of 2009.35 This was in many ways quite different from what emerged as Dodd-Frank. But that was not by accident. Many of the omissions were strategic. As Geithner unabashedly remarked, “[W]e didn’t want Congress designing the new capital ratios or leverage restrictions or liquidity requirements. Whatever their flaws, regulators were much better equipped” to decide those technical issues. “History suggested that Capitol Hill would be too easily swayed by the clout of the financial industry and the politics of the moment; we didn’t think that was the place for the intricate work of calibrating the financial system’s shock absorbers.”36 In other words, what the Treasury and the Fed knew to be the main drivers of the crisis were kept off the legislative agenda. What the Treasury did want Congress to provide were the legal powers that Geithner believed to have been lacking at the crucial moment in September 2008. If the challenge was to structure a more sustainable symbiosis between Washington and Wall Street, that was better done, in the Treasury’s view, by way of the administrative and regulatory state, rather than by way of congressional pitch battles.

  Though the Treasury sought to orchestrate a chorus of regulators behind its proposals over the summer of 2009, it soon realized that it would face dogged resistance from the FDIC and from within Congress. They shared a deep suspicion of the complicity of the Fed and the Treasury with Wall Street and the enhanced powers that Geithner was looking for. To ensure collective responsibility, Bair and Frank insisted that oversight over the entire system should be exercised not by the Treasury and the Fed alone but by a Financial Stability Oversight Council chaired by the Treasury but gathering together all the key regulators. The idea of crisis management by committee appalled Geithner. But the council, in fact, was given many of the powers that he wanted. It would have the right to designate systematically important institutions. Those could be placed under a regime of heightened supervision and regulation including regular stress testing. If a large bank was on the point of causing a systemic crisis, the council’s rights of managerial intervention were extensive. Ahead of time, all systemically important institutions would be required to prepare living wills mapping out how they should be resolved in case of bankruptcy. And this oversight and control could be extended to foreign banks operating in the United States.

  The Fed was pivotal to Geithner’s vision of future control. But in political terms it was a liability. To say that the crisis dented the Fed’s public standing would be an understatement. It polarized and in due course flipped the politics of the institution.37 In 2008 Bernanke, like his predecessor, Alan Greenspan, had been significantly more popular with Republicans than with Democrats. By 2010 he was almost equally unpopular with both, and on the right wing the drumbeat of the Tea Party was mounting. Meanwhile, for Obama, Bernanke was a token of the bipartisanship he craved. In August the president announced his nomination for a second term as Fed chair. Time magazine ended 2009 by naming Bernanke its man of the y
ear.38 But that did nothing to endear him to either the right wing of the Republicans or the left wing of the Democratic Party.39 December 2009 and January 2010 saw fierce clashes in the Senate over Bernanke’s reappointment. Desperate to rally support, the White House mobilized influential figures such as Warren Buffett to lobby on Bernanke’s behalf. To make matters worse, at the same time Bernanke himself was working the phones, struggling to stop Dodd’s Senate draft of the financial reform legislation from stripping the Fed of oversight over the largest banks.40

  In their effort to retain the Fed’s role at the heart of financial governance, Bernanke and Geithner were forced to make a pawn sacrifice. They conceded the formation of a separate consumer finance agency—Warren’s Consumer Financial Protection Bureau.41 It allowed the reform campaign to claim a major win. It drew the fire of lobbyists. And it was largely irrelevant to the vision of systemic stabilization that Geithner and Bernanke were pursuing. They could concede regulation of credit cards and consumer loans as long as they retained oversight over the banks with balance sheets greater than $50 billion. Indeed, consumer protection and macroprudential regulation might very well be at odds. As Larry Summers remarked to the president, the “airline safety board shouldn’t be in charge of protecting the financial viability of the airlines.”42 That was fair but it begged a further observation. Whereas there are plenty of safety agencies, there are, in fact, no agencies responsible for ensuring the financial viability of airlines or any industry other than banks. Airlines are expected to take care of their own finances. But Geithner and Summers preferred to sidestep the ramifications of that thought.

