CONFIDENCE LOST
John Kenneth Galbraith, the renowned economist who insisted corporations wield too much power in America and government should play a large, constructive and necessary role in managing the economy, is now back in style. So too is his warning that we should not embrace the “dangerous cliché that in the financial world everything depends on confidence.” Rather, he cautioned, “One could better argue the importance of unremitting suspicion.”
One also could argue that in the run up to the worst financial collapse in more than 70 years, the powers that be in finance and business were indeed seduced by an overwhelming and entirely unfounded sense of confidence and infallibility. From unscrupulous mortgage brokers and sub-prime debt peddlers to the enormous and eminently discoverable Ponzi scheme of Bernard Madoff, suspicion was largely absent.
Certainly this holds true as well for the prospective homebuyers who willfully or ignorantly failed to assess their own ability to support high-risk mortgages. They failed in hordes to fully understand that the higher the investment yield, the greater their risk of failure.
Perhaps if the Wall Street “rulers of the universe” had not been gripped by arrogance and blinded by their outlandish sense of entitlement, they could have avoided the financial pit they created. Perhaps if regulators and politicians of all stripes had not been held in thrall by these same gilt-edged, thoroughly oblivious financial market players, the economy and the public trust it embodies might have been preserved.
After all, most community banks have managed to push through the financial storm, keep lending to local folk worthy of their trust and continue observing sound business and financial practices. They have been dubbed “too small to fail,” but the better term would be “too sensible to fail.” The FDIC says banks with less than $1 billion in assets are seven times less likely to fail than their bigger compatriots.
Looking back now, it seems all too easy to spot the disastrous misjudgments, to take the grim tally of how misguided and utterly bankrupt of common sense our financial system has become. As their companies lost billions of dollars and collapsed, or took additional billions from the federal bailout trough, Wall Street dished out at least $18.4 billion in bonuses to its employees last year, says the New York state attorney general. This, the sixth-largest such payout in history, shocked the nation and was called “outrageous” and “shameful” by President Barack Obama, among others. Even now, we must remember that this economic collapse was born in home loans tossed out like hot dogs at a baseball game to families who were never even asked if they could pay them back. The industry developed its own language for this gross abdication of business principles and responsibility: They were called “no docs,” for “no documentation,” or “NINAs,” for “no income/no asset” loans. Bank executives, mortgage brokers, property assessors and real estate agents all received raises and bonuses for pushing these things out the door.
Investment bankers, mortgage repackagers and the oblivious chief executives at Freddie Mac and Fannie Mae bought yachts in Florida and homes in the Bahamas with the river of cash generated by repackaging these lousy loans and selling them to one another in ever more complicated combinations. A “no doc” loan in Albuquerque, New Mexico, for instance, might be bundled together with others from that city and bought as a single package by a bank in Los Angeles, California, which would include bundles from other places across the country. Because the final package included possibly thousands of sub-prime loans, there would be no way to tell how truly risky they were. But because they were risky, they would pay the buyer an attractive interest rate, until the package began to crumble as homebuyers defaulted and their homes lost value.
The banks, investment bankers and funds and mortgage companies that wound up holding these packages abruptly had assets on their books that were dead in the water, under water or both. A multibillion-dollar insurance market grew from nothing as these same reckless executives then issued insurance against the failure of these sub-prime loan packages, insurance backed by no cash for payments when the loans went bad.
“Beware of Geeks Bearing Formulas”
These financial officers invented and embraced wildly complicated “risk assessment” computer programs to justify what they were doing. The star of that show was something called “value at risk,” hatched by a bunch of statistical and computer geniuses toiling away at J.P. Morgan. VaR, as it was known, ran a proposed or existing investment through a mass of computer- generated probability scenarios and allegedly could determine daily—hourly if necessary—exactly how much money could be lost on that investment. As the legendary Warren Buffett has said, “Beware of geeks bearing formulas.”
