Ramesh S Arunachalam
In his recent piece[iii], Mr Paul Krugman, someone whom I immensely respect, has made some erroneous statements and so, the correct facts need to be highlighted, especially given the fact that the article distorts the truth at a time when the New York primary is around the corner. That is the objective of this post! The two statements given at the beginning - made in a space of 13 years by Sandy Weill, the legendary banker and creator of the Citigroup - say it all...
Ok, let us now turn our attention to Mr Paul Krugman and his article in The New York Times. Mr Krugman asks a question and answers the same, “But were big banks really at the heart of the financial crisis, and would breaking them up protect us from future crises? Many analysts concluded years ago that the answers to both questions were no. ... pounding the table about big banks misses the point”[iv]
Sorry Mr Krugman, but you are wrong and clearly wrong in your above answers. And let me explain why. And as I do so, I will also bring in the brilliant commentary of the former Labor Secretary, Mr Robert Reich[v] who has provided an excellent but brief critique of your very biased and factually wrong article.
Mr Robert Reich puts forth four basic points that demolish the factually wrong arguments made out in your article Mr Krugman and I quote Mr Reich below,
1. “The biggest Wall Street banks did indeed precipitate the crisis on Wall Street in 2008 because of their gambling in newfangled financial instruments and fancy derivatives even they didn't understand.
2. Their size did make a difference because they were so interconnected with other financial entities both in the U.S. and around the world that they were "too big to fail." Today's biggest Wall Street banks are much bigger than they were in 2008.
3. Size also has a bearing on their political influence. The reason the Glass-Steagall Act was scotched by Bill Clinton's administration, and the Clinton administration wouldn't agree with the CFTC to regulate derivatives, had a lot to do with the influence of Wall Street over the Clinton administration and over Congress. The political power of the biggest players on the Street is even larger today – as evidenced by their capacity to whittle back significant parts of Dodd-Frank in the regulatory process.
4. Breaking up the biggest banks isn’t a radical idea. In fact, many experts – including the current president of the Federal Reserve Bank of Minneapolis (who’s a Republican and a former executive of Goldman Sachs), and the former head of the Federal Reserve Bank of Dallas -- have called for exactly this. [vi]“
Having set the context, I would now like to remind Mr Paul Krugman about the real causes of the 2008 financial crisis as seen through the eyes of the comprehensive Financial Crisis Inquiry Commission (FCIC) Final Report[vii]. I start with the role of the big banks and then move to other causes:
a) Removal of barriers and significant de-regulation - due to the intense and strong lobbying by the (large) banks - helped the banking industry to grow stupendously and irresponsibly, thereby leading to the 2008 financial crisis!
“During the 1990s the shadow banking system steadily gained ground on the traditional banking sector—and actually surpassed the banking sector for a brief time after 2000. Banks argued that their problems stemmed from the Glass-Steagall Act. Glass-Steagall strictly limited commercial banks’ participation in the securities markets, in part to end the practices of the 1920s, when banks sold highly speculative securities to depositors.” (FCIC Final Report) ...
“In the spring of 1996, after years of opposing repeal of Glass-Steagall, the Securities Industry Association—the trade organization of Wall Street firms such as Goldman Sachs and Merrill Lynch—changed course. Because restrictions on banks had been slowly removed during the previous decade, banks already had beachheads in securities and insurance. Despite numerous lawsuits against the Fed and the OCC, securities firms and insurance companies could not stop this piecemeal process of deregulation through agency rulings.[viii] Edward Yingling, the CEO of the American Bankers Association (a lobbying organization), said, ‘Because we had knocked so many holes in the walls separating commercial and investment banking and insurance, we were able to aggressively enter their businesses—in some cases more aggressively than they could enter ours. So first the securities industry, then the insurance companies, and finally the agents came over and said let’s negotiate a deal and work together.’[ix]” (FCIC Final Report)
“By 1997...the Fed also weakened or eliminated other firewalls between traditional banking subsidiaries and the new securities subsidiaries of bank holding companies.[x]” (FCIC Final Report)
“In 1998, Citicorp forced the issue by seeking a merger with the insurance giant Travelers to form Citigroup. The Fed approved it, citing a technical exemption to the Bank Holding Company Act,[xi] but Citigroup would have to divest itself of many Travelers assets within five years unless the laws were changed. Congress had to make a decision: Was it prepared to break up the nation’s largest financial firm? WAS IT TIME TO REPEAL THE GLASS-STEAGALL ACT, ONCE AND FOR ALL?
