The Obama administration’s hollow commitment to the punishment and reform of Wall Street was evident early on. Rahm Emanuel, Obama’s first chief of staff, apparently sent a memo to Christine Varney, the assistant attorney general for the Antitrust Division inside Eric Holder’s Justice Department, asking her and her colleagues to tread lightly in their work so as not to upset Wall Street and endanger the sluggish recovery. This memo revealed the administration’s conciliatory long-term strategy, which explains the rationale behind many of Obama’s key appointments, both within the Justice Department (tasked with filing criminal charges or reaching settlements regarding financial malpractice) and for the various government agencies (responsible for preventing the recurrence of reckless mortgage lending and risky financial activity). In both arenas, the administration was largely under-resourced, over-powered, and, at times, outright deferential.
It is a bit much to take the administration’s self-congratulatory tone in prosecuting the worst offenses of major financial institutions. While it can boast lucrative settlements – $1.92 billion from HSBC for money laundering, $550 million from Goldman Sachs for an overly complex financial instrument, the blockbuster $13 billion from JP MorganChase for lax due diligence of mortgages primed for securitization – it is a calamity of justice that the administration deliberately refrained from launching criminal investigations. These settlements have largely been reached on the condition that these large institutions were not de jure guilty of fraud.
The 1934 Securities Exchange Act, in Rule 10b-5, defines fraudulent activity as, in the summarizing words of Predator Nation author Charles Ferguson, “a misstatement or omission that is sufficiently material to affect an investor’s opinion; that is made intentionally; that the investor relied upon in making his decision; and that directly caused actual losses.” As any literate and numerate knows, fraud is precisely what many individuals and institutions were committing. According to the hugely influential Clayton report, which reviewed a sample of 911,000 loans from 23 investment banks, 28% of the loans failed to meet numerous underwriting standards, and 39% of these clunkers were pawned off to duped investors (who trusted the investment grade status given by the rating agencies).
Now, one might ask, aren’t fines the only possible means of retribution for this kind of corporate malfeasance ? How could one person or a small group of people be held accountable for the activity of such massive institutions? Well, a law was passed to address this precise question: in 2002, in the wake of the Enron scandal, Congress passed the Sarbanes-Oxley Act in order to criminalize the known misrepresentation or manipulation of balance sheets in order to impress customers and shareholders. If Enron President Jeffrey Skilling can be sentenced to a 24 years in president for accounting prestidigitation, then so can bank senior executives involved in the financial crisis who signed off on their companies’ accounting statements – executives like Citigroup’s Vikram Pandit (whose company relied on an accounting loophole to hide its toxic mortgages inside SIVs and off its balance sheets), Lehman Brothers’ CEO Dick Fuld and CFO Erin Callan (for the Repo 105 accounting trick) and AIG’s inflated values of its CDS (credit default swap, i.e. investment insurance) portfolio.
These and other senior executives were (criminally) dismissive of early warnings about the implosion of the real estate market, substandard due diligence practices, and faulty accounting and asset valuations. For instance, Citigroup ignored early alarm-ringing about low-quality loans and their hasty approval for securitization . Lehman’s senior vice president Matthew Lee was brushed aside with his warning to Fuld, Callan, and two other executives, and vice president for accounting at AIG, Joseph St. Denis, resigned in 2007 after AIGFP executive Joseph Cassano refused to let him audit their CDS portfolio (which Cassano tragically saw as unlikely to cost the company “even one dollar,” only to need $180 billion in federal assistance over the next two years).
Yet, despite an abundance of avarice and pride that would leave even Dante horrified and speechless, the Justice Department and its partners at the SEC have not found means or courage to lodge criminal charges against a single person. Why? Rahm Emanuel, whose message of restraint and conciliation (which I surmise originated in the Oval Office itself) borders on servility. And what else could explain the president’s appointments within the Justice Department and the SEC? Here is Charles Ferguson‘s much under-reported exposé of the people he put in charge of prosecuting and reforming the financial industry:
The attorney general (Eric Holder) and the head of the Justice Department’s criminal division (Lanny Breuer) both come to us from Covington & Burling, a law firm that represents and lobbies for most of the major banks and their industry associations; indeed Breuer was co-head of its white collar criminal defense practice, and represented the Moody’s rating agency in the Enron case. Mary Schapiro, the head of the SEC, spent the housing bubble in charge of FINRA, the investment banking industry’s “self-regulator,” which gave her a $9 million severance for a job well done. And her head of enforcement, perhaps most stunningly of all, is Robert Khuzami, who was general counsel for Deutsche Bank’s North American business during the entire bubble.