Even when VaR failed massively in the classic garbage-in/garbage-out manner, few worried. It failed, for example, to spot the peril at Long Term Capital Management, one of the early hedge fund flyers that began to collapse and burn in 1998, when it received a more-than-$3 billion bailout, and was liquidated in 2000. Alan Greenspan, our then-revered Federal Reserve chairman, was reassuring. Don’t worry, be happy, he told Congress and everyone else hanging on his every word. The market takes care of bad apples, frauds, poor judgment calls and all those other gremlins that might bring down the financial system. Greenspan these days professes to be “in a state of shocked disbelief” that his colleagues in high finance so disastrously overreached.
It’s safe to say he is not quite as shocked as the millions of Americans who’ve lost their homes, jobs and life savings after being blandly, condescendingly reassured for years that nothing could go wrong with the strongest economy in the world.
That’s why the federal government, for all practical purposes, stopped regulating banks, the financial services industry and the stock market. When things really began to fly apart, the Securities and Exchange Commission, with just one person in its so-called Office of Risk Assessment, had not brought a serious case of securities law violation in years. The SEC, which is supposed to stand between Wall Street thieves and the public upon whom they prey, had a proudly stated goal in those years of reviewing the soundness of every investment adviser in the nation once every five years. Never mind that the commission didn’t have the budget, the staff or the will to come even near that bogus five-year goal. Bernie Madoff was only the most headline- grabbing beneficiary of this abdication of responsibility. When SEC investigators came calling, Madoff said, trust me. And they did.
The person picked by President Obama to run the SEC is Mary Schapiro, who has pledged to restore it as a tough regulatory agency. Schapiro’s last job was head of the Financial Industry Regulatory Authority, Wall Street’s self-policing organization. Needless to say, Schapiro has serious work to do—and quickly, if investors are going to have any confidence in the SEC cops again.
“Practices of the Unscrupulous Money Changers Stand Indicted …”
“The rulers of the exchange of mankind’s goods have failed through their own stubbornness and their own incompetence,” Franklin Delano Roosevelt said in his first inaugural address in 1933 in the midst of the Great Depression. “Practices of the unscrupulous money changers stand indicted in the court of public opinion, rejected by the hearts and minds of men.” FDR eerily sounds as correct today as he did then. But unfortunately he was quite wrong that those practices were rejected. They remain very much with us today as we crawl through the rubble of our economy.
FDR believed that the economy of this country was a “sacred trust” that he accused bankers and businessmen of treating with “callous and selfish” disregard. His indictment was too polite, but he was right: Commercial and retail bankers, investment bankers, employers and the other “rulers of the exchange of mankind’s goods” hold our lives in their hands. They hold the power to create and destroy. They hold the power to act shamefully or righteously, to build confidence in their values, talent and virtues, or to obliterate that confidence.
We now painfully understand what the alleged guardians of this public trust did with it. Those who ran AIG, Lehman Brothers, Washington Mutual Bank, Bank of America, Citigroup and the others intentionally or ignorantly lied about their risk exposures, potential losses and earnings capabilities. And this violation of the public trust was aided and abetted by then-Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke, firm believers in free-market discipline and deregulation, and the architects of last year’s give-themthe- money bailout strategy. Arrogance? How about trotting up to Capitol Hill and asking Congress for $750 billion for failing banks based on a three-page letter that was not even a plan? Trust us, Paulson and Bernanke said. Congress was ready to go along.
The furious public, at least, seemed to understand that trust was being violated. It flooded Congress with angry e-mails, letters and phone calls. The result was a slightly lengthier plan and an alleged agreement from Paulson that Treasury would track the money it was handing out to busted banks, impose tough requirements on how it was spent and limit the posh salaries of executives who got this corporate welfare.
It did nothing of the sort.
Treasury Was Clueless
The Congressional Oversight Panel, set up to ride herd on these taxpayers’ billions, concluded earlier this year that Treasury was not tracking the funds and was being, shall we say, less than forthcoming in admitting its ignorance and failures. “The recent refusal of certain private financial institutions to provide any accounting of how they are using taxpayer money undermines public confidence,” the panel declared in January. “For Treasury to advance funds to these institutions without requiring more transparency further erodes the very confidence Treasury seeks to restore.”