As Congress began fashioning legislation, the banks were close at hand. In 1999, the financial sector spent $187 million lobbying at the federal level, and individuals and political action committees (PACs) in the sector donated $202 million to federal election campaigns in the 2000 election cycle. FROM 1999 THROUGH 2008, FEDERAL LOBBYING BY THE FINANCIAL SECTOR REACHED $2.7 BILLION; CAMPAIGN DONATIONS FROM INDIVIDUALS AND PACs TOPPED $1 BILLION.[xii]
In November 1999, Congress passed and PRESIDENT CLINTON signed the Gramm-Leach-Bliley Act (GLBA), which lifted most of the remaining Glass-Steagall-era restrictions. The new law embodied many of the measures Treasury had previously advocated.[xiii] (FCIC Final Report)
The new regime encouraged growth and consolidation within and across banking, securities, and insurance. The bank-centered financial holding companies such as Citigroup, JP Morgan, and Bank of America could compete directly with the “big five” investment banks—Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Stearns—in securitization, stock and bond underwriting, loan syndication, and trading in over-the-counter (OTC) derivatives. The biggest bank holding companies became major players in investment banking. THE STRATEGIES OF THE LARGEST COMMERCIAL BANKS AND THEIR HOLDING COMPANIES CAME TO MORE CLOSELY RESEMBLE THE STRATEGIES OF INVESTMENT BANKS. Each had advantages: commercial banks enjoyed greater access to insured deposits, and the investment banks enjoyed less regulation. Both prospered from the late 1990s until the outbreak of the financial crisis in 2007. However, Greenspan’s “spare tire” that had helped make the system less vulnerable would be gone when the financial crisis emerged—all the wheels of the system would be spinning on the same axle.” (FCIC Report)
“From 1998 to 2007, the combined assets of the five largest U.S. banks—Bank of America, Citigroup, JP Morgan, Wachovia, and Wells Fargo—more than tripled, from $2.2 trillion to $6.8 trillion.[xiv] And investment banks were growing bigger, too. The assets of the five largest investment banks—Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Stearns—quadrupled, from $1 trillion in 1998 to $4 trillion in 2007.[xv]” (FCIC Final Report)
Likewise, “From 2000 to 2007, large banks and thrifts generally had $16 to $22 in assets for each dollar of capital, for leverage ratios between 16:1 and 22:1. For some banks, leverage remained roughly constant. JP Morgan’s reported leverage was between 20:1 and 22:1. Wells Fargo’s generally ranged between 16:1 and 17:1. Other banks upped their leverage. Bank of America’s rose from 18:1 in 2000 to 27:1 in 2007. Citigroup’s increased from 18:1 to 22:1, then shot up to 32:1 by the end of 2007, when Citi brought off-balance sheet assets onto the balance sheet. More than other banks, Citigroup held assets off of its balance sheet, in part to hold down capital requirements. In 2007, even after bringing $80 billion worth of assets on balance sheet, substantial assets remained off. If those had been included, leverage in 2007 would have been 48:1, or about 53% higher. In comparison, at Wells Fargo and Bank of America, including off-balance-sheet assets would have raised the 2007 leverage ratios 17% and 28%, respectively.[xvi]” (FCIC Final Report)
It was in the above context of unbridled, irresponsible and ravenous (burgeoning) growth by the big banks and other financial intermediaries that the 2008 financial crisis occurred. Let us be clear about that! And please note the fact that the FCIC, which was the statutory commission inquiring into the 2008 financial crisis strongly highlighted the issue that ‘PACs and Lobbying’ indeed played a HUGE role in the shattering of Glass-Steagall-era restrictions, which - as all of you can see - happened in November 1999, when Bill Clinton was the President. And we all know what happened because of the ‘Shattering of Glass-Steagall’ and as John Reed, former co-CEO of Citigroup, acknowledged to the FCIC, in hindsight,
“the compartmentalization that was created by Glass-Steagall would be a positive factor,” making less likely a “catastrophic failure” of the financial system.[xvii] (FCIC Report)
In fact, in my humble opinion, the de-regulation that happened during mid-end 1990s (including the “The Shattering of Glass-Steagall”) was a very important reason for the 2008 financial crisis as Greenspan’s “spare tire” that had helped make the system less vulnerable disappeared and all the wheels of the system were SUDDENLY spinning on the same axle, which finally broke and manifested itself as the financial crisis of 2008, whose effects, were are still reeling under today!
