Confidence Men: Wall Street, Washington, and the Education of a President

by Ron Suskind

  “Goldman wrongly permitted a client that was betting against the mortgage market to heavily influence which mortgage securities to include in an investment portfolio,” said Robert Khuzami, the head of the SEC’s enforcement division, in a written statement on April 13. Goldman, as expected, denied any wrongdoing.

  But a match had been struck. The company’s stock plummeted. In the first half hour after the SEC’s suit was announced, the company’s share price dropped more than 10 percent, wiping out over $10 billion of Goldman’s market value.

  As his former employer was sucked into a prosecutorial vortex, Gary Gensler was thinking of gazelles. They were part of a favorite “way the world works” metaphor—one that Summers and Geithner and other old friends had often heard. “The way Washington works is you often start with what’s optimal, a best solution to some complex problem, and, surprisingly, there’s often quite a bit of bipartisan consensus on what will actually work, at least in private. That’s your herd of gazelles. But you’ve got to get them across the savanna safely, to a distant watering hole. And the longer it takes, the more you lose. You may end up with very few. You may lose them all. Because there are predators out there, lions and tigers, packs of hyenas, and they’re big and fast and relentless—considering how any significant solution to a big problem is bound to be opposed, do or die, by some industries or interests who’d figured out a way to profit from the ways things are, even if they’re profoundly busted, and often because they’re profoundly busted! So that’s your challenge: see how many gazelles you can get to the watering hole.”

  The Goldman prosecution, he was thinking, might turn the tide. Something had to. He’d been losing gazelles for four months, since the House passed a version of financial regulation that included significant loopholes for end users of derivatives.

  Those loopholes themselves were victories for the financial lobby. In the Senate it was bound to get worse.

  After his girls knocked off, Gensler trolled the financial filings of the large investment banks night after night. He, of course, could read a balance sheet; he’d overseen the drafting of enough of them. Goldman’s balance sheet was generally considered a work of accounting arts—some would have said dark arts.

  Back in mid-December of 2009 he’d found something that surprised him: Morgan Stanley’s filing to the SEC for its third quarter, which ended September 30, had a notation about the company’s over-the-counter derivatives portfolio. There it was, on page 139: only 40 percent of the bank’s OTC derivatives were collateralized.

  After the September crash, the estimations were that the major banks were demanding from one another sufficient posted collateral to back up their swap positions. Uncollateralized OTC derivatives, in the form of CDOs, were, after all, what got AIG in trouble. When the values on the CDOs plummeted, Goldman and JPMorgan made collateral calls on AIG. After making several payments, the insurer—which had not initially set aside sufficient capital—ran out of cash. A chain reaction ensued in which many financial institutions had swap obligations with one another that had, as well, been uncollateralized—they owed collateral, and needed to come up with it, and were owed. Geithner’s justification for paying 100 cents on the dollar for AIG’s swaps was to stem that panic, rather than, as some later suggested, to try to unwind the insurance-like swaps that linked banks in a disastrous daisy chain. In the backroom dealings on derivatives reform, the banks were stressing that they’d learned their lesson, that they didn’t need the great dark pools of OTC derivatives to be forced onto clearinghouses—which demanded sufficient collateral and were themselves backstop trades. Morgan seemed to accidentally undercut such assurances with this tiny notation. The result: nearly 60 percent of Morgan’s $80 billion–plus derivatives book was uncollateralized—an exposure of roughly $55 billion.

  Gensler did a bit more research, feeling like he was back being a young executive for Goldman, digging through financial filings. Come January, he had a “deliverable” for his ex officio role of deciphering complex trading issues for Summers and, less frequently, Geithner. He had discussed with both men Volcker’s suggested ban on proprietary trading by banks; both remained quietly opposed. And in the months since Obama’s meeting with Volcker and Wolf, both had succeeded in bringing up logistical issues about how such a rule might be implemented—it was, indeed, complex—and so had successfully “slow-walked” it almost to a dead stop. Obama, otherwise occupied, again didn’t follow up on the matter, which was turning into a smaller version of the previous spring’s Citibank breakup scandal—a presidential decision slowed to oblivion—and no one the wiser.