And while one might expect the administration to be secretive about its protection of the big banks and its reason for doing so, Lanny Breuer was brazenly transparent about the justification for their restraint. In 2012, the Justice Department announced its $1.92 billion settlement with HSBC for its circumvention of various sanctions (this may sound like a hefty fine, but it represents just 4 weeks of their earnings). Among other criminal activity, it handled money for Iran, Mexican drug cartels, and Saudi banks tied to al-Qaeda. It also facilitated transactions for the genocidal regime in Sudan. And why didn’t anyone go to jail for this crime? It is not as if no one ever has: in 2010, an Iranian-American, Reza Safarha, was sentenced to ten months in prison for trafficking $300,000 in stolen office supplies – activity that in no way benefitted the Iranian government.
Let’s ask Mr. Breuer. His answer? “Had the US authorities decided to press criminal charges,” he claims, “HSBC would almost certainly have lost its banking license in the US, the future of the institution would have been under threat and the entire banking system would have been destabilized.” I’m no legal expert, but I don’t believe it is Mr. Breuer’s job to worry about whether, Holder’s dubious doctrine regarding “collateral consequences” notwithstanding, the successful prosecution of a case would result in the loss of thousands of jobs. His duty, as Assistant Attorney General for the Criminal Division of the Justice Department, is to punish the individuals and institutions that were grossly negligent in their businesses practices and caused a recession that saw the loss of 7 to 8 million jobs and the evaporation of trillions of dollars of wealth. If the Bush administration can pull off the fuzzy logic justifying say, privatized profits-socialized losses, or the Supreme Court can rule, as it did in the Citizens United decision, that “corporations are people,” then surely some corporate lawyers working on behalf of the administration can finagle a legal case for the imprisonment of such gross and deliberate criminal conduct.
But more worrisome has been the administration’s failure to enact the kinds of meaningful regulations of the financial industry that would prevent a replay of the lending, investing, and insurance practices that jeopardized the world economy.
While the administration did succeed in passing the Dodd-Frank Act in 2010, the several regulatory agencies’ drafting and approving the hundreds of rules is where the sausage is really made, and the financial lobbyists and their congressional sympathizers have used their money and connections to “slow down, deter or impede” (in the encouraging words of Mitch McConnell) any inconvenient legislation, because, after all, the “regulators are there to serve the banks” – as Republican Chairman of the House Financial Services Committee Max Baucus put it. But one must be careful not to assume that only Republicans have been responsible for this polite accommodation; it has been a rather bipartisan affair. One of the three Democrats on the CFTC’s five-member commission – a kind of Kennedy-esque crucial swing voter – left the agency thirteen months after Dodd-Frank’s passage in order to work for the DC law firm Patton Boggs on behalf of the lobbyists. And speaking of bipartisanship, one cannot forget the infamous Democratic Wall Street sycophant Chris Dodd, who, after successfully killing the Brown-Kaufman Amendment that would have effectively ended too big to fail, “reached across the aisle” to share some birthday cake with Republican Senator Richard Shelby.
The financial lobbyists have all of the advantages, including a phalanx of suave and sharp industry experts. According to The Nation, financial lobbyists have outnumbered consumer protection advocates since Dodd-Frank’s passage by a ratio of 20 to 1. They’ve also spent nearly a billion dollars trying to dilute the rulemaking of agencies like the CFTC, SEC, and CFPB. And what exactly is this money used to pay for? Access and face time with people like Gary Gensler – head of the CFTC and perhaps the most stalwart defender of the public interest – who naively adopted an open-door that benefited the big banks. Here is Gary Rivlin‘s summary of how lobbyists and their congressional partners overwhelm and under-resource regulatory agencies like Gensler’s:
[A] lobbyist for one of the big trade groups will complain to a friendly ally in the House that the CFTC is moving too fast or ignoring its warnings. So then the treasury secretary receives a formal complaint signed by this or that House committee chair imploring him to intervene before Gensler inadvertently finalizes a rule that sends half the derivatives jobs overseas. Dodd-Frank expanded Gensler’s mandate exponentially: his agency is slated to go from monitoring $40 trillion in transactions each year to something closer to $300 trillion. And the very first bill Republicans introduced after taking over the House in the 2010 midterms—HR 1—was a measure that would have cut the CFTC’s funding by one-third.