  In the wake of Lehman what preoccupied the Treasury most was the question of how a failing megabank could be safely contained. For Geithner there was no substitute for the combination that had finally stabilized the situation in October 2008—wide-ranging guarantee powers by the FDIC ideally in combination with general liquidity support from the Fed and recapitalization and ring fencing of losses orchestrated by the Fed and the Treasury. The crisis had shown the need to add well-resourced resolution authority for those banks that were beyond saving. But the mood in Congress was ugly and Sheila Bair was on the warpath. In the end Dodd-Frank embodied a severe rejection of the practices of 2008. There would be no more taxpayer-funded bailouts. The Fed could offer general liquidity support but was barred from offering facilities tailor-made for specific banks. In consultation with the president and the Fed, the Treasury was required to place failing institutions under the control of the FDIC. It would operate the bank as a going concern with a view to breaking it up and selling off the component parts. The one element of control that the Treasury preserved was that it would be responsible for funding the FDIC’s resolution, with the costs to be recouped after the crisis had passed by a levy on the financial industry. Bernanke and the Fed thought they could live with the deal. The Fed chair had always been unhappy with the ad hoc interventions he had had to make under the terms of section 13(3) emergencies. From Geithner’s point of view it was an alarming restriction. As ever, he turned to his favorite analogy between financial crises and national security: “The president is entrusted with extraordinary powers to protect the country from threats to our national security. These powers come with carefully designed constraints, but they allow the president to act quickly in extremis. Congress should give the president and the financial first responders the powers necessary to protect the country from the devastation of financial crises.”43

  For Geithner the “populist fury” of the “atonement agenda” was a dangerous distraction from the tough-minded technical business of addressing a crisis.44 But the grief and distress caused by the crisis were forces to be reckoned with. They ran through American society in waves, and early 2010, as Dodd-Frank reached a critical point in its labored passage through Congress, was one such moment. Three years since the real estate bubble burst, the full effects of the credit crunch and mass unemployment were making themselves felt. Between 2007 and 2009, 2.5 million homes had been foreclosed and the crest had not yet been reached. As 2010 began, 3.7 million families were more than ninety days past due on their mortgage payments. Millions more were struggling to make ends meet, one or two months behind on their payments. Over the next twelve months 1.178 million homes would slide into foreclosure, the worst year of the crisis. With prices still falling, ever more properties were sinking into negative equity. As one analyst remarked in early 2010: “We’re now at the point of maximum vulnerability. People’s emotional attachment to their property is melting into air.”45 In the worst-hit areas, such as Florida, fully 12 percent of properties were given up by their owners or seized by banks for foreclosure. Foreclosure proceedings were operating at such a pace that they were given over to quasi-automated legal processes that turned out to be ruinously flawed. In a nightmarish administrative and legal tangle, ever more victims were sucked into the crisis.

  The contrast in fortunes between Wall Street and Main Street was increasingly intolerable. The big banks had been bailed out. Some of the most unscrupulous bosses might face legal action, but they were not facing personal ruin. They retired to lifestyles of wealth and comfort.46 None had gone to jail. And those at the top of the tree on Wall Street were bouncing back apparently without shame or second thought. The bonus season in 2009 was better than ever, netting $145 billion for the executives at the top investment banks, asset managers and hedge funds, as compared with $117 billion in 2008.47 Goldman made $13.4 billion in profit for its shareholders and paid its own staff $16.2 billion in compensation and bonuses.48 Astonishingly, even Citigroup, which had a loss of $1.6 billion in 2009 and survived the year only due to government action, paid out $5 billion in bonuses. The bankers were happy to leave the past behind, but the American public was not. In the spring of 2010 Wall Street’s approval rating with the general public stood at 6 percent.49 And the regulators and their lawyers were finally catching up with the events of the last three years. On April 16, 2010, the SEC announced that it would be bringing charges against Goldman Sachs for misleading the investors to whom it had sold inferior quality mortgage-backed securities. The announcement unleashed a firestorm of indignation. Finally a really big name was going to have to face the music. To the embarrassment of the administration, Dodd-Frank was carried across the finish line not by the energy of the Treasury or the White House but by a new wave of popular fury.