And make no mistake! Much of this happened because the big banks could lobby hard and strong as the FCIC report correctly notes. Citigroup, in particular, was one of the key lobbyists and as the New York Times reported, Citigroup CEO Sandy Weill hung in his office “a hunk of wood—at least 4 feet wide—etched with his portrait and the words ‘The Shatterer of Glass-Steagall.’”[xviii] That says it all...
Therefore, the role of Big Banks in causing the 2008 financial crisis (in the first place) needs no further emphasis as also evident from the discussion - on ‘Countrywide Financial’, a sub-prime lender cited by Mr Kruman – that follows!
b) Mr Krugman made a comment on ‘Countrywide Financial’ and other such sub-prime lenders being the real culprits and not the big banks and I would like to set the record straight on the same.
“By the end of 2007, most of the subprime lenders had failed or been acquired, including New Century Financial, Ameriquest, and American Home Mortgage. In January 2008, Bank of America announced it would acquire the ailing lender Countrywide. It soon became clear that risk—rather than being diversified across the financial system, as had been thought—was concentrated at the largest financial firms. Bear Stearns, laden with risky mortgage assets and dependent on fickle short term lending, was bought by JP Morgan with government assistance in the spring.” (FCIC Report)
“Before the summer was over, Fannie Mae and Freddie Mac would be put into conservatorship. Then, in September, Lehman Brothers failed and the remaining investment banks, Merrill Lynch, Goldman Sachs, and Morgan Stanley, struggled as they lost the market’s confidence. AIG, with its massive credit default swap portfolio and exposure to the subprime mortgage market, was rescued by the government. Finally, many commercial banks and thrifts, which had their own exposures to declining mortgage assets and their own exposures to short-term credit markets, teetered. IndyMac had already failed over the summer; in September, Washington Mutual became the largest bank failure in U.S. history. In October, Wachovia struck a deal to be acquired by Wells Fargo. Citigroup and Bank of America fought to stay afloat. Before it was over, taxpayers had committed trillions of dollars through more than two dozen extraordinary programs to stabilize the financial system and to prop up the nation’s largest financial institutions.” (FCIC Report)
As noted earlier and also in the subsequent sections, much of the problems emanated because “over time, banks and securities firms used securitization to mimic banking activities outside the regulatory framework for banks. For example, where banks traditionally took money from deposits to make loans and held them until maturity, banks now used money from the capital markets— often from money market mutual funds—to make loans, packaging them into securities to sell to investors. Securitization was not just a boon for commercial banks; it was also a lucrative new line of business for the Wall Street investment banks, with which the commercial banks worked to create the new securities.” (FCIC Report)
The above needs to be noted carefully!
