The Weekend That Changed Wall Street

by Maria Bartiromo

  The issue is that Fannie Mae and Freddie Mac, being GSEs—government-sponsored entities—have the support of the U.S. Treasury but are also partly investor-owned and publicly traded like any other public company’s stock. Companies, investors, and governments around the world buy their debt because of the belief that the U.S. Treasury will support them. As Frank told me in 2009, “We should not have entities that investors buy with a wink and a handshake that if anything goes awry, the U.S. Treasury will be there to bail them out.” But so far there has been no change to that structure, although in mid-2010, the companies were forced to de-list from the New York Stock Exchange, and they moved to another exchange. They did this after failing to meet the minimum trading requirement of $1 a share for more than thirty days. Fannie Mae and Freddie Mac stock prices hit lows of 35 and 40 cents, down from 2007 highs in the mid-50s and mid-40s respectively. Their all-time highs were well above $100 a share. Meanwhile, the cost to taxpayers of government conservatorship continues to mount—$145.9 billion as of this writing, and expected to rise much higher.

  While financial reform was moving forward in Washington, the situation on Wall Street remained volatile. One disturbing note was a consistently nervous market. Upswings did not involve broad investor participation. There were a variety of reasons. One, of course, was that the wounds of 2008 and the first part of 2009 had not yet healed. The money lost was so severe in many cases that people couldn’t stomach the thought of losing even more. They opted for bonds and cash over the perceived risk of stocks. Banks were frozen, uncertain of the new expenses to come. A “flash crash” on May 6 didn’t help matters. It was a scary day at the NYSE as we watched unprecedented activity.

  The day started with a lot of nervousness over the situation in Greece. By the afternoon, huge sell orders were coming in without balancing buy orders. The NYSE operates under an auction system. If there is an overload of sellers, the specialist must be a buyer in order to make a market. Amid volatile activity, the NYSE decided to employ a temporary time-out, stopping trading on a handful of stocks that showed unusual trading levels so the specialists could analyze their next steps. These included widely held stocks like Procter & Gamble and Accenture. But during the ninety-second trading pause, the business didn’t stop; it was diverted to other electronic traders. With no buyers, stocks plummeted, and the Dow dropped 1,000 points. It all happened in a flash.

  The shocking event illuminated an uncomfortable reality: The NYSE may have stopped trading, but others didn’t. There was no standard across all exchanges. It was like putting up a fence but leaving a giant hole in the middle. The SEC knew it but did nothing about it. In effect, the system was flawed, and we were lucky it didn’t get much worse. Watching the Dow drop caused jitters, even though it recovered quickly.

  SEC chairman Mary Schapiro told me it was a wake-up call, and the SEC acted very quickly. She summoned all the exchanges and said to them, “You’re not leaving this room until we figure out not so much what went wrong, that’ll take a little bit of time, but how do we deal with the symptoms and what happened?” She got a good response from the exchanges, and they set about establishing new controls that would prevent a recurrence. But the panic people felt on May 6 would take a while to subside.

  This event brought me back to considering the question of confidence, the foundation of market strength. Did individual investors lack faith in the market? At the heart of investing is the idea that the stocks we buy will rise or fall based on the performance of an individual company, the state of a sector, or the health of the economy as a whole. If investors did not believe this to be the case—or, more pointedly, if they believed the game was rigged against them—they would stay away. Who could blame them?

  By late spring, Barney Frank’s committee in the House and Chris Dodd’s committee in the Senate had each completed a financial-reform bill, and they were similar enough that legislators were confident they would be able to reconcile them in a legislative compromise acceptable to both parties. And they didn’t waste any time making it happen.

  On Friday, June 25, just as day was breaking, weary lawmakers emerged from a large conference room in the Dirksen Senate Office Building after twenty straight hours of negotiation. At the front of the crowd were Dodd and Frank, rumpled but smiling, with the announcement that financial reform was a reality. The newly named Dodd-Frank bill had passed committee and would move on for a vote in both chambers.

  Frank, who had got some but not all of what he wanted, was ebullient in the media. “Uncertainty is the great enemy of markets, and we’ve now provided a framework of certainty,” he boasted.

  The primary elements of the bill were the following:

  The creation of a ten-member Financial Services Oversight Panel, composed of the Treasury secretary, the Federal Reserve chairman, a presidential appointee with insurance expertise, and heads of regulatory agencies and the new consumer protection bureau.

  The Consumer Financial Protection Agency would offer a number of protections on traditional financial products, such as checking accounts and credit cards.

  Greater oversight and transparency on the $615 trillion derivative market, stipulating that high-risk derivatives be traded on public exchanges and be insured by third-party clearinghouses.

  A modified version of the Volcker Rule, which would allow banks to invest up to 3 percent of their equity in proprietary trading.

  New oversight capability for the Federal Reserve, designed to prevent future collapses, particularly regarding financial entities dubbed “too big to fail,” including an orderly liquidation process for ailing firms.

  New rules on executive pay that would require compensation to be set by independent directors and approved by shareholders.