Here’s one example of that process. Eugene Scalia, the son of Antonin Scalia and one of the industry’s chief henchmen, has made several formal complaints about the pace of rule-writing and the methodology that informs it. If the SEC churns out a rule without having carefully considered the cost-benefit analysis according to a report produced by, say, the Business Roundtable, then the industry can cry foul and send the regulators back to the drawing board. This exhausting process explains why some rules have consumed 21,000 man hours and why, at this stage, only a fraction of the rulemaking has been completed. After three years, only the CFTC had written a majority of its rules (40 of 60), while the SEC, the Federal Reserve, and the FDIC still had most of their work ahead of them.
So, how successful have the banks been in diluting reforms? Let’s take a look at five separate areas, some of which were in dire need of serious updating, or, in other cases, first-time regulation.
MORTGAGE LENDING – Subprime lending lies at the root of the financial crisis – and the recession as a whole: astonishingly, half of the pre-meltdown growth in GDP was in some way related to the real estate bubble (construction, appliances, furniture, etc.). The ubiquity of “no-doc” lending and other loanshark-style mortgages obviously needed to be fixed. As a result, Dodd-Frank created a class of mortgages called Qualified Residential Mortgages (QRM) which mandate income certification and compliance with strict income-to-debt ratios. These safe loans are thus highly unlikely to cause much trouble. In this regard, Dodd-Frank has been a boon to reforming bank practices. However, Dodd-Frank also allows for the issuing of two other kinds of loans, including “qualified mortgages” (QM) with lower standards, as well as an even riskier class of mortgages (non-QM).
Dodd-Frank also created rules for the creation of mortgage-backed securities. Intermediary securitizers do not have to share any of the risk of the esteemed QRMs, but they do have to bear 5% of the risk when securitizing the other mortgages. Dodd-Frank envisioned that by forcing the big banks to “have skin in the game,” they would be less reckless and thus less likely to package such shoddy instruments. However, economists have already demonstrated that such requirements do not mitigate risk; they simply distribute it to massive, highly leveraged institutions. Here is one Princeton economist’s elaboration of the “hot potato” theory that challenges the widespread assumption about the efficacy of securitization, especially of toxic assets like still extant and poor quality (non-QM) loans:
By selling a bad loan, you get rid of the bad loan from your balance sheet. In this sense, the hot potato is passed down the chain to the greater fool next in the chain. However, issuing liabilities against bad loans does not get rid of the bad loan. The hot potato is sitting on your balance sheet or on the books of the special purpose vehicles that you are sponsoring. Thus, far from passing the hot potato down the chain to the greater fool next in the chain, you end up keeping the hot potato. In effect, the large financial intermediaries are the last in the chain. They are the greatest fool. While the investors who buy your securities will end up losing money, the financial intermediaries that have issued the securities are in danger of larger losses. Since the intermediaries are leveraged, they are in danger of having their equity wiped out, as many have painfully learned.
THE VOLCKER RULE – This observation leads us to the consideration of the Volcker Rule, which is misleadingly construed as a reinstatement of Glass-Steagall’s erection of a firewall between commercial and investment banking, the collision of which allowed the big banks to gamble so heavily in real estate. True: the regulators have banned some of the greatest incentives in proprietary trading, and banks may no longer engage in financial market-making that is imprudent or systemically destabilizing. But the regulators now have to define what kinds of practices will be considered acceptable. For instance, they are unable to agree on whether hedging (like the kind that gave us the London Whale debacle) will be permissible. The submission of over 17,000 comments on the Volcker Rule has contributed to its delay, and in 2012 Republicans voted to postpone its finalization to 2014.
OTC DERIVATIVES MARKET – Dodd-Frank successfully pushed for the regulation of previously over-the-counter derivatives, like the combustible credit default swaps that brought down AIG. Thanks to Clinton’s capitulation to the neoliberal disciples of Friedman and Greenspan – Larry Summers and Robert Rubin – such swaps were effectively spared regulation in 2000. Dodd-Frank mandates three important changes: price reporting, supervision, and central clearing. However, the lobbying industry has already taken a major bite out of this much needed supervision. Originally, Dodd-Frank called for swaps dealers who take in $100 million or more in revenue to abide by these regulations, but then, the industry pressed hard, and Republican Representative Randy Hultgren proposed that the de minimis exception be raised to $3 billion, which was later boosted to $8 billion, an eighty-fold increase.