And “much of the risk of CDS and other derivatives was concentrated in a few of the very largest banks, investment banks, and others—such as AIG Financial Products, a unit of AIG[xix]—that dominated dealing in OTC derivatives. Among U.S. bank holding companies, 97% of the notional amount of OTC derivatives, millions of contracts, were traded by just five large institutions (in 2008, JPMorgan Chase, Citigroup, Bank of America, Wachovia, and HSBC)—many of the same firms that would find themselves in trouble during the financial crisis.[xx] The country’s five largest investment banks were also among the world’s largest OTC derivatives dealers.” (FCIC Report)
And as the FCIC report further notes, “Our sample deal, CMLTI 2006-NC2, shows how these funding and securitization markets worked in practice. Eight banks and securities firms provided most of the money New Century needed to make the 4,449 mortgages it would sell to Citigroup. Most of the funds came through repo agreements from a set of banks—including Morgan Stanley ($424 million); Barclays Capital, a division of a U.K.-based bank ($221 million); Bank of America ($147 million); and Bear Stearns ($64 million).[xxi] The financing was provided when New Century originated these mortgages; so for about two months, New Century owed these banks approximately $940 million secured by the mortgages. Another $12 million in funding came from New Century itself, including $3 million through its own commercial paper program. On August 29, 2006, Citigroup paid New Century $979 million for the mortgages (and accrued interest), and New Century repaid the repo lenders after keeping a $24 million (2.5%) premium.[xxii] (FCIC Report)
That is not all – there is more and that is the issue of fraudulent Loans.
As the FCIC report notes, “Ed Parker, the head of mortgage fraud investigation at Ameriquest, the largest subprime lender in 2003, 2004, and 2005, told the FCIC that fraudulent loans were very common at the company. ‘No one was watching. The volume was up and now you see the fallout behind the loan origination process,’ he told the FCIC.[xxiii] David Gussmann, the former vice president of Enterprise Management Capital Markets at Fannie Mae, told the Commission that in one package of 50 securitized loans his analysts found one purchaser who had bought 19 properties, falsely identifying himself each time as the owner of only one property, while another had bought five properties.[xxiv] Fannie Mae’s detection of fraud increased steadily during the housing bubble and accelerated in late 2006, according to William Brewster, the current director of the company’s mortgage fraud program. He said that, seeing evidence of fraud, Fannie demanded that lenders such as BANK OF AMERICA, COUNTRYWIDE, CITIGROUP, AND JP MORGAN CHASE repurchase about $550 million in mortgages in 2008 and $650 million in 2009.[xxv] ‘Lax or practically non-existent government oversight created what criminologists have labeled crime-facilitative environments, where crime could thrive,’ said Henry N. Pontell, a professor of criminology at the University of California, Irvine, in testimony to the Commission.[xxvi]” (FCIC Report)
The above discussion shows that Mr Krugman’s comment on countrywide financial and other such sub-prime lenders being the real culprits and not the big banks holds no water and I would like to set the record straight on the same! In fact, there is more evidence on the role of the big banks which I plan to share in another post on a later date!
That said let us now move on and look at all the causes of the 2008 financial crisis as it is relevant to the issues being brought up in the US Presidential elections! I look at them, one by one hereafter:
c) A combination of excessive borrowing, risky investments, and lack of transparency put the financial system on a collision course with crisis.
“Clearly, this vulnerability was related to failures of corporate governance and regulation, but it is significant enough by itself to warrant our attention here. In the years leading up to the crisis, too many financial institutions, as well as too many households, borrowed to the hilt, leaving them vulnerable to financial distress or ruin if the value of their investments declined even modestly. For example, as of 2007, the five major investment banks—Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, and Morgan Stanley—were operating with extraordinarily thin capital. By one measure, their leverage ratios were as high as 40 to 1, meaning for every $40 in assets, there was only $1 in capital to cover losses. Less than a 3% drop in asset values could wipe out a firm. To make matters worse, much of their borrowing was short-term, in the overnight market—meaning the borrowing had to be renewed each and every day. For example, at the end of 2007, Bear Stearns had $11.8 billion in equity and $383.6 billion in liabilities and was borrowing as much as $70 billion in the overnight market. It was the equivalent of a small business with $50,000 in equity borrowing $1.6 million, with $296,750 of that due each and every day. One can’t really ask ‘What were they thinking?’ when it seems that too many of them were thinking alike.” (FCIC Report)
Anyone with financial sense will argue that such leverage is ridiculous. Yet it was allowed and consciously by the powers that be. Where were regulators and law/policy makers? I just don’t know!
d) Over-the-counter derivatives contributed significantly to this crisis.
