by Nomi Prins
But what they didn’t disclose was that about a week earlier, as we’ve discussed, the Fed had announced that it would begin to pay interest on bank reserves. So instead of following its mandate to provide incentives to banks to part with their capital, thereby loosening credit for American citizens, the Fed was encouraging banks to hoard their cash so they could earn interest.123
All of the stabs at pushing money into the financial system simply never really made their way to the public as promised. On January 15, 2009, the Group of Thirty, an international nonprofit organization of top economists led by former Fed chair Paul Volcker, put in their two cents’ worth in a report about the economic crisis: “The issue posed by the present crisis is crystal clear. How can we restore strong, competitive, innovative financial markets to support global economic growth without once again risking a breakdown in market functioning so severe as to put the world economies at risk?”124
The report concluded that central banks should be strengthened but not only during times of crisis. The Fed and other central banks should promote and maintain financial stability even when the economy is at its strongest, because market participants often make their riskiest deals during those periods.
According to a CNN report, the group had cautioned, “Regulators should pay particularly close attention to relatively new and largely unregulated financial instruments such as credit default swaps, collateralized debt obligations, and over the-counter derivatives.”125
What the Group of Thirty failed to mention was the unregulated role that the Fed itself was playing in building up an unprecedented book of risky assets for firms that had no business and no historical precedent gaining access to the Fed’s money.
But all those billions and trillions in Federal funds were about protecting the American taxpayer, right? Well, that’s the line we got, but the trickle down thing just didn’t work out. On January 30, 2009, the Fed once again switched up its own regulations to help certain banks borrow even more money. The first rule change allowed bank holding companies (BHCs), as Goldman Sachs and Morgan Stanley had become, to borrow money even if they are unable to put up enough collateral. The second major rule change allowed BHCs to borrow money from their own affiliates with greater ease. This shift would let companies move money around internally, potentially creating the appearance of more liquidity, and effectively allow them to mislead the public about their true financial health.126
The Real Cost and Risk of the Bailout
Even from the beginning of the bailout, as the banking system continued to exhibit a desperate propensity to inhale money, the true cost of keeping it functional seemed almost too big to comprehend—not that anyone wanted to do the math. Big, scary media headlines went from pegging the bailout cost at $2 trillion127 in late October 2008, to more than $4 trillion by mid November,128 to $7 trillion by late November 2008.129
By the time this book went to press, the full scope of the subsidization of the banking industry encompassed more than $13 trillion, and more than half of that came directly from the Fed.130 It’s all enough to make your head spin. But first, there are some dots to connect. What was the Fed thinking? Shouldn’t it have had less, rather than more, unilateral power? How does the Fed relate to the taxpayer?
The answers require examining the individual tentacles of that $13.3 trillion rescue of the banking system, which by early June 2009 was roughly divided into $7.6 trillion from the Fed, $2.3 trillion from the Treasury (not including additional interest payments), and $1.5 trillion of fresh FDIC guarantees, if needed. In addition, there was $1.4 trillion of joint assistance and a $300 billion housing bill.131 The figures are sobering.
In the meantime, we’re on the hook for any money that the Fed isn’t transferring to the Treasury, in addition to interest payments on rising national debt to back the continued costs of the bailout. “Taxpayers are taking on more risk than before. If the Fed takes a loss, its profits suffer. If the Fed turns over less to the Treasury, we will see raises in taxes or debt to compensate,” Paul Kasriel told me.132
And therein lies the dual danger. On the fiscal side, there’s the resulting inflation problem that comes from deluging the world with our Treasury debt: the more Treasury bonds that are out there, the less valuable they are and, thus, the higher their rates and the higher our interest payments. In fiscal year 2008, the interest payments for all public debt were $451 billion, with a 2008 national deficit of $455 billion.133 Official predictions for the 2009 deficit were $1.8 trillion and for 2010, $1.2 trillion, though I believe it will be higher.134
This kind of interest “becomes a circle and a noose to the economy because we have to keep printing money to make interest payments at rising rates,” Blythe McGarvie, an economist and the founder and CEO of Leadership for International Finance, told me. “If nothing else, this financial collapse has shown that too much borrowing, or leverage, will bring down a company. Similarly, a nation can be hollowed out.”
From a macroeconomic standpoint, rising inflation disrupts the ideals of full employment, hard work, and responsibility for risk. McGarvie added, “Banks are reshaping themselves in order to get a handout—that’s not embracing capitalism, it’s crippling it.”135 The asset drain will cause an increase in U.S. government interest payments and debt, which, as I mentioned, will deflate the value of U.S. Treasury bonds, U.S. goods, and the dollar.