  What resurrected, of course, was external necessity, Volcker’s proprietary trading in the wake of Scott Brown. As the president groped for a narrative, as he’d told staffers darkly, he reached back, not surprisingly, to the campaign and summoned Paul Volcker to stand behind him at a press conference on January 21—Summers and Geithner standing sheepishly nearby—to announce the he had heeded that “tall guy” and would push for a ban on proprietary trading. With Volcker behind him—as done to such winning effect during the campaign—Obama dubbed the provision “the Volcker Rule.” Then, like the rest of financial reform, “he staffed it out,” according to one senior financial regulator.

  Geithner’s and Summers’s positions didn’t change. For Summers, as he’d revealed to Wolf the previous fall when the president said he wanted to do this, it was personal, a lone victory for his vanquished opponent Volcker. Geithner felt it was an imperfect, backdoor way to establish the kinds of Glass-Steagall barriers that didn’t fit with banks’ needed latitude to respond to whatever the marketplace demanded. Neither one stood in the way when Dodd’s committee quietly punched a hole in the hull, saying that any provisions for how to define and enforce a ban on banks’ making large trading bets using taxpayer funds to trade could be “modified” by regulators at their discretion.

  Obama wasn’t much involved with derivatives, either. But the Morgan Stanley data, Gensler thought, might catch his attention. He showed Summers the Morgan exposure and explained its particulars. Summers was startled. “The president is not going to like this,” he said emphatically.

  But nothing happened—the White House was leaving financial regulation to Geithner’s deputies at Treasury and to Congress.

  Gensler, who had become something of a one-man show on derivatives, was now being noticed, profiled in the press, and mentioned in the same breath with Volcker and Elizabeth Warren. It was an odd position for a regulator from a sleepy no-name agency, but it fit into a larger concept: that the nature of regulation itself had to change, that the job of regulators such as Warren, if she ultimately ran her consumer agency, and Gensler, at CFTC, was not to be a friend of the industries they oversaw, emerging from them to take the big regulatory jobs and then, returning to some corporate suite once their term was up.

  But come spring, as Wall Streeters were busy calling Gensler “the most dangerous man in Washington,” he was starting to feel like an imposter. Say what they will, financial lobbyists had the upper hand and were making steady advances.

  By mid-April, though, Gensler saw it: a plan to save some gazelles. Senator Blanche Lincoln, a conservative Democrat from Arkansas, had become chairwoman of the Senate Agriculture Committee six months before, when an enfeebled Ted Kennedy ceded his chairmanship of the Senate’s Heath, Education, Labor and Pensions Committee to Iowa’s liberal lion and longtime agriculture chairman, Tom Harkin. All manner of financial lobbyists considered this a stroke of fortune, especially considering that derivatives issues, and oversight of Gensler’s Commodity Futures Trading Commission, were handled by Agriculture—a holdover from the decades when derivatives were called “futures” and dealt solely in commodities such as corn and wheat.

  Over the past month, Lincoln had been meeting with the committee’s ranking Republican, Georgia’s Saxby Chambliss, to work out a derivatives deal that was shaping up to be more favorable to industry than the House legislation. That
package, even the proud Barney Frank privately admitted, had to ingest too many exemptions to assure passage, especially for “end users”—such as airlines working derivatives to manage fuel costs—that could be exploited by the four largest banks, controllers of 97 percent of the derivatives market.