“The enactment of legislation in 2000 to ban the regulation by both the federal and state governments of over-the-counter (OTC) derivatives was a key turning point in the march toward the financial crisis. …
OTC derivatives contributed to the crisis in three significant ways. First, one type of derivative—credit default swaps (CDS)—fuelled the mortgage securitization pipeline. CDS were sold to investors to protect against the default or decline in value of mortgage-related securities backed by risky loans. Companies sold protection—to the tune of $79 billion, in AIG’s case—to investors in these newfangled mortgage securities, helping to launch and expand the market and, in turn, to further fuel the housing bubble.
Second, CDS were essential to the creation of synthetic CDOs. These synthetic CDOs were merely bets on the performance of real mortgage-related securities. They amplified the losses from the collapse of the housing bubble by allowing multiple bets on the same securities and helped spread them throughout the financial system.
Goldman Sachs alone packaged and sold $73 billion in synthetic CDOs from July 1, 2004, to May 31, 2007. Synthetic CDOs created by Goldman referenced more than 3,400 mortgage securities, and 610 of them were referenced at least twice. This is apart from how many times these securities may have been referenced in synthetic CDOs created by other firms. …
While financial institutions surveyed by the FCIC said they do not track revenues and profits generated by their derivatives operations, some firms did provide estimates. For example, Goldman Sachs estimated that between 25% and 35% of its revenues from 2006 through 2009 were generated by derivatives, including 70% to 75% of the firm’s commodities business, and half or more of its interest rate and currencies business. From May 2007 through November 2008, $133 billion, or 86%, of the $155 billion of trades made by Goldman’s mortgage department were derivative transactions.[xxvii] “(FCIC Report)
Here you go again. Another example, where regulation was banned by LEGISLATION and as the FCIC report argues and I quote, “the enactment of legislation in 2000 to ban the regulation by both the federal and state governments of over-the-counter (OTC) derivatives was a key turning point in the march toward the financial crisis”.
Why on earth would the Federal Government ban regulation with a legislation and purchase a crisis? Good lord, it beats me…and I simply don’t understand why this happened? Was it lobbying, friendly relationships of policy/law makers with Wall-Street firms, paid speeches, and/or campaign donations that did the trick? I am not sure but I simply don’t fathom why this banning of regulation happened in the year 2000 (Y2K)! That is not all and read on...
e) Widespread failures in financial regulation and supervision proved devastating to the stability of financial markets in the United States.
“The sentries were not at their posts, in no small part due to the widely accepted faith in the self-correcting nature of the markets and the ability of financial institutions to effectively police themselves. More than 30 years of deregulation[xxviii] and reliance on self-regulation by financial institutions, championed by former Federal Reserve chairman Alan Greenspan and others, supported by successive administrations and Congresses, and actively pushed by the powerful financial industry at every turn, had stripped away key safeguards, which could have helped avoid catastrophe. This approach had opened up gaps in oversight of critical areas with trillions of dollars at risk, such as the shadow banking system and over-the-counter derivatives markets. In addition, the government permitted financial firms to pick their preferred regulators in what became a race to the weakest supervisor.” …
“Changes in the regulatory system occurred in many instances as financial markets evolved. But as the report will show, the financial industry itself played a key role in weakening regulatory constraints on institutions, markets, and products. It did not surprise the Commission that an industry of such wealth and power would exert pressure on policy makers and regulators. From 1999 to 2008 the financial sector expended $2.7 billion in reported federal lobbying expenses; individuals and political action committees in the sector made more than $1 billion in campaign contributions. What troubled us was the extent to which the nation was deprived of the necessary strength and independence of the oversight necessary to safeguard financial stability.” (FCIC Report)
Please note the comment on failure of financial regulation and supervision in causing the crisis as well as the reference to lobbying expenses, campaign contributions and the power and wealth of Wall-Street to ‘exert pressure on policy makers and regulators’. For a moment I thought that it was Bernie Sanders who had written this report but I was sadly mistaken! These words appear in the final report of the FCIC, the Statutory Commission that inquired into the Financial Crisis of 2008.