During the economic crisis the Fed presented four gifts to the financial sector that will have long lasting negative effects on the nation’s financial security. The first two were the risk laden lending facilities and the Fed’s refusal to entertain public accountability, but the last two will prove even more dangerous and more expensive. The Fed’s quickness to transform anything (except Lehman Brothers) into a bank holding company and its speedy, seemingly thoughtless bank merger blessings will have lasting negative repercussions over the short and long term. Big, convoluted institutions drained trillions of dollars of public capital and wrecked the general economy. Yet they are destined to remain financial mammoths because the Fed wouldn’t let them go extinct. That’s not what a bank regulator should be doing to promote general economic and financial stability. The Fed did an abysmal job of guarding the nation from Wall Street’s excesses as they were building, and rather than admit or correct its errors, the Fed simply printed more money, in the hopes of shoving them under the rug. Yet, both the Bush and the Obama administrations wanted to give the Fed more power as a systemic risk regulator. What does that say about the likelihood that all of this will happen again?
6
Everyone Saw This Coming
Give ’em the old three ring circus. Stun and stagger ’em. When you’re in trouble, go into your dance.
—Billy Flynn, Chicago
We might not have gotten into this mess if the state of the general economy weren’t inextricably linked to financial firms that take unwarranted risks and hoard excessive profits. But that’s not the case. The truth is that Wall Street simply can’t buy and sell the underlying waste of our economic system and expect things to be peachy. The meltdown was predictable, and various people did in fact predict it. In 2004, I wrote a whole book about how big mergers and complex securities were a disaster waiting to happen. Catastrophe is inevitable when there are no meaningful boundaries guiding companies in an exceedingly complex financial system.
Why do I say catastrophe is inevitable? Because none of today’s disasters are new. We have already seen most of the ingredients of this financial crisis in one form or another—some readers may have even lived through the Great Depression. And yet the people in power, both on Wall Street and in Washington, have worked extremely hard to not learn the lessons of earlier crises.
The Second Great Bank Depression wasn’t some random event. It’s not as if every ordinary citizen spontaneously decided to stop paying bills. It’s not as if every international government woke up one day to an economic catastrophe and blamed it on a Wall Street gone crazy. It wasn’t even the culmin
ation of a string of bad luck. Not quite. This epoch contains the same elements as every other Wall Street-led scheme. The nineteenth century railroad barons couldn’t have succeeded without starry eyed investors putting up funds for companies that were later shown to be engaging in stock fraud.1 The Great Crash of 1929 wouldn’t have occurred if companies hadn’t fabricated earnings and investors hadn’t flocked to buy their stocks with oodles of borrowed money.2
Back then, many stocks were purchased on margin—another name for our old friend leverage. A small number of stocks could be put up as collateral for large loans that could be used to buy more stocks. As stocks fell in value, the original collateral was not worth as much, so lenders made margin calls, demanding even more collateral. To get money to pay off those margin calls, investors needed to sell their stocks. When investors sold more, stock values fell further. So began the vicious downward spiral that led to the 1929 crash.
This exact cycle occurred again during the Second Great Bank Depression. Investors and banks had borrowed large sums of money backed by small amounts of securities, or assets that were backed by subprime mortgages.
All of that borrowed money was floated on an ever shrinking and devalued pot of loans and assets. Investors and banks that had borrowed against them were stuck owing a lot of money to make up for the assets’ decline in value. The problem was, banks had no way to make up the difference because no one was buying their structured assets. That’s the real reason credit seized up. All of the actual money in the system was sucked out to back the aforementioned $140 trillion worth of borrowing. The underlying collateral of structured assets, which were re-dubbed “toxic,” had no buyers and, therefore, no value.
During the Great Crash, investors who were forced to liquidate their holdings exacerbated the plunge in stock prices. U.S. stock prices dropped 33 percent from their then historic peak in September 1929 to their low in November.3 By July 8, 1932, after three painful years, the Dow Jones reached a low of 41.22 points, an 89 percent drop from its pre crash high. It took twenty five years to regain its high of 382, with a lot of ups and downs in between.4
A Law That Really Worked
The Great Depression was an economic and emotional blight on American history. During the early 1930s, a quarter of the nation was unemployed.5 Home foreclosures were at record highs. In 1933, at the peak of the four year depression, around 1,000 homes were foreclosed every day,6 and 10 percent of American homes were bank-owned.7 One out of five banks shut down.8 Between 1929 and 1933, 9,000 banks had to suspend their operations because of financial problems.9 (By comparison, 10,000 homes were foreclosed daily by early 2009, and a total of 2.3 million properties had undergone foreclosure actions during 2008.10 For the first three months of 2009, foreclosure action was brought against more than 800,000 properties, up 24 percent from the first quarter of 2008.)11
Jolted by the Crash of 1929 and its economic fallout, Americans in the 1930s were fearful of the present and desperately hoped for a better future. But it took three years of pain and denial before FDR was elected president by a landslide, receiving 57 percent of the popular vote and winning forty two states on November 8, 1932.12
FDR’s famous inauguration address on March 4, 1933, in which he said “the only thing we have to fear is fear itself,” brought the country together amid disdain for the bankers who had wrecked so many lives.13 Roosevelt christened his presidency the next day with two proclamations: one called Congress back to the Capitol Building for a special session, and the other declared a bank holiday under the dormant provisions of the wartime Trading with the Enemy Act.14 (Although sometimes, the enemy lies within.)
