by Nomi Prins
Lee Pickard, who headed the SEC’s trading and markets division from 1973 to 1976, and helped write the original net capital rule in 1975,65 later said, “The SEC modification in 2004 is the primary reason for all of the losses that have occurred.”66 It was a decision that helped spur the Second Great Bank Depression and that altered the credit landscape for big time investment banks in this way: Assume that an investment bank holding more than $5 billion in total assets owns $100 million’ worth of toxic assets. Under the old rule, it could have borrowed $1.2 billion against those assets. If the assets lost all of their value, the investment bank would have been out collateral for $1.2 billion. That’s a lot but still perhaps manageable. Instead, under the 2004 rule change, the bank was allowed to borrow $3 billion, increasing its potential loss almost threefold.
Investment banks such as Bear Stearns and Lehman Brothers went bust because they didn’t have enough substitute collateral behind the money they had borrowed. At the same time, their creditors wanted to be paid back. The credit problem that engulfed the overall economy would have been nearly two-thirds the size if leverage had remained at twelve times, instead of being upped to thirty times. As we know, the federal government, otherwise known as our tax dollars, saved Merrill Lynch.
The Bank Holding Company Bonanza
Another important problem that the pre 1933 banking system exposed was that when banks consolidated themselves as bank holding companies, they could buy all sorts of nonbanking companies. Some of the companies under the bank holding company umbrella were less stable than simple consumer oriented banks that only took deposits and provided loans. This precise problem was remedied by the Glass Steagall Act, which prohibited bank holding companies from owning other types of financial service firms.67 Glass-Steagall contained overall systemic risk by limiting the risk taking investment banks to a smaller, isolated category that could not merge and corrode the commercial banks. Today, Treasury Secretary Geithner is talking about having a single regulator, such as the Fed, contain systemic risk; instead he should resurrect Glass Steagall, which successfully did just that. “From the 1940s to the 1970s, only a handful of banks failed each year, usually as a result of insider abuse or fraud,” Bernard Shull and Gerald A. Hanweck wrote in their 2001 book on the history of the U.S. banking system, Bank Mergers in a Deregulated Environment.68
The Bank Holding Company Act of 1956 strengthened the intent of the Glass Steagall Act by legislating that bank holding companies, defined at the time as companies that owned two or more banks, could not acquire banks outside the state where they were headquartered and would be severely limited in their ownership of nonbanking firms. The Bank Holding Company Act also gave the Federal Reserve Board the power—and the responsibility—to approve or deny bank holding company applications. Today, a bank holding company is defined as a company that owns or controls one or more banks, or that holds 25 percent or more of a bank’s voting shares. Fed approval is also needed if a bank holding company wants to buy 5 percent or more of another bank or bank holding company, effectively, merging with that company.69 The Fed’s power to deny a bank holding company the right to form still stands, but it was not used in the years leading up to the Second Great Bank Depression.70 In fact, the Fed did not reject a single merger or acquisition application since October 2005.71 So much for using your power for good.
The Fed’s ability to decide the fate of a bank holding company is vital. When banks buy other businesses, their focus may be diverted to more speculative, easy money opportunities, to the detriment of the boring, yet stable, consumer deposit and loan business. Before the Bank Holding Company Act, bank holding companies—Transamerica, for instance—were involved in other financial services, such as insurance and real estate, and had even invested in commodities, such as fish packing.72 Banks throughout the country were similarly able to use customer deposits as capital or collateral to take on nonbanking investments. If those tertiary investments grew too risky, consumer deposits were imperiled.
Like Glass-Steagall, the idea behind the Bank Holding Company Act was simple. Risk is mitigated if banks aren’t allowed to buy anything and everything; clarity is fostered over the books of that bank, which makes regulation easier; and too much financial concentration (the “too big to fail” thing) is prevented from destabilizing the system.
You might say that the Bank Holding Company Act was too simple—and perhaps too smart—for its own good. Much of its intent was decimated less than three decades later by an increase in bank mergers in the mid 1980s, spurred by government intervention under Ronald “Government Is Not the Answer” Reagan.73
“Given the willingness of the U.S. government to underwrite takeovers, [the large number] of bank and thrift failures in the 1980s created choice acquisition targets for merging banks interested in new markets,” University of California economics professor Gary Dymski wrote in his 2002 paper The Global Bank Merger Wave.74 Similar (but bigger) government backed mergers occurred in late 2008 in a nominal attempt to stabilize the economy.
The restrictions put forth in the Bank Holding Company Act were substantially deregulated by the Riegle Neal Interstate Banking and Branching Efficiency Act of 1994 (IBBEA). The act allowed interstate bank mergers and led to even greater concentration among fewer power players in the banking industry. Five years later, of course, the Gramm Leach Bliley Act, in addition to decimating Glass-Steagall, negated the rest of the intent of the Bank Holding Company Act by allowing bank holding companies to again buy nonbank companies like insurance firms and just about anything else.