And without a doubt, the BIG BANKS were indeed part of the industry that LOBBIED hard and strong to get lax and laissez-faire regulation that led to the crisis. And not only did they lobby to get lax and laissez-faire regulation but they also brilliantly sold the idea of self-regulation to Law/Policy Makers and Regulators, who readily bought this idea…and faced the consequences via the financial crisis of 2008...
f) The captains of finance and the public stewards of the United States financial system ignored warnings and failed to question, understand, and manage evolving risks within a system essential to the well-being of the American public. Theirs was a huge miss, not a stumble.
“The prime example is the Federal Reserve’s pivotal failure to stem the flow of toxic mortgages, which it could have done by setting prudent mortgage-lending standards. The Federal Reserve was the one entity empowered to do so and it did not. The record of our examination is replete with evidence of other failures: financial institutions made, bought, and sold mortgage securities they never examined, did not care to examine, or knew to be defective; firms depended on tens of billions of dollars of borrowing that had to be renewed each and every night, secured by subprime mortgage securities; and major firms and investors blindly relied on credit rating agencies as their arbiters of risk. What else could one expect on a highway where there were neither speed limits nor neatly painted lines?” (FCIC Report)
The reader will note the emphasis on the ‘pivotal failure’ of the regulator – the Federal Reserve. The reader will also note that the FCIC report mentions the fact that “financial institutions made, bought, and sold mortgage securities they never examined, did not care to examine, or knew to be defective; firms depended on tens of billions of dollars of borrowing that had to be renewed each and every night, secured by subprime mortgage securities; and major firms and investors blindly relied on credit rating agencies as their arbiters of risk!”. And surely, as the FCIC report argues in the next point (given below), law/policy makers and regulators did have a huge say in creating such a “highway where there were neither speed limits nor neatly painted lines” and where reckless driving was the norm (rather than the exception). This set the context for the Banks and the big banks to run amok...as has been illustrated right through the FCIC report!
g) Dramatic failures of corporate governance and risk management at many systemically important financial institutions were a key cause of this crisis.
“There was a view that instincts for self-preservation inside major financial firms would shield them from fatal risk-taking without the need for a steady regulatory hand, which, the firms argued, would stifle innovation. Too many of these institutions acted recklessly, taking on too much risk, with too little capital, and with too much dependence on short-term funding. In many respects, this reflected a fundamental change in these institutions, particularly the large investment banks and bank holding companies, which focused their activities increasingly on risky trading activities that produced hefty profits. They took on enormous exposures in acquiring and supporting subprime lenders and creating, packaging, repackaging, and selling trillions of dollars in mortgage-related securities, including synthetic financial products. Like Icarus[xxix], they never feared flying ever closer to the sun.
Many of these institutions grew aggressively through poorly executed acquisition and integration strategies that made effective management more challenging. The CEO of Citigroup told the Commission that a $40 billion position in highly rated mortgage securities would ‘not in any way have excited my attention,’ and the co-head of Citigroup’s investment bank said he spent “a small fraction of 1%” of his time on those securities. IN THIS INSTANCE, TOO BIG TO FAIL MEANT TOO BIG TO MANAGE.
Financial institutions and credit rating agencies embraced mathematical models as reliable predictors of risks, replacing judgment in too many instances. Too often, risk management became risk justification.
Compensation systems—designed in an environment of cheap money, intense competition, and light regulation—too often rewarded the quick deal, the short-term gain—without proper consideration of long-term consequences. Often, those systems encouraged the big bet—where the payoff on the upside could be huge and the downside limited. This was the case up and down the line—from the corporate boardroom to the mortgage broker on the street.