  Emotions ran so high in the spring of 2010 that it took a coalition of Treasury, centrist Democrats and business lobbyists to block a last-minute effort to ban any banks enjoying an FDIC guarantee from engaging in derivatives trading of any kind. For the biggest banks this would have been truly costly. The resulting compromise “pushed out” only 10 percent of the least dangerous derivatives. Similarly, a last-minute proposal to address “too big to fail” by putting a cap on the total size of bank balance sheets was blocked in the banking committee by Chris Dodd and other “moderate” allies. One vital late amendment that did make it into the final law was the Collins Amendment of May 2010.50 Drafted behind the scenes by the FDIC, it demanded that whatever capital standards the Fed and the regulators set for the biggest banks should at least match the level required of the smaller FDIC-regulated banks. Bair wanted to roll back the favoritism shown to the big banks under the Basel II regime. She also wanted to ensure that capital standards applied to holding companies as well as commercial banking subsidiaries. The Fed and the Treasury resisted. They insisted that setting capital requirements was their regulatory prerogative. The banks screamed that the demanding new capital standards would force them to cut credit by $1.5 trillion. It came down to a struggle in the House and Senate reconciliation process, in which Senator Susan Collins and Bair prevailed with the backing of Dodd.

  IV

  The Dodd-Frank legislation that Obama signed into law on July 21, 2010, was hailed as the most significant act of regulation since the 1930s. Critics scoffed that it did not set a very high bar. It is easy to be cynica
l about a messy piece of legislation riddled with compromises and defined as much by what it left out as what it covered. And the incoherence became worse after the passage of the law. While the legislation was in Congress the bank lobbyists—conscious of how high emotions were running—had held back. As they well understood, passing the act was only the first round. Once the law was on the statute books and the argument over implementation began behind closed doors, they swarmed all over the legislation. Amid the inherent complexity of the subject matter, the rivalry between the regulators and the vociferous clamor of the lobbyists, implementing Dodd-Frank became a quagmire.

  All told, Dodd-Frank called on regulators and agencies to formulate 398 new rules for the financial sector. Each one became the target for no-holds-barred lobbying by interested parties, who could now operate outside the limelight of congressional debate. By July 2013, three years on from the passage of the law, barely 155 of the 398 required rules had been finalized.51 The highly controversial Volcker rule was a case in point.52 How to draw internal divisions inside banks to insulate client money from proprietary trading was a hugely technical and contentious business. Even with the best will in the world it was nearly impossible to draw a line between the actions of a bank in making a market for a client and trading on its own behalf. What emerged was less a “bright” regulatory line than a Rorschach blot. It took until December 2013 for the five agencies involved to agree on a wording of the basic Volcker rule, 1,238 days after Dodd-Frank was passed.53 The result was a 71-page document with an explanatory addendum that ran to a modest 900 pages. Banks were not so much told what to do as they were invited to demonstrate that they were not in violation of the rule. What exactly would constitute proof of compliance was a matter for further negotiation.54 The best advice the lawyers could offer was that it was up to banks to decide the level of “regulatory risk tolerance” they were comfortable with. After passing the law in July 2010 and issuing the “final” formulation of the Volcker rule in December 2013, 2014 began with a new round of discussions about the “guidance” that would be issued to explain those regulatory risks. The only thing that was clear was that it would generate enormous demand for compliance officers and corporate lawyers. As Jamie Dimon of J.P. Morgan famously griped, to negotiate the new “system,” a banker needed the services not only of a lawyer but of a psychiatrist too.55