The Fed and the SEC, meanwhile, remained ill equipped to monitor the spate of bank mergers and the increasingly complex web of financial and other services and activities that banks pursued. Their authority and staffing levels remained on par with the much simpler and clearer banking functions that had existed for most of the middle part of the twentieth century. That’s assuming that with appropriate staff levels, they would have had the courage to contain Wall Street’s prowess and truly protect the public. And that, sadly, is a huge leap. Indeed, the Fed’s philosophy throughout the Second Great Bank Depression reeked of its pre-Great Depression negligence—only on an even larger scale. Therefore, it is becoming even more crucial for us to reinstate Glass Steagall, now more than ever, before the banking world can run the American economy through the ringer again and expect to be bailed out for the risk its structure, practices, and rules incur.
7
Bonus Bonanza
Let Wall Street have a nightmare and the whole country has to help get them back in bed again.
—Will Rogers, August 12, 19291
People take pay very seriously on Wall Street. I know this because I worked for investment banks for more than ten years. I didn’t start out making a lot of money—and I didn’t end with the multimillion dollar paychecks of those that stayed “in the game,” as they call it—but I quickly learned that what you make and how well you argue your worth to your bosses will determine your entire career in the industry. If you don’t act like you care deeply about what you make, you’re not going to be successful.
To be fair, there are whiffs of meritocracy. But Wall Street mostly measures its actors by propulsion, and money equals validation in a hyper competitive world. Money confirms your worth in the general pecking order of your firm and to the rest of the Street. To be super successful (which I wasn’t), you have to convince yourself that you are not only better than everyone else, but that you are entitled. Your status, which includes the internal politics of your rise, how the higher ups view you, and how the CEO views them, is tied to your total compensation, your Number.
You are always aware of your Number.
Around the time that bonuses are unveiled in late December or early in the New Year, depending on the firm, you’re told—well, not so much told as made aware—not to disclose your Number to anyone. This way, senior managers can control dissent among the ranks and avoid annoying conversations in which employees compar
e their pay. The Number is part of the strategy. The people who make the most money tend to be the best negotiators and are the ones in the right line of ascent. Your line of ascent shows up in your compensation. To make a fortune on Wall Street, it’s not enough to produce revenue for your firm. You have to be in bed with the right manager, and he (or she) in turn has to be in bed with the right manager in his (or her) line of ascent. Hitch your money shuttle to the right rocket at the right firm, and you, too, can touch super wealth and power.
But the value of money is fleeting. The financial world does not create anything beyond the temporary value that it extracts, which makes bonuses on Wall Street as ephemeral as they are extreme. A trader is as good as his or her last trade, the firm’s stock as good as its last quarter’s earnings and whether they beat or missed analyst expectations. On Wall Street, pay is based on the deals that closed that year, never mind whether the long term effects of those deals are ruinous. The money is already in your pocket; if not in cash, then in other forms of compensation. The bonus system is gluttonous in the short term and careless in the long term.
Life is a lot harder to stomach when you’ve lost your job and your retirement fund, and the IRS is auditing you, and then you hear that one or ten or twenty or a hundred people on Wall Street each bagged $10 million or more during what had been a horrific year for most everyone else. You can’t help but wonder just what the hell made these people God’s gift or why your tax dollars are subsidizing them, either directly, through federal bailouts, or indirectly, through the transfer of wealth they created. No one in Washington asked you or me whether we wanted to contribute to executives’ bonuses.
Beyond that, and I say this as a former bonus recipient, Wall Street doesn’t produce anything of lasting value. Transactions are fleeting and revenues are booked up front, regardless of how transactions turn out down the line. If a merger fails, so what? Investment banks collect fees when mergers are initiated, and they keep their millions even if the mergers turn out to be a terrible idea. The goal is very simple: make money. The goal is not to promote growth and economic welfare throughout the land.
People get paid for creating an illusion of value that is based on some ill defined notion or demand for a particular product, on assumptions, on internal evaluations, and on sheer spin. The more competitive and complex the financial industry became, the more firms had to find ways to extract money by creating increasingly complex securities and transactions. Plain vanilla securities, as they’re called, didn’t return as much to investors or make as much for Wall Street bankers at year’s end. It’s the same with any new consumer technology. When iPhones came out in June 2007, they sold at $499 a pop. Less than two years later, the original model went for $199. Apple needed something to get that $500-per item price back, so it came out with the iPhone 3G. In the same way, Wall Street always needs to create something new or to leverage or package something to the hilt to keep the money flowing.
My brother works as a trader for one of the largest pension funds in the country. He makes slightly more than the national median wage. But the Wall Street firms that supply him with financial services pay people up to ten times more than the median, even though his fund is their client. As the market and pension funds were melting in late 2008 through 2009, he was incensed to see that brokers from the bigger firms kept pulling up in Lincoln Town Cars. “Why can’t they take a cab or rent a car like anybody else from the airport?” he wondered. It was as if they were living in a tomb: a tomb with no newspapers or CNN. Of course, the brokers weren’t paying for the Town Cars—the pensioners were picking up the tab, without even getting so much as a “thank you.”