Our examination revealed stunning instances of governance breakdowns and irresponsibility. You will read, among other things, about AIG senior management’s ignorance of the terms and risks of the company’s $79 billion derivatives exposure to mortgage-related securities; Fannie Mae’s quest for bigger market share, profits, and bonuses, which led it to ramp up its exposure to risky loans and securities as the housing market was peaking; and the costly surprise when Merrill Lynch’s top management realized that the company held $ 55 billion in “super-senior” and supposedly “super-safe” mortgage-related securities that resulted in billions of dollars in losses.” (FCIC Report)
Yet the law/policy makers and regulators swore by self-regulation. Why were they so dogmatic and blind sighted? In my humble opinion, self-regulation is an oxy-moron and has never worked. It pushes people to fly like Icarus who did not fear flying closer to the sun and simply perished. Now, this again, is a clear failure on the part of policy and law makers who were convinced by these Big Banks, Large Wall-Street Firms, Financial Conglomerates and Corporations to bring in the paradigm of self-regulation as a key component of the regulatory and supervisory process! Again, as before, the cost of this decision was very high and it resulted in the financial crisis of 2008, whose impact, we are still feeling today...
Let us move further on and get to the governance of compensation which played a very important role in the 2008 financial crisis. Indeed, compensation is one factor among many that contributed to the financial crisis of 2008 in the United States and elsewhere! And the FCIC report has also mentioned the same and this is quoted below:
h) The Governance of Compensation Was a Key Cause for the Crisis
“Both before and after going public, investment banks typically paid out half their revenues in compensation. For example, Goldman Sachs spent between 44% and 49% a year between 2005 and 2008, when Morgan Stanley allotted between 46% and 59%. Merrill paid out similar percentages in 2005 and 2006, but gave 141% in 2007—a year it suffered dramatic losses.[xxx]
As the scale, revenue, and profitability of the firms grew, compensation packages soared for senior executives and other key employees. John Gutfreund, reported to be the highest-paid executive on Wall Street in the late 1980s, received $3.2 million in 1986 as CEO of Salomon Brothers.[xxxi] Stanley O’Neal’s package was worth more than $91 million in 2006, the last full year he was CEO of Merrill Lynch.[xxxii] In 2007, Lloyd Blankfein, CEO at Goldman Sachs, received $68.5 million;[xxxiii] Richard Fuld, CEO of Lehman Brothers, and Jamie Dimon, CEO of JPMorgan Chase, received about $34 million and $28 million, respectively.[xxxiv] That year Wall Street paid workers in New York roughly $33 billion in year-end bonuses alone.[xxxv] Total compensation for the major U.S. banks and securities firms was estimated at $137 billion.[xxxvi]” (FCIC Report)
In effect, what was happening was that, in all these firms, the focus was on the short-term performance, incentives, and compensation when, in reality the risks (which existed) were mostly, medium and/or long-term. And of course, the regulator and law/policy makers sat and watched as compensation soared way beyond acceptable levels and firms started paying as high as 50% of their revenues in compensation.
Did not the regulators and policy/law makers find it strange that: a) Goldman Sachs spent between 44% and 49% of its revenue a year on compensation (during the years 2005 to 2008); b) Morgan Stanley allotted between 46% and 59%; and c) Merrill paid out similar percentages in 2005 and 2006, and more importantly, gave as high as 141% in 2007 (a year it suffered dramatic losses). What, on earth, were the regulators and policy/law makers doing?
Basically, as the FCIC report correctly argues, a lot of this happened because conflicts of interest were at play and they were responsible for the financial crisis of 2008 in a big measure. While there are innumerable examples from the FCIC report that I could cite towards conflicts of interest that were responsible for the financial crisis of 2008, one very relevant example is given below:
i) Conflicts of interest were at play and they were responsible for the financial crisis of 2008 in a big measure.
