by Nomi Prins
The SEC is supposed to regulate all public companies and ensure the integrity of their books. That’s its job. The problem is that ensuring integrity in a den of iniquity is a tall order. When the market is good, it makes regulatory bodies complacent, and when the market is bad, they suddenly have to scramble to take care of the inevitable jump in cases. Either way, life is never easy for the SEC, which is why it needs to step up to regulate better, not step aside in complacency or make postcrisis promises.
In 2001, the SEC had a spending authority of $423 million dollars. The figure was bumped up to $716 million in 2003, following the Enron and WorldCom scandals, and it reached a high of $913 million in 2005, where it remained, more or less, through the financial crisis of 2008-2009.36 Despite slight budget increases, the number of staff members fell substantially between 2005 and 2007, in the middle of the housing boom, record Wall Street profits, and the buildup of leveraged debt.37 Indeed, just as the SEC had done pre Enron, it lagged behind the ball and lost staff during a period when things “looked” good.
By the time it was necessary to study what the leveraged subprime securities market had done to the banking industry, there weren’t enough people working at the SEC to deal with it. Shapiro’s first request in 2009 was for resources and support, “to investigate and go after those who cut corners, cheat investors, and break the law.”38 The SEC’s philosophy continues to be, better late than never.
That’s how you fall prey to Wall Street deflection tactics. Take Goldman CEO Lloyd Blankfein saying on September 21, 2008, “When Goldman Sachs was a private partnership, we made the decision to become a public company, recognizing the need for permanent capital to meet the demands of scale. While accelerated by market sentiment, our decision to be regulated by the Federal Reserve is based on the recognition that such regulation provides its members with full prudential supervision and access to permanent liquidity and funding.”
He was talking as if Goldman Sachs wanted regulation. What the firm happened to need was money, and it was scared stiff of suffering the fate of Lehman Brothers, so it decided to simply become a regular bank for a short while: “We believe that Goldman Sachs, under Federal Reserve supervision, will be regarded as an even more secure institution with an exceptionally clean balance sheet and a greater diversity of funding sources.”39
Four and a half months later, the firm took it back. “Operating our business without the government capital would be an easier thing to do,” Goldman CFO David Viniar told a Credit Suisse Group conference in Naples, Florida. “We’d be under less scrutiny and under less pressure.”40
On April 13, 2009, having passed the government stress tests—as if it had any chance of not passing—Goldman Sachs was proud to announce “[an] offering of $5 billion of its common stock for sale to the public. . . . After the completion of the stress assessment, if permitted by our supervisors and if supported by the results of the stress assessment, Goldman Sachs would like to use the capital raised plus additional resources to redeem all of the TARP capital.”41
Okay, go ahead and laugh. So, they want to pay back $10 billion in TARP to be under less scrutiny, yet they are going to sit on the $12.9 billion they got from the AIG bailout, the almost $30 billion of cheap debt they raised under the Temporary Liquidity Guarantee Program (TLGP), and the approximately $11 billion they still have available under the Fed’s Commercial Paper Funding Facility LLC (CPFF).42
See? For every flip, there is always a flop. Whenever an advantage presents itself, a Wall Street exec will grab it—even if it means contradicting what he just did yesterday. Success on Wall Street is defined by figuring out how to creatively bend the rules in order to squeeze more money from clients, investors, and the world. So, why would you trust Wall Street to create the rules in the first place? Even the bonus payouts that caused such duress to Congress were cloaked in new disguises to avoid detection.
For instance, American Express CEO Ken Chenault received $26 million in compensation in 2007, including $1.24 million in salary, $6 million in bonus cash, $6.5 million in stock awards, $8.3 million in options, and approximately $4 million in other forms of compensation. For 2008, he certainly toed the public line and received zero in cash bonuses, but he still made more than in 2007—ready for this?—$27.3 million, including $1.25 million in salary, $10.13 million in stock awards, $8 million in option awards, and $6.1 million in nonequity incentive plan compensations, plus $1.8 million in other forms of compensation. 43 On January 9, 2009, American Express received $3.39 billion in TARP money.44
It’s Obvious We Need Better Regulation
Identifying the villains makes us feel better. And when they are imprisoned or fined or fired, many of us take comfort: there is justice in the world after all, we think, and maybe this time things will change. But let’s be honest: 2008 is the new 2001, just as in 2001 Enron was the new savings and loan (S&L) scandal. When the underlying conditions remain, and those underlying conditions encourage excess, then the same basic problem will keep coming back with a new face.
Every period of scandal has its villains. This time around, Bernie Madoff heads a whole new pack of them. But their prison terms don’t change the system in which they operate. Besides, as much as federal prosecutors want their public pound of flesh, many of these executives were merely operating along gray lines—legality, ethics, and morality aside—and keeping up with the Joneses. Self entitled excess can’t be simply chalked up to greed. In the dog eat-dog world of Wall Street and Corporate America, excess symbolizes competitive advantage and pedigree within a select pecking order. But rather than pointing fingers, we need to do the harder work of reconstructing a better, more stable financial system. On top of that, several important reforms are needed that must work simultaneously.