Not surprisingly, Secretary of the Treasury William H. Woodin was crucial to FDR’s efforts. Like so many treasury secretaries before and after him, Woodin came from the private sector. A close personal friend of FDR’s and a Republican to boot, he had gone to Columbia University but left to make it as a businessman before completing his degree.15
In 1922, Woodin became president of the American Car and Foundry Company and also served as chairman of the board of several leading locomotive companies. In shades of Tim Geithner decades later, Woodin was appointed to be a director of the Federal Reserve Bank of New York, before being appointed treasury secretary in 1933. He was forced to resign roughly ten months later.16 The Senate Banking Committee discovered that Woodin was on J.P. Morgan’s preferred customer list, and he had retained some preferred stock options as a result.17 It was tough to break Wall Street ties, even then. Woodin died soon afterward.18
But before that, he did the nation a lot of good. Geithner should have taken note. After consulting with Woodin, the president declared the bank holiday, which lasted four days and was meant to “prevent further runs on the banks and allow Woodin time to draft the necessary legislation.” Which Woodin did.
The night of March 5, 1933, FDR met with a group of congressional leaders at the White House, including Senator Carter Glass (D VA) and Representative Henry Steagall (D AL), chairmen of the committees that would create the legislation that restructured the banking landscape. The banks did stabilize after they reopened, and that paved the way for the Glass Steagall Act of 1933, which passed in Congress on June 15, 1933.19 FDR signed it into law the very next day.
Glass and Steagall insisted that a single bank entity should not control financial products that had widely varying levels of risk that could cause damage to the American public.20 The Glass-Steagall Act prohibited commercial banks (banks that take customers’ deposits or give them loans) from engaging in reckless speculation by creating, borrowing excessively against, or trading risky assets. These tasks were left to the investment banks.
The Pecora Commission of 1932 was instrumental in helping legislators understand the problems stemming from the industry and in creating lasting solutions to protect the public. Named for assistant district attorney from New York Ferdinand Pecora, who served as chief counsel, it investigated the irresponsible practices of Wall Street and helped galvanize public support for measures like the Glass Steagall Act, which changed the very structure of Wall Street.21
The commission’s hearings were held from April 11, 1932, to May 4, 1934, before the Senate Committee on Banking and Currency Investigation of Wall Street.22 The hearings revealed a range of shady practices by banks and their affiliates.23 Conflicts of interest, such as banks underwriting unstable securities in order to pay off bad loans, were central to the committee’s findings. So was the havoc that investment trusts, or off book entities, had wreaked on the economy by allowing banks to hide their true conditions.24 These findings were a revelation for many regular Americans and inspired a widespread cry for change.25 Unfortunately, the lure of money seems to aid forgetfulness. These shady practices would return in the 1990s under other names to cause further mayhem.
The commission’s work led to two major regulatory acts besides Glass Steagall: the Securities Act of 1933 and the Securities Exchange Act of 1934, which created the Securities and Exchange Commission (SEC) to enforce the rules of that act.26 These acts obligated institutions that raised public debt to provide better disclosure of their books, and regulators to make sure that happened.27
Unfortunately, the SEC didn’t quite offer the public the security it was supposed to provide.28 The idea behind the creation of the SEC was that it would “protect and make more effective the national banking system and Federal Reserve System” and “insure the maintenance of fair and honest markets.”29 But the SEC did not grow alongside the increasingly complex financial firms and transactions it was supposed to be regulating and the structures those firms created to make money. Wall Street, as we shall see in the next section, took full advantage of the loopholes.
When Pecora published his memoirs in 1939, Wall Street under Oath: The Story of Our Modern Money Changers, he wrote, “Bitterly hostile was Wall Street to the enactment of the regulatory legislation. Legal chicanery and pitch darkness were the banker’s stoutest allies.”30 You gotta love a
guy who’s not afraid to tell it like it is and pursue real change, despite the might of the mighty.
FDR and the sitting Congress had the spine to combat this lack of transparency and Wall Street aggression with deep, not cosmetic, changes—which is why the banking industry fought them for years. Eventually, to the multitrillion-dollar detriment of the nation, the bankers won. The Second Great Bank Depression that began in 2008 was the result. Then, as now, there were certain firms at the center of the storm.
Goldman, Sachs and Company was one of the firms hauled in front of the Pecora Commission.31 By the turn of the twentieth century, Goldman was raising the most short term debt, called commercial paper, in the United States.32 The firm was also the leading industrial sector banker in the country. Partners under the Goldman umbrella invested in and established the Goldman Sachs Trading Group in the 1920s. Through it, Goldman sponsored a set of investment trusts, or mini trading corporations (the Goldman Sachs Trading Corp., Shenandoah Corp., and Blue Ridge Corp.). Their closest modern day equivalent is the hedge, and private equity, fund. They took in investor money, made speculative bets on shady securities, and borrowed substantially against the securities to make more.