  But Gensler had a ringer, a plant. When Lincoln became chairwoman, she needed a top staffer with expertise in derivatives. She found one . . . on Gensler’s staff. Robert Holifield, an effusive and preternaturally polished thirty-one-year-old, had stayed in close touch with his old boss. His new boss, Lincoln, was meanwhile facing an ever-more-serious primary challenge from Arkansas’ progressive attorney general, Bill Halter, who was gaining ground in early April charging that she was soft on Wall Street. Gensler huddled with Treasury and crafted a subtle threat: if Lincoln went with the package she was crafting with Chambliss, the White House would, in essence, take Halter’s side by publicly saying her deal was inadequate. This “warning” was delivered to Lincoln on Friday, April 9. She had the weekend to think over her next move.

  On April 13, a few hours after early-morning news broke about the SEC’s charges against Goldman, Arkansas’ senator stepped to the lectern to announce a startling about-face: she wanted all derivatives operations to be removed from banks. They needed to be spun off, so that taxpayers—with their obligations, still, to bail out “too big to fail” banks—wouldn’t be on the hook to bail out derivatives activities. Plainly said, banks would have to spin off their most profitable business. There was more: she was also stipulating that the derivatives dealers had to act as “fiduciaries,” always putting their clients’ interests ahead of their own.

  Reaction was swift. Startled Republicans, who’d been counting on Lincoln’s acquiescence, were outraged, as were all-but-speechless financial industry lobbyists. But this time they had unlikely kindred. Some reform-minded Democrats and even Sheila Bair thought this idea might be ill-considered. You wouldn’t want something as unwieldy and dangerous as derivatives trading to be spun off into an array of subsidiary companies. At least housed within banks, the burgeoning derivatives industry would be inside institutions that submitted to regular—albeit, of late, rather ineffectual—regulatory oversight.

  It didn’t matter. A week later Gensler, with a staff of seven, arrived early at the Agriculture Committee hearing room. He was carrying a stack of what was fast becoming one of the most consequential documents in the U.S. government. After finding the Morgan data, Gensler had gone back to the files. He needed a way to detail the dangerous ongoing credit exposures in the derivatives market, and the web of interrelationships, in a way that a busy senator could look at and quickly understand. He and his staff worked through several models—graphs, charts, printed PowerPoints.

  Finally, he had it: a single page with three pie charts, one for each of the major categories of the $400 trillion over-the-counter derivatives industry: foreign exchange derivatives, single-currency interest rate derivatives, and equity-linked, or commodity, derivatives. Using data his staff had dug up from the Bank for International Settlements, or BASEL, he’d produced color-coded charts showing the division of each pie among the three major players in the market: nonfinancial customers, such as Boeing and its fuel; reporting dealers, such as Goldman and JPMorgan; and other financial institutions, such as insurance companies.

  The one-pager was a corollary to the Morgan findings from the winter; it showed that more than half of the derivatives market was operating in shadows and was without collateral, just like Morgan was. If there was another systemic risk moment, companies across the world would have to come up with collateral, in almost unfathomable amounts, that they had not already set aside. These so-called dark pools, where no one could be sure of the size and scope of another institution’s liabilities, create precisely the fear and uncertainty that helped shut down the flow of money through the global economy. Systemic risk from derivatives, in other words, was still with us, and worse than ever.

  In the minutes before the vote, senators from both parties were looking at the pie charts, each and every one, like kids who had just been handed back a failing test paper. The charts showed the financial system still loaded with dangerous interconnections; one meltdown, like a Lehman, could bring it all down.

  Lincoln’s bill passed the committee 13 to 8, with a surprise vote from Iowa Republican Charles Grassley.

  Crowded into the chamber, side by side with representatives from public interest groups, journalists, and assorted onlookers, were Wall Street lobbyists who could scarcely believe what they were seeing.

  “This is the way we make our money—they’re trying to take away our lifeblood,” said one of them, who, like most lobbyists, wouldn’t give his name. “Maybe we did this to ourselves, sure, but we’re just responding to the way things are. We’ve gone ‘long’ on developing markets around the world, and gone ‘short’ on America, where the whole game is using debt to give people what they haven’t been able to earn, and may never earn, and derivatives is a key way we make that possible.”