We need to put all derivatives, $684 trillion of them in whatever their forms, on regulated platforms.45 We should not do it in the way that Wall Street has suggested and Treasury Secretary Geithner has echoed, which is to regulate only the ones that are already easiest to understand and have the least built in profits. No, we need to outlaw all over the counter manifestations of these products as well. It is always suspect when Wall Street agrees to do something, because it’s usually to avoid a harsher and more necessary regulation later. And to find a more secretive ploy to making money.
On October 31, 2008, even before the ink on their TARP checks was dry, sixteen major banks, including major TARP recipients Bank of America, Merrill Lynch, JPMorgan Chase, Morgan Stanley, Citigroup, Goldman Sachs, and Wachovia, wrote a letter to Tim Geithner, then president of the Federal Reserve Bank of New York.46 In it, the group committed to use a warehouse for credit derivatives, which would basically act as a clearinghouse that would process payments, the terms of derivatives, and credit events (a company or a package of loans defaulting). In other words, it would provide the red tape.
Those major dealers committed to having a central cash settling of contracts by November 30, 2009, such that a full “96% of settlement volume on electronically matched transactions across market participants [will be] settled via TIW [Trade Information Warehouse] and CLS.”47
On the surface, this seems like a good thing. Regulators and members of the futures industry convened before the House Agriculture Committee to debate the regulation of credit default swaps (CDSs) and other derivatives in early February 2009.48 They reviewed a related draft bill, the Derivatives Markets Transparency and Accountability Act of 2009.49
The proposed act suggested that over the counter, or OTC (that is, privately traded), derivatives be subject to reporting rules set by the Commodity Futures Trading Commission. The commission would also determine which OTC agreements could “disrupt the market,” and therefore open up a wide interpretative gap as to which ones counted.50 So, the lobbyists prevailed. The act did not make every OTC agreement subject to mandatory transparency or regulation, meaning that Wall Street will figure out a way to make money and keep certain agreements hidden.
Lobbyists
were also against provisions that would make it illegal for market participants to use naked CDSs (CDSs for which they had no exposure to the underlying security), for fear that this would keep banks and other investors out of the market. They were dead set on this.
“This provision would cripple the CDS market by making investment capital illegal and removing liquidity providers,” warned Stuart J. Kaswell, the executive vice president and general counsel of the Managed Funds Association (MFA), in his testimony.51
Proponents of CDS regulation included various smaller corporate entities and their lobbyists, such as the National Cotton Council of America of Cordova, Tennessee, represented by Gary Taylor, CEO of Cargill Cotton Inc. He argued that speculative investment funds and OTC transactions “disrupted the futures and markets of energy and agriculture commodities.” He called for setting limits on hedge fund traders.52 The cotton industry could claim legitimate need for derivatives to hedge its risk of certain crops not paying off, because it is subject to the weather and other external factors. It might make those markets a little less fluid, but that also means they’ll be less volatile. And you know that if the members of a market want regulation, it’s entirely necessary.
But it’s unfair that certain financial firms can trade the same derivatives without constraints and have no responsibility to provide cotton, no matter what external conditions are like. The problem is that when you have various interests gaming the markets for their own reasons, you create too many ways for certain groups to profit and others to be impaired. The solution is that anyone trading a derivative should do so because it’s attached to a legitimate business purpose, beyond simply making money, or there should be a clearer line between investment banks that do so on behalf of their clients as opposed to only for their trading books.
Some Solutions
1. Don’t Let Risk Lurk Off the Books
We need to remove any off-book means of hiding debt, something that we were all so horrified about during the Enron days. This means getting rid of structured investment vehicles (SIVs) and all of their manifestations.
These SIVs are a way to hide debt legally and have no other legitimate purpose, yet there is no discussion about eliminating them. Whatever future name Wall Street may concoct for places to hide debt or losses off book, regulators should simply have a blanket retort: “You can’t do that.” Done.
2. Don’t Let Investment Banks Be Bank Holding Companies
There is a big structural problem in letting any firm become a bank holding company (BHC). When firms such as Goldman Sachs and Morgan Stanley were approved by the Federal Reserve Board to become BHCs on September 21, 2008, they exposed the federal government’s true gullibility and desperation.53 The change in designation instantly enabled these companies to draw on a wider government and taxpayer safety net, and all they had to do was “volunteer” for more regulation from the government.
