The special inspector general for TARP (the Troubled Asset Relief Program) reported on July 21 that the bank bailout that has been going on since September 2008 has cost $3.7 trillion in actual expenditures and guarantees to the banks. Not surprisingly, the banks are prospering. But in a just world, the failed banks would have been shut.
Of course, the impact of the financial crisis goes far beyond that—wiping out jobs, wealth, and optimism. The Economist calls it America’s “sharpest trauma since the second world war.” Yet no one has been held accountable.
On July 21, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act. “Because of this law,” he declared, “the American people will never again be asked to foot the bill for Wall Street’s mistakes. There will be no more taxpayer funded bailouts. Period.” Obama praised the work of the broadly smiling Sen. Chris Dodd (D-CT) and Rep. Barney Frank (D-MA), then led a long applause.
Everyone knows that, if Goldman Sachs fails tomorrow, the government will bail it out. In fact, the financial-reform law does not seriously address the issues raised by the Crisis of 2008. Rather than diminishing the big banks’ power, the new law enhances it, institutionalizing Too Big To Fail. TBTF, the heart of the current crisis, allows the big banks, because of the implicit government guarantee, to borrow at lower rates than smaller banks. The funding of the TBTF banks is consequently subsidized by the taxpayers. Moral hazard—heads, the banks win; tails, the taxpayer loses—will continue unabated. By selling mortgage-backed securities, the banks financed the subprime market long after it was clear the loans were made to people who couldn’t afford to pay them back.
Wall Street’s culture of greed and wretched excess exploded in 2008, hurting almost everyone in the country. The financial sector had ballooned far beyond its economic and social utility by funding speculation and gambling in place of long-term projects. The new law should have created legal structures to deal with Wall Street’s culture. The Glass-Steagall Act did that in 1933—it directly attacked the quick-buck culture that caused the 1929 crash and the Great Depression. Ferdinand Pecora, who directed the Senate’s 1933 year-long investigation of banking practices, wrote of the “riotous speculative excesses of the wild bull market of 1929.” Glass-Steagall’s solution was to separate commercial banking from investment banking. In 1939, Pecora wrote that the public “is sometimes forgetful” and may need to be “reminded what Wall Street was like before Uncle Sam stationed a policeman at its corner, lest, in time to come, some attempt be made to abolish that post.” Glass-Steagall held the line until 1999, when the Clinton administration fired the policeman.
Glass-Steagall divided the banking functions because they represented different cultures. Commercial banking performed the essential social and economic purpose of allocating scarce capital for long-term investment. Investment banking performed useful economic functions by underwriting new issues of stocks and bonds, but its other activities looked to the short term. Glass-Steagall said that short-term speculative, irrational exuberance will always lead to boom and bust, so it should be segregated from the essential banking functions. The investment bankers could gamble and lose their money if they wanted, but they were on their own. The essential banking functions were supported by the government via deposit insurance and the ability to borrow from the Federal Reserve. Glass-Steagall built a legal wall between the two cultures. Additionally, in the 1990’s the investment banks converted to the corporate form where the shareholders had limited liability and the officers had none. The bank officers could then make risky bets with other people’s money, taking the profits for themselves while leaving the losses to the shareholders and taxpayers.
In 2000, Washington legalized derivatives, which became the bankers’ favorite new toy. Derivatives, which are based on futures contracts invented in 18th-century England to protect the price of corn for farmers, turned the banks into casinos. They are a device to permit betting on stocks, bonds, commodities, and such invented things as volatility. (There is, if you can believe it, a CBOE Volatility Index.) In the second quarter of 2010, Goldman Sachs lost hundreds of millions shorting volatility, proving that even the vampire squid can make a mistake. Wall Street’s appetite for gambling turned out to be insatiable. Currently, the banks’ bets with one another through derivatives have a face amount of $600 trillion—ten times the world’s economic output. They also tie the banks together, creating one great big TBTF. Derivatives are private contracts between two parties, and their terms and even existence are unknown to competitors or regulators. Normally, a collapsed bubble in one part of the economy does not bring the house down. Derivatives, however, turned the subprime-mortgage collapse into a system-wide failure.