  Hefty taxes, totaling around $20 billion, for financial firms to pay for some of the bill’s provisions. It was unclear how these taxes would be calculated, but this was one of the most controversial aspects of the bill.

  The optimism of the dawn agreement began dissipating almost immediately. In the early hours of Monday, June 28, Senator Robert Byrd, ninety-two, died, robbing the Senate of a critical sixtieth vote on the bill. The timing of Byrd’s passing was reminiscent of that of another Senate lion, Ted Kennedy, whose death earlier in the year made the passage of President Obama’s health care bill uncertain. As a plan was under way for Byrd’s body to lie in repose on the floor of the Senate, ironically, it was Kennedy’s successor, Senator Scott Brown, one of a few Republicans who had been prepared to vote for the bill, who balked. Brown announced that he would no longer support the bill because of the $20 billion tax against large banks that was added in the final days of negotiation. Democrat Russ Feingold also said he would vote against the measure. Dodd’s committee hurriedly regrouped to revisit the item, dropping the provision and salvaging Brown’s support.

  On July 15, the Senate passed the financial reform bill with a 60–39 vote tally. As President Obama prepared to sign it into law, the question was, what would the impact of the bill be? I spoke with many experts and began to piece together an idea of what impact it would have. Investors were initially encouraged that it was not as strict as many people had feared, particularly when it came to proprietary trading.

  Some observers were skeptical about instituting yet another layer of bureaucracy with the Consumer Financial Protection Agency. Richard Bove, an analyst with Rochdale Securities, offered a reality check. “So now we’re going to do a bunch of things,” he said. “We’re going to slap restrictions on the pricing in the credit card industry. We’re going to slap restrictions on fees for insufficient funds or check bouncing. It’s going to put the consumer in a much more difficult position, since the banks can’t live with the rules the way they’ve been established.” Bove predicted that as many as 14 million checking accounts, representing 10 million customers, might be closed—in effect, harming the very people the bill was supposed to help.

  Another financial expert voiced concern with the limitations on
derivatives trading, telling me, “This provision would require bank-holding companies to move their derivatives businesses out of their best capitalized, most regulated, and most creditworthy subsidiaries. This is the precise opposite of what the other derivatives provisions are intended to achieve—to reduce systemic risk by imposing capital requirements for derivatives dealers and major participants, increasing regulation, and reducing credit risk. The provision would put U.S. banks at a tremendous competitive disadvantage to foreign banks, which would be able to continue to operate their derivatives businesses out of their subsidiary banks outside of the United States” Indeed, a source of mine at Deutsche Bank had been practically giddy with the possibilities. “If the American government prevents derivative activity at banks, we’re going to clean up,” he said.

  Banks were also trying to anticipate what effect the new capital requirements would have on them. The issue wasn’t just the congressional package, but also new international rules, imposed as part of the Basel Accords, scheduled to take effect in 2012. The new rules would require much greater capital levels, which could have the effect of restricting lending. The thinking was, if a bank was worried about keeping capital high, it might be reluctant to lend.

  I spoke with Vikram Pandit at the International Economic Forum in Russia in June 2010, and he told me, “I’m concerned about the Basel rules, not so much because of the impact they will have on us or most American banks. I think American banks are generally in very good shape, and we [Citigroup] certainly are as well. But the bigger impact is the amount of liquidity and the amount of capital they’d require you to hold is going to have a real impact on the amount of lending and credit creation in the world.” Pandit cited a study that predicted a decline in GDP by almost 3 percent as a result of the requirements. “I mean, these are big numbers,” he said. “We all want the banking system to be safe. There’s nobody, by the way, who wants it more than I do, having been through what I’ve gone through, but we’ve got to make sure we don’t make a false choice between bank safety on one hand and the underperforming economy on the other hand.”

  When I got back to New York, I ran into Pandit again, and he told me the Basel liquidity requirements for banks called for $3- to $5 trillion in liquidity. “Where do you think that three- to five trillion will come from?” he asked rhetorically. “The lending pool.”

  One of the biggest questions regarding financial reform was whether the new regulatory superagency would have the wherewithal to be more effective than the current agencies. A former chairman of the SEC told me that the agency didn’t have the resources to properly regulate the industry. “How will the SEC manage the extensive new obligations it will have when regulatory reform passes?” he wondered. Under reform, the agency that missed Madoff and the financial crisis would have responsibility for ten thousand hedge funds previously unregulated, among other things.

  When I spoke with Schapiro in June, I asked her point-blank if the SEC was capable of keeping up with the job. She acknowledged that there were only thirty-seven hundred people to handle thirty-five thousand regulated entities. “We do need more people,” she agreed. “I think we’re covering the waterfront right now—and we could do it more comprehensively, and that’s our goal. And I will say Congress has been generous in the last two years to give us significant budget increases. But make no mistake about it, we are just now in 2010 getting back to the staffing levels that we enjoyed in 2005. And if you think about what’s happened in our markets from 2005 to 2010, and to know this agency didn’t grow at all during that period is pretty frightening.” I had been hearing from others that the SEC couldn’t keep up, due to staffing levels and pay levels and experience levels, and Schapiro seemed to agree that there was a steep hill to climb. But she suggested to me that the SEC has been able to tap into a new sense of patriotism that was bringing new blood into the public realm. She put a confident face on it, even knowing the huge challenges ahead.