But it is naive to think that this means they will be subject to stricter regulatory oversight. As I mentioned earlier, the Gramm-Leach-Bliley Act stealthily inserted an all encompassing definition for what a financial holding company (FHC) is, broadening the one in the 1956 Bank Holding Company Act to include any firm that is “financial in nature” or “incidental to such financial activity” or “complementary to a financial activity and does not pose a substantial risk to the safety or soundness of depository institutions or the financial system generally.”54
This designation includes almost any financial firm. As FHCs, financial firms will get to do everything they were already doing before they attained that status. Furthermore, as BHCs, they also have access to more federal support. And given that the firms converting to BHCs had a minimum of two years to comply with BHC rules (meaning two years to crush these rules), those firms brought under the protective umbrella of the federal government will continue to reap bailout money and loans, propelling an inherently risky system.
Meanwhile, remember that Goldman Sachs announced on April 13, 2009, that it was going to raise its own money to pay back the $10 billion that it took from TARP. CEO Lloyd Blankfein even went on National Public Radio’s popular show All Things Considered to discuss his intent, telling NPR’s Robert Siegel, “I will tell you precisely when Goldman Sachs gives its money back: as soon as we are able to, while still being able to perform our functions in the capital markets systems subject to the approval of our regulators.”55 How damn mercenary of him. But he conveniently mentioned nothing about the other $54 billion in government assistance. 56 And, sadly, he wasn’t asked to. He did acknowledge public anger over Wall Street bonuses. “I’ll accept the premise that the numbers, in the benefit of hindsight, of course, look much too high, because today they’d never be those numbers,” Blankfein said. “Because today, people aren’t creating that kind of value. So it’s almost a foreign thought that we ever could have been in that world.
“But let me transport you back to 2005, 2006. In those years, Goldman Sachs actually had issues retaining our talent,” he said defensively.57
3. Don’t Nationalize Risky Banks, Break Them Up
The debate over nationalizing banks by having the government take them over until stability is achieved, or creating bad banks as a kind of holding pattern for toxic assets to be separated from the rest of a bank’s books, got a lot of play during the Second Great Bank Depression. But the government had already poured trillions of dollars into the backing of, or lending against, bad assets from these banks. And it had purchased substantial stakes through preferred or common shares in them. Some people believe that the next logical step is for the government to simply run the banks. Not only do I think this idea of nationalizing the banks (if they remain structured as they are) is dangerous, the underlying decision to capitalize the banks’ bad assets (the crux of all of the federal bailout plans) was terrible.
Most of the discussions avoid the fundamental problem: banks should not be constructed as they currently are. They should be separated into commercial and speculative entities. Otherwise, nationalization attempts would entail taking on huge risk and potential losses, rather than simply backing consumer oriented or public good- oriented banking functions. Therefore, to nationalize effectively would require breaking up the banks first. To contemplate the idea without this consideration is asking for the government to take on a possible bottomless pit of loss.
As for creating a “bad bank,” we should resist taking on the toxic assets of the entire banking industry at all costs. Not only because there is no clear way to evaluate these assets, which are merely estimates from a host of self interested parties—those selling them and others who might buy them on the cheap—but because the toxic assets are tied to substantial amounts of borrowing or leverage. If you take on the asset, you take on that leverage, and that could be an incredibly costly exercise. Again, it would be better for all of those former free-market advocates in the industry and the government to separate the banks into consumer and speculative companies. Then the government could back the consumer ones. Let the toxic assets stay on the books of the speculative firms; some will implode, some will survive. That’s the thing about free market capitalism. Let it happen. Plus, why would you nationalize—that is, have a government take over and run—something you can’t quantify? These institutions aren’t simple deposit and-loan banks, as Glass Steagall’s survival would have rendered them. They are convoluted cesspools of seething risk. If we do nationalize, it should be limited to the consumer related parts.
On January 26, 2009, David E. Sanger of the New York Times noted that “privately, most members of the Obama economic team concede that the rapid deterioration of the country’s biggest banks, notably Bank of America and Citigroup, is bound to require far larger investments of taxpayer money.”58 When he wrote the piece, those two banks had already sucked in $509 billion from us taxpayers.59
Sanger didn’t comment on how dangerous it is to fund the destruction of “too big to fail” entities. Besides, the idea of “investment” keeps
getting mixed up in the press and in D.C. with the word nationalize. The terms nationalization or partial nationalization had been batted around by members of Congress, such as House speaker Nancy Pelosi (D CA), who disclaimed it almost as soon as she mentioned it in an interview on ABC’s This Week in late January 2009. “Well, whatever you want to call it,” said Ms. Pelosi, “if we are strengthening them, then the American people should get some of the upside of that strengthening. Some people call that nationalization. I’m not talking about total ownership,” she abruptly added.60
As if capitalizing banks, which is what the government is doing, and running them are somehow equivalent. On the back of that debate, Newsweek ran a cover on the February 16, 2009, issue stating, “We Are All Socialists Now.”61 The idea was that banks want help from the government when they screw up and no oversight when they’re raking it in. And the government merely runs in and complies.