When Congress legalized derivatives, and the banks definitively turned into casinos, all federal backups should have been unequivocally removed. The banks were no longer serving the public and were no longer entitled to any subsidy. But the bankers kept the explicit and implicit federal supports. That political failure has cost the taxpayers $3.7 trillion and counting. From 2000 to 2008, the financial system paid salaries never seen before in human history. Annual salaries of over $100 million became common; in 2009 the average salary for all Goldman employees, including secretaries and runners, was $700,000.
Both the Bush and the Obama administrations put the very people who had wrecked the system—Larry Summers, Tim Geithner, and Ben Bernanke—in charge of fixing it. Not surprisingly, they decided to bail out the casinos. Similarly, the legislative designers of the Dodd-Frank Act were the same people who had protected Fannie Mae and Freddie Mac as they packaged and sold worthless mortgages.
The new law authorizes the Fed and the Treasury to bail out the big banks without congressional approval and with minimal judicial review. Congress, of course, passed TARP, but most of the bailout had no statutory authority—it was illegal. For example, there was no statutory authority for the Treasury’s trillion-dollar guarantee of money-market funds. The new law legalizes the previously illegal parts of the bailout.
“No financial firm will be ‘too big to fail,’” says Chris Dodd, because the law provides a “predictable, orderly, and safe process for shutting down dangerous Wall Street firms . . . without endangering the entire economy.” The senator assured us that “middle-class families on Main Street won’t have to pay a penny.” Part II of the act is entitled “Orderly Liquidation Authority”; it provides that the Fed, FDIC, and Treasury can put any “financial company” into receivership if they find it to be a threat to the system. The FDIC can then dispose of its assets as it does now with banks. The courts must find the Fed, FDIC, and Treasury acted in an arbitrary and capricious manner before they can set aside the receivership.
The problem with this approach is that, because of derivatives, all of the banks are interdependent, so the system fails as a whole. The new law only requires the clearing of whatever derivatives the CFTC or SEC determines should be cleared. All others will remain private contracts whose existence is known only to the parties.
The bankers tell us they have to be big to compete with international banks, some of which are state owned. Prof. Simon Johnson of MIT, a former economic counselor and director of the research department at the International Monetary Fund, writes, “There is simply no evidence—and I mean absolutely none—that society gains from banks having a balance sheet larger than $100 billion.” Johnson further noted that “capping the size of our largest banks at one-fifth or one-tenth of their current level could not strangle credit.” In October 2009, former Fed Chairman Alan Greenspan said that breaking up TBTF banks may in fact result in a net economic benefit: “If they’re too big to fail, they’re too big . . . In 1911 we broke up Standard Oil—so what happened? The individual parts became more valuable than the whole. Maybe that’s what we need to do.”
The synthetic Collateralized Debt Obligation (CDO) is one of the more bizarre of recent inventions. It owns no assets, yet it refers to them; it is pure gambling. This financial “innovation” was designed to allow short bets on mortgage-backed securities. You can short IBM by borrowing a share and selling it. You replace it by buying another, preferably after the price has dropped. That couldn’t be done with debt-backed securities because they were all different. The use of the synthetic CDOs greatly multiplied losses when the bubble burst. John Kenneth Galbraith, in The Great Crash of 1929 (1954), writes, “Such is the genius of capitalism that where a real demand exists it does not go long unfilled. In all great speculative orgies devices have appeared to enable the speculator so to concentrate on his business.” The synthetics should be banned, but Dodd-Frank lets them live.
Glass-Steagall was 37 pages long; the current Dodd-Frank Act goes on for 2,319 pages. Senator Dodd says, “no one will know how the new law will work until it’s passed and we see the regulations.” The Wall Street Journal reported (July 14) that the new law will “unleash the biggest wave of new federal financial rule-making in three generations.” It will require “no fewer than 243 new formal rule-makings by 11 different federal agencies.” Regulation, of course, is what failed last time. The Fed had their people in the banks watching every day as the banks turned into casinos. Congress, by punting to regulatory agencies, is abnegating its constitutional obligation.