Few people begrudge Bill Gates or Steve Jobs or Michael Dell their wealth because it was generated on tangible achievements, on products and services that a vast number of people actually use and have a need for. An actor or an actress might get paid millions for a film, but at least the film has lasting life and entertainment value. The same goes for an obscenely paid football player. At least, he might produce a great moment that becomes part of the national culture. On a less public but equally important level, people all over the country build cars, teach kids, put out fires, and design homes. What they do has a lasting and necessary impact. Only a banker would say that about another banker.
From my own experience, I get far more fulfillment from writing an article than I did from convincing a client to do a trade, even if I believed the trade would benefit the client. But for the most part, transactions on Wall Street simply don’t provide any immediate benefit to most of the country. Pushing money around and extracting huge profits are not activities that make Americans better, safer, or even more entertained.
CEOs Dodge the Blame
Congress tends to mimic public outrage in the wake of financial scandals—although it doesn’t always find time for follow-through. No congressperson in recent years has more vehemently denounced the gluttony of once exulted executives than Congressman Henry Waxman (D CA), the former chairman of the House Committee on Oversight and Government Reform.
On March 7, 2008—a few weeks before the fall of Bear Stearns and six months before subprime loan problems would seem like a mole on an elephant compared to the effects of a full blown banking and economic crisis—Waxman summoned to Washington a trio of men who’d made a ton of money during the trippy times of the housing boom.
The motley three financial kings were Angelo Mozilo, founder and CEO of Countrywide Financial Corporation, and former chairmen and CEOs E. Stanley O’Neal of Merrill Lynch and Charles Prince of Citigroup.2 They had collectively sucked up more than $460 million in compensation from 2002 to 2006.3 The topic of the hearing was CEO Pay and the Mortgage Crisis.4 (It might have been more useful to call it Why Will All Three Companies Implode a Few Months from Now?)
Even as financial companies showed signs of impending failure—or, as in the case of Countrywide Financial, sat accused of committing outright fraud—their execs, from lenders to developers to bankers, were reaping extravagant compensation.5 (Waxman was pulling down somewhere between $150,000 and $165,000 annually for his public office, still better than the median American salary but hardly enough to cover the private drivers for the men who sat before him, whose dollars kept many a congressperson in office.)6
“The CEOs of the five hundred largest American companies received an average of $15 million each in the year 2006, and that was a 38 percent increase in just one year,” Waxman said, infuriated. The year 2006 was the pinnacle for bonuses, after which the subprime and credit balloons began to leak.
It wasn’t only the CEOs raking it in, of course. There were traders at some Wall Street firms who made as much as CEOs at others did. But in general, CEOs set their own standard, particularly when the economy goes south. Those financial titans who can’t even claim to have produced anything tangible are the biggest pillage culprits.
The anger at the hearings was almost palpable. Mozilo had already sealed a $4 billion deal on January 11, 2008, for Bank of America to acquire his flailing company.7 But during the years when he and the other two head execs sitting before Waxman had compiled their stash, stock in their companies had been buzzing. Mozilo effused to the committee, “From 1982 to April 2007, our stock price appreciated over 23,000 percent. As a result, earlier in this decade I received performance based bonuses earned under a formula based on earnings per share.”
It was as if to say, “So, why am I here?” The man had balls. Even with full knowledge of the true condition of the loans on his books, Mozilo felt compelled to give a shout out to capitalism. “You know,” he said, “the capitalistic system when not abused is a wonderful system, but when abused it is terrible.”8 Mozilo, like so many other moguls, cried abuse only when constraints were put on his money. He had whined about his downsized 2006 compensation package in an e mail that Elijah E. Cummings (D MD) read to the committee.
“Boards have been placed under enormous pressure by the left wing, anti business press and
the envious leaders of unions and other so-called CEO comp watchers,” Mozilo wrote. “I strongly believe that, a decade from now, there will be a recognition that entrepreneurship has been driven out of the public sector.”9 We now realize that any entrepreneurship driven out of the financial markets has left town on a stagecoach driven by someone like Mozilo, horsewhip in hand.
Mozilo shouldn’t have been concerned that the long term prospects for CEOs would wane. Historically, the “pressure” that made him feel uncomfortable tends to give way to continued excess. One step back. Two steps forward. This is particularly true when no meaningful systemic changes or restraints are put on the routine practice of getting paid up front for transactions that have long term impact.
Mozilo danced around the more important questions at the hearing, the ones regarding the plethora of abuses that were standard fare at his firm and that implicated Countrywide as a central player in the subprime component of the larger economic crisis. Back in November 2007, Senator Chuck Schumer (D NY) wrote a letter to the Federal Housing Finance Board warning its chairman, Ronald A. Rosenfeld, about the Federal Home Loan Bank’s $51 billion in cash advances to Countrywide that were collateralized by $64 billion in bad mortgages.