And with very good reason. Last September, Bank of America proudly announced a $50 billion deal to take over Merrill Lynch using no government cash. B of A chief executive Kenneth Lewis bragged publicly he had gotten a hell of a deal and had turned his back on any proposed government bailout money. “Merrill Lynch’s capital structure looks good,” he said at the time. Wrong.
Here we have one of the biggest, most powerful and supposedly most savvy financial institutions in the world doing a $50 billion deal ignorant of what it was really buying. By January, it found Merrill’s books so full of bad assets that the federal government had to put up $20 billion of our money to get the deal done.
This has become an all-too-common story as the country’s financiers line up for their government handouts. It has not occurred to them, apparently, that such ignorance is a stark demonstration that they are unworthy of the trust they have been given. Either they didn’t know and should have, or they did know and lied about it. Either way, they should be fired. How else can the public be reassured that such malfeasance and incompetence are not rewarded or perpetuated?
Self-dealing and Conflicts of Interest
The disintegrating economy has exposed a financial system shot through with self-dealing and conflicts of interest that all but guarantee the violation of the public trust. Where were the responsible, principled CEOs, chief financial officers and boards of directors who refused to load their companies’ books with bad debt? Where were the accountants willing to defy their clients’ foolishness and speak out effectively on the dangers ahead? Where were the SEC and all the other government regulators charged with protecting the public trust?
No surprise that securities analysts’ calls on stocks and bonds, or on proposed mergers and acquisitions, are overwhelmingly positive. People at the SEC in charge of policing lousy investments regularly take lucrative jobs with the companies they regulate, and corporations rarely hire troublesome regulators. But then, the businesses producing those problematic investments and doing the dicey deals have staffs of their own securities analysts to examine each transaction and rate them for public consumption. An analyst who consistently finds fault with his employer’s products does not win favor.
One check on this self-dealing is the bond and corporate credit-rating services that also are supposed to signal good and bad deals and companies to investors. But Moody’s, Standard & Poor’s, Fitch and the others are paid by the very companies they are rating. AIG, the world’s largest insurance company, boasted an AAA rating right up to the day it collapsed. Likewise, Freddie Mac and Fannie Mae, not to mention Lehman Brothers and Merrill Lynch, Moody’s, et al., have not explained their wholly unfounded confidence in their Wall Street clients. Even as they were forced to downgrade AIG (and only after it was clear to everyone else the company was a dead man walking), they were less concerned that they had blown their responsibilities to the investing public than they were very concerned that their downgrading would have scuttled the market because AIG was so intertwined with so many financial behemoths.
Restoring Confidence
The new president, his cabinet secretaries and regulators talk of toughening regulation, restructuring the financial sector to root out these conflicts of interest and restoring confidence in the financial markets and the American economy. But because so many have earned handsome livings on Wall Street within the very system they are now being asked to reform, it will not be easy. Promises and talk mean nothing without performance.
A frank and detailed admission of responsibility and a public apology would be a good place to start. We have not heard a single chief executive apologize for the mistakes made. Instead they claim ignorance, they say they were overtaken by events, they ask us now to believe they are victims of the markets. Wall Street Journal columnist Peggy Noonan has referred to this as “The Age of Empty Suits.” These executives knew that they were making tons of money by taking on tons of barely understood risk and that this was too good to be true. Some ignored the warnings of their own internal auditors. “When the music is playing,” said Citigroup chief executive Charles O. Prince, “you have to get up and dance.”
To restore that trust and rebuild confidence in markets and the economy, the new administration, Congress and corporate America now have the ability to exploit a tremendously powerful confluence of opportunities. First, they can put the nation back to work. There is vast public support, for example, for the badly needed public works part of what emerged as a $1 trillion- plus stimulus/bailout package that not only will build at least some bridges and roads but also green-up private and public edifices of all kinds and help create new eco-friendly, energy-efficient industries and products. (There could have been more for job-creation infrastructure spending, but in a White House-backed move to win Republican support, some of the money was siphoned to tax breaks, among other items—to the dismay of critics who have little faith such tax cuts will add jobs or boost spending.)