  Six days later, on April 27, Michigan’s canny seventy-five-year-old Democratic senator, Carl Levin, chairman of the Senate’s Permanent Subcommittee on Investigations, was looking to prove in public hearings exactly why Goldman Sachs was under investigation.

  A few months before, in January, the independent, blue-ribbon, bipartisan Financial Crisis Inquiry Commission, headed by a former California state treasurer named Phil Angelides, had begun to hold hearings. Slow and steady, they were going at the financial crisis, and the actors involved, piece by piece.

  Not Levin. He went with a frontal assault: pull in the most recognizable actors on Wall Street and let them explain how they make their money.

  At the hearing table before his committee on April 27 was a procession of Goldman Sachs executives, culminating in a late-afternoon appearance by CEO Lloyd Blankfein.

  Throughout the day, Levin offered examples of how giant firms such as Goldman had their many arms moving in a kind of subtle coordination to ensure that, no matter how the market broke, they won.

  In questioning Goldman executives, Levin pressed this point without much success. The questions were too technical, and the executives could simply claim they knew only what their department was doing, not other departments.

  Levin needed a CEO. Blankfein, atop the much reviled and feared Goldman, was his sterling opportunity.

  His committee’s investigators had pulled up internal e-mails on the Abacus deal and read them aloud, showing that Goldman traders knew that the securities, freshly painted and buffed for sale, were actually ticking time bombs.

  Blankfein stammered and, under hot lights, tried to explain how Goldman could represent the interests of clients who could have conceivably made money on Abacus at the same time that the firm was a “market maker,” drawing investors into a liquid market by taking the “other side” of the bet on the securities these traders were interested in, and hoping to crush them.

  Finally, Levin had his opening.

  LEVIN: We’ve heard in earlier panels today in example after example where Goldman was selling securities to people and then not telling them that they were taking and intended to maintain a short position against those same securities. I’m deeply troubled by that, and it’s made worse when your own employees believe that those securities are “junk” or “a piece of crap” or a “shitty deal,” words that emails show your employees believe about a number of those deals . . . Now there’s such a fundamental conflict it seems to me when Goldman is selling securities, which particularly when its own people believes they are bad items . . . Given that kind of a history . . . how do you expect to deserve the trust of your clients? And is there not an inherent conflict here?

  BLANKFEIN: Our clients’ trust is not only important to us, it’s essential to us, it is why we are as successful a firm as we are and have been for 140 years. We are one of the largest client franchises in market making in the kinds of activities we’re talkin
g about now, and our client base is a pretty critical client base for us, and they know our activities, and they understand what market making is.

  LEVIN: Do you think they know that you think something is a piece of crap when you sell it to them and then bet against it, do you think they know that?

  BLANKFEIN: I want to make one thing clear . . . the act of selling something is what gives the opposite position of what the client has. If the client asks us for a bid, and we buy it from them, the next minute we own it and they don’t . . . we can cover that risk, but the nature of the principal business in market making is that we are the other side of what our clients want to do.

  LEVIN: When you sell something to a client, they have a right to believe that you want that security to work for them. In example after example . . . we’re talking about betting against the very thing you’re selling, without disclosing that to that client. Do you think people would buy securities from you if you said, “you know, we want you to know this, we’re going to sell you this, but we’re going out and buying insurance against this security succeeding. We’re taking a short position” . . . That’s a totally different thing from selling a security and no longer having an interest in it . . . Is it not a conflict when you sell something to someone, and then are determined to bet against that same security, and you don’t disclose that to the person you’re selling to?

  BLANKFEIN: In the context of market making, that is not a conflict. What clients are buying . . . is they are buying an exposure. The thing that we are selling to them is supposed to give them the risk they want. They are not coming to us to represent what our views are. They probably, the institutional clients we have, wouldn’t care what our views are, they shouldn’t care. We do other things at the firm . . . where we are fiduciaries.

  LEVIN: And that’s the part that’s very confusing to folks . . .