  In July 2010, I hosted an important panel discussion at the Aspen Ideas Festival. For more than ninety minutes before a packed auditorium, Alan Greenspan, David Rubenstein of the Carlyle Group, and the economist David Hale offered a clear and brutally honest analysis of where the economy was headed. There was agreement that a key priority was getting the business community spending again, but Greenspan and Rubenstein believed that the financial reform bill would probably accomplish just the opposite. Why? “The regulatory bill has an extraordinary amount of items that empower the regulators to implement and promulgate rules,” Greenspan said. “I can tell you how it’s going to play out, having been there.” In effect, Greenspan said, the uncertainty created by a slew of unclear rules would discourage spending and lending. Rubenstein agreed. “The business community is in hibernation, sitting on cash. They don’t know what the tax rates are going to be, what the regulation is going to be.” He called upon the administration to end the demonization of the business community. “Often in Washington, they love employees but they hate employers,” he observed.

  Rubenstein, who I recalled felt so bullish back in 2007, was sober as he described a world where the economic momentum was shifting away from the United States. “We’ve been the biggest economy in the world since 1870,” he said. “We will lose that title to China roughly around 2035.” Ultimately, he suggested that the United States might be number three among world economies. “There’s nothing the president or the Congress can do,” he declared—not because they didn’t have a role to play, but because the political will has been lacking when it comes to addressing real issues. “Congress is dysfunctional,” he said, highlighting the overemphasis on vague regulations and the underemphasis on making hard choices. He concluded sadly, “Tough decisions don’t get made in Congress.” Indeed, many of the people I interviewed complained that the financial bill was a “political solution” whose value was more about the administration’s scoring a win than about true reform.

  In some respects, the public narrative was just as important as the regulatory environment—maybe even more so. Regulations fail; we’ve seen it time and again. The truth is, it’s not possible to legislate perfection, even when the strictest regulations are in place. The health of the system is in the hands of the men and women who ply their trade in the halls of finance. I have spoken at length with hundreds of them—from top executives and heads of state to global investors and brokers and traders—and they all emphasize their willingness to rethink practices. Complicating their task is the rapidity of growth and change in a global marketplace where there are billions of players—long, short, buyers, and sellers. And that in itself is a form of checks and balances.

  September is a cruel month for America. The attacks of September 11, 2001, took away the lives of thousands of people, many of whom worked on Wall Street. The events of September 12–14, 2008, destroyed the financial lives of countless others. In no way is a lost nest egg comparable to a lost life, and in no way can a comparison be drawn between the horrors of the terrorist flights and a financial setback, however painful and widespread. Still, there is one thing both events have in common: each in its own way was an assault on our way of life.

  The financial debacle was a crisis of the capitalist system that is the underpinning of our economy and our national prosperity. Now, almost two years after the worst economic weekend the United States has seen since the Great Depression, we are still trying to figure out what went wrong and how to fix the system that failed.

  Critics of Wall Street contend that the failure can be laid in the laps of the commercial bankers, investment bankers, and traders who took irresponsible risks and jeopardized not only the futures and savings of friends, family members, and fellow Americans but also the futures of young Americans who will be paying for the folly of the decade past for years to come.

  Others maintain that the root of the problem were liberal policies that, especially through Fannie Mae and Freddie Mac, encouraged lending to tens of thousands of people who were not financially equipped
to be homeowners. Still others blame the inattentive regulators, or the repeal of the Glass-Steagall Act. Clearly, there is no shortage of theories and blame to go around. But blame won’t fix the system and restore the most crucial element of America’s economic success: confidence.

  In the best of all worlds, banks, investment firms, and major players such as AIG would be chastened by the devastation that their risk-taking wrought on America and would become stringent self-policemen of their own excesses. But let’s not be naive that such a scenario is possible.

  At the same time, one wonders if a raft of new regulations, such as those being proposed in Congress at this writing, is meaningful. Many Republicans argue that larding on more rules by a bigfoot government is pointless since the regulations that were already in place either weren’t implemented or didn’t work. And, they point out, some of the rules being considered would put the U.S. financial industry at a disadvantage to foreign rivals. Some conservatives and Tea Party libertarians maintain that the whole problem would be solved if the dice rollers on Wall Street understood that there would never again be a bailout by Washington, and that no entity—corporate or financial—would ever be deemed too big to fail. All these debates continue as this book goes to press.

  There will always be disagreements about the best way forward, but there are questions that are on everyone’s mind: Have we learned our lesson? Are we going to be able to avoid another September 2008? My belief is that in the long run, no, we won’t. And while that’s sobering, it is also a function of capitalism as it is meant to be. Free markets are free markets. It’s messy, but this very freedom is what we prize above all else. Companies are going to make mistakes again. Another time will come when there will be overleveraging. But that doesn’t mean we shouldn’t strive to do better, to allow the system to operate optimally and fulfill its highest purpose.