There is agreement as well that the new stimulus package must continue to stabilize and even renew a shaky banking system and, over time, loosen credit across the country to get the economy rolling again. But the new team of federal managers of the banking system has to show consistency and judgment that Paulson, Bernanke and the old team did not. One day they were going to use our money to buy bad bank assets, the next day it was, “Oh, never mind, we are buying preferred shares of banks to help improve their balance sheets.” Now, we are back to the purchase of bad assets while sinking money into the failed Detroit version of the domestic auto industry.
There is also the opportunity to help responsible homeowners who face foreclosures and those with mortgages that now exceed the market value of their houses. A government that can bail out banks also can help refinance and renegotiate home loans and revalue real estate to keep people in their homes.
There is a major opportunity as well to restore public confidence by reviving intelligent regulation of the banking and financial services industries. This must ensure transparency so investors, mortgage holders, shareholders and other key stakeholders can fully understand the scope and quality of their investments, understand where their money is and why, and understand the full measure of the risks they take. This does not require new regulations so much as new regulators with a respect for their mission and pride in their jobs. It also requires, without question, a new attitude by investors who should have learned by now that caveat emptor remains wise advice.
Former Fed chief Paul Volcker, now special adviser to President Obama, is pushing even more ambitious goals. He would have regulators limit the size of banks, for example, so no single one, such as Citigroup, can get “too big to fail.” He wants regulators to monitor executive pay more closely and actively supervise the hedge funds that helped push Lehman, Merrill and others over the edge. This is pretty strong stuff, and not all of it will survive the inevitable political battling. But when Volcker talks, people listen, especially when he is arguing that all this and more is necessary to redeem the system.
The Elephant in the Room
Finally it will be difficult to build long-lasting confidence in our economy, either at home or abroad, without evidence that we are adopting measures to pay down what will be a trillion-dollar-plus budget deficit from all this stimulating activity. This legacy of debt will be the elephant in the room, ultimately stomping on any developing confidence in a new American administration and its recovering economy. Until that elephant is cut down to size, it will be difficult, for example, to convince China, Japan and Germany—all huge and historically loyal buyers of U.S. debt—that their faith and cash are justified.
Addressing that debt with programs to reduce it effectively may be more difficult to put in place than any stimulus package or bailout program ever was. That is because the only way to cut down that elephant is to reduce the Holy Trinity of federal spending—defense, Social Security and Medicare.
There are plenty of pundits, economists, politicians and Wall Street types who retain their cynicism about all this. Plenty who believe that, even now, little will change because our political and financial systems are run by too many with a vested interest in keeping them the same. That is, run by those with little regulation, a blind eye to Wall Street’s reckless avarice and open arms to the omnipresent piles of corporate campaign contributions. After all, it was 1933 when FDR looked into the teeth of a far worse economic meltdown than today’s and told the American people that “there must be an end to a conduct in banking and in business which too often has given to a sacred trust the likeness of callous and selfish wrongdoing.”
“Small wonder that confidence languishes,” he declared, “for it thrives only on honesty, on honor, on the sacredness of obligations, on faithful protection, on unselfish performance. Without them, it cannot live.” And here we are, 76 years later, grappling once again with Wall Street and the government’s “callous and selfish wrongdoing.”
We can only hope that our best and brightest, be they Democrats or Republicans, bankers or stock brokers, White House insiders or Capitol Hill lobbyists, can come together to take effective and powerful action to heal the shattered lives and confidence produced by the worst economic implosion in more than 75 years. The measures necessary and possible are no mystery. Polls as President Obama took office showed that the public, normally addicted to quick fixes, seemed willing to give a new administration the time to restore that trust. It can be done.
Steve Lawrence has been a business and financial journalist for more than 30 years, holding editor and writer positions at The New York Times, Forbes, Time Inc. and the Financial Times of Canada, among others. He is a Washington, D.C., writer, editor and communications consultant for clients including the International Finance Corp. of the World Bank, McKinsey & Co. and Crowe Horwath LLP.