Dodd-Frank’s emphasis on delegating legislative authority to the SEC, the Fed, the FDIC, the Treasury, and seven other agencies is another gift to the big banks. The big banks can afford high-priced lobbyists and will use the regulatory process to benefit themselves and hurt the smaller banks. Consequently, Dodd-Frank ensures that the institutions that caused the crisis will do it again. Michael Lewis, author of The Big Short, insists, “To put it in the crudest possible way, these firms have to be smaller and less profitable.”
The new law ended up close to what the Obama administration originally proposed. The more substantial restrictions on the banks were all stripped in the last week of debate. The Volcker rule would have prohibited proprietary trading—banks trading for their own account—but exceptions were added that were broad enough that banks can continue to do what they are doing. The rule, as enacted, says, in effect, You can’t do what you’re not doing now anyway. Similarly, the effort to bring the shadow world of derivatives into the sunshine was beaten back. Earlier versions of the act required that they be traded on exchanges, which would have subjected them, and their pricing, to public scrutiny. But with the bill that was signed, they will continue to be the casino’s favorite betting vehicle. When the market crashed in 2008, nobody knew who owed what to whom. Banks stopped dealing with one another because they didn’t know who held bad bets that would bust them. The other problem was that the synthetic CDOs and mortgage-backed securities were so strange that they could not be accurately valued by the Fed. Since the bank’s assets and liabilities could not be reliably ascertained, the Fed did not know if a bank was bust or not.
The financial crisis has hurt almost all Americans. The true unemployment rate, according to Investor’s Business Daily (IBD), is 24.1 percent—very close to the Great Depression’s 25-percent rate. (IBD counts the underemployed and those too discouraged to be looking actively.) The civilian labor force is 153.7 million—the Labor Department reports 14.6 million as unemployed to arrive at its 9.5 percent rate, while IBD reports 37 million as jobless. We expect one million home foreclosures this year, up from 900,000 last year. The Obama administration argues—as did the Bush administration—that the country was hurtling toward another great depression, but the bailout pulled us “back from the brink.” Things would be much worse, they say, if they had not intervened. The question is, has the depression been canceled or just postponed? The Fed’s continuation of its zero-interest-rate loan program to the banks reflects a continued concern that we remain in close proximity to the brink.
What about those enormous Wall Street bonuses that preceded the recent crash? Well, the bonuses for 2009 and 2010 are back to 2007 levels. The federal pay czar reported on July 23 that 80 percent of the Wall Street bonuses he studied were unmerited. U.K. Chancellor of the Exchequer Alastair Darling announced, in December 2009, a new bank-bonus tax. The tax is imposed on discretionary bonuses above £25,000. The tax rate is 50 percent and is nondeductible. In the second quarter of this year Goldman Sachs paid $600 million in the U.K. bonus tax. Such a tax seems a modest response to the obscene bonuses, but our Congress did not even consider it.
The public’s view of the government’s economic policies since 2008 is negative. A Pew Research poll taken July 15-18 reports that most Americans believe these policies have helped big banks, large corporations, and the wealthy while providing little or no help for the poor, middle class, or small businesses. Fully 74 percent say the policies have helped the big banks, while only 23 percent believe they have helped small business.
Both the annual deficits and the national debt have risen to dramatic new heights. Almost all have been hurt except the individuals and institutions that caused the trouble. Americans are furious about the bailouts—75 percent of the public has opposed them from the beginning. Congress, nonetheless, passed the Bush administration’s TARP in September 2008 after first defeating it. TARP, the New York Times reported on July 11, has turned out to be toxic for those congressmen who voted for it. Lawmakers from both parties who backed TARP “remain haunted by the vote.” Republicans expected healthcare to be the leading point of contention with Democrats for the November elections, but the bipartisan TARP vote has already become a “more resonant issue.” Both parties underestimated how bitterly the people would react to government bailing out the profligate banks. Since the public is so opposed to the big banks, why is Dodd-Frank so favorable toward them?
Congress is given a place of primacy in the Constitution, making it the first branch of government and the most representative. Short elections, Jefferson said, will keep them honest. But a recent Gallup poll reports that one half of Americans have little or no confidence in Congress.