CAPITALIZATION – Another much needed reform was in the realm of capitalization, since many of the biggest banks had been leveraged at 30 to 1 at the peak of the pre-crisis bubble (or 3% of assets), giving them cheaper access to gambling chips. Remarkably, many banks will continue to operate with a minimum 3% leverage ratio in accordance with Basel III’s international banking standards. Dodd-Frank has imposed a 5% capital requirement on the largest bank-holding companies (BHCs), and a 6% requirement on their subsidiary insured depository institutions; however, former FDIC Chairwoman Sheila Bair, among others, feels that an 8% capital requirement would have been more effective.
However, these limitations are still too low to do away with the prospect of another too big to fail scenario, and they are not set to take effect until 2018! Thus, with the wholly imaginable prospect of another liquidity crisis, the government may still be on the hook to step in with taxpayer money to bail out the banks. (Republicans led the effort to abolish a plan to mandate the creation of a $19 billion reserve fund.)
EMERGENCY FUNDING – Questions still remain as to what would happen if the big banks experienced another collapse. According to the latest OLA plan, “single point of entry,” the FDIC would harvest the mega-banking hold companies for debt to be converted into equity while keeping its subsidiaries alive. However, as one critic has rightly pointed out, the FDIC only has jurisdiction over federally insured depository institutions and not over other non-bank financial players like Lehman Brothers or AIG. Thus, the Federal Reserve may be required to step in under its 13(3) authority as the “lender of last resort,” despite the fact that Dodd-Frank limits the conditions under which it may intervene. For instance, it may only assist a singular and still solvent company rather than numerous insolvent ones (as Matt Taibbi convincingly argues was the case – in a truly must-read article – when in 2008-2009 the Fed surreptitiously provided hundreds of billions of dollars in undisclosed loans to individual troubled banks). In other words, it is still not clear what happen would during another implosion. Here is Stephen J. Lubben’s assessment of the current situation:
The full impact of these changes will be difficult to understand until the new safety net is tested in a crisis. Two vital questions are the use of Title II resolution authority and 13(3) authority, both of which are powerful tools that do not require Congressional approval. In both cases, the Dodd-Frank Act leaves regulators significant discretion to balance the potential need for broad assistance in order to maintain financial stability during a crisis, with the need to ensure accountability, minimize moral hazard, and properly delimit the scope of the public safety net. Even given this regulatory discretion, the statutory language clearly mandates an emphasis on accountability and strong limitations on indiscriminate assistance.
Unfortunately, early signs are that regulators may be leaning toward a greater emphasis on the ability to provide liquidity assistance during a crisis than on fulfilling the accountability mandate of the Dodd-Frank Act [emphasis added]. It is concerning that the “single point of entry” approach to resolution has at times been portrayed as involving indiscriminate support of the full range of bank subsidiaries in order to maintain the value of the institution. The provisions for executive accountability under resolution authority proposals are also weak. The failure of the Federal Reserve to promote the required regulations to limit emergency lending also raises serious concerns.
So, to summarize: massively leveraged banks may still purchase mortgages of poor quality, repackage them into securities without assuming much risk, insure them via credit default swaps, spark another crisis (unforeseen by underfunded and overburdened regulatory agencies) and leave several government agencies days or hours to cobble together another trillion dollar ad hoc bailout of undisciplined institutions that are a third bigger than they were six years ago. Some reform, eh?
One might expect this kind of silent coup by corporate interests in some bleak corner of the former Soviet Union or a kleptocratic West African republic. What else could possibly happen that would convince the public that the interests of such mega-corporations only rarely overlap (a point also surprisingly made by the Bush-appointed Bair) with those of the average consumer-citizen? Whether it be their disproportionately low (or negative) share of the tax burden, the loss of millions of decent jobs in exchange for cheap (and inexpensive) commodities, or consolidation across numerous industries and the accelerating illusoriness of genuine consumer choice, there are many reasons to demand a reconfiguration of our economic system. The only hope one can foresee in the near future is the ascendancy of Elizabeth Warren or someone like her prior to the 2016 election – someone who has devoted her life to consumer protection. Does anyone really believe the Hillary Clinton would do anything more than pay lip service to the need for “meaningful yet measured regulation” or some such empty verbiage? Until the Democratic Party, in its upper positions, is able to stand up to its powerful donors (hence inviting the catch-22 of passing campaign finance reform), capital’s influence in Washington will be difficult to impeach…just as they like it.