A “high profile example of conflict of interest … is the settlement that the SEC reached with Goldman Sachs, in which that firm paid $550 million to settle charges filed by the Commission, and acknowledged that disclosures made in marketing a subprime mortgage product contained incomplete information as they did not disclose the role of a hedge fund client who was taking the opposite side of the trade in the selection of the CDO.”[xxxvii] (FCIC Report)
And I quote
“2. Goldman acknowledges that the marketing materials for the ABACUS 2007-ACI transaction contained incomplete information. In particular, it was a mistake for the Goldman marketing materials to state that the reference portfolio was "selected by" ACA Management LLC without disclosing the role of Paulson & Co. Inc. in the portfolio selection process and that Paulson's economic interests were adverse to CDO investors. Goldman regrets that the marketing materials did not contain that disclosure. (http://www.sec.gov/litigation/litreleases/2010/consent-pr2010-123.pdf , Page 2, point 3)”
Before I close this piece, I would like to quote the FCIC report one final time and I do so below for the benefit of the American Public:
“Henry Paulson, the CEO of Goldman Sachs from 1999 until he became secretary of the Treasury in 2006 testified to the FCIC that by the time he became secretary many bad loans already had been issued—“most of the toothpaste was out of the tube”— and that “there really wasn’t the proper regulatory apparatus to deal with it.”[xxxviii] (FCIC Report)
“Paulson provided examples: “Subprime mortgages went from accounting for 5 percent of total mortgages in 1994 to 20 percent by 2006. . . . Securitization separated originators from the risk of the products they originated.” The result, Paulson observed, “was a housing bubble that eventually burst in far more spectacular fashion than most previous bubbles.”[xxxix] (FCIC Report)
“Under Paulson’s leadership, Goldman Sachs had played a central role in the creation and sale of mortgage securities. From 2004 through 2006, the company provided billions of dollars in loans to mortgage lenders; most went to the subprime lenders Ameriquest, Long Beach, Fremont, New Century, and Countrywide through warehouse lines of credit, often in the form of repos.[xl] During the same period, Goldman acquired $ 53 billion of loans from these and other subprime loan originators, which it securitized and sold to investors.[xli] From 2004 to 2006 Goldman issued 318 mortgage securitizations totalling $184 billion (about a quarter were subprime), and 63 CDOs totaling $32 billion; Goldman also issued 22 synthetic or hybrid CDOs with a face value of $35 billion between 2004 and June 2006.[xlii]” (FCIC Report)
I trust that the above clarifies for Mr Paul Krugman the involvement of big commercial banks and other financial intermediaries in causing the 2008 financial crisis! There is no way that the big banks can be absolved from their role in creating and sustaining the 2008 financial crisis, who effects were are still feeling today.
And there is no better evidence for this than the argument of Sandy Weill - ‘The Original Shatterer of Glass-Steagall’, legendary banker and creator of the Citigroup - who in an interview on CNBC’s SquawkBox said, bring back the Glass-Steagall Act of 1933[xliii]. That is the IRONY of life indeed!!!
[i] Please see - http://www.nytimes.com/2010/01/03/business/economy/03weill.html which notes as follows – “Sitting in his office on the 46th floor of the General Motors building in Manhattan, Sandy Weill is surrounded by reminders of a lifetime on Wall Street. The space is breathtaking with floor-to-ceiling windows and views stretching out over Central Park. One wall is devoted to framed magazine and newspaper articles chronicling his career. A Fortune magazine clipping from 2001 declares Citi one of its “10 Most Admired Companies. On another wall hangs a hunk of wood — at least 4 feet wide — etched with his portrait and the words “The Shatterer of Glass-Steagall.” The memento is a reference to the repeal in 1999 of Depression-era legislation; the repeal overturned core financial regulations, allowed for the creation of Citi and helped feed the Wall Street boom.
[v] Robert Bernard Reich is an American political commentator, professor, and author. He served in the administrations of Presidents Gerald Ford and Jimmy Carter and was Secretary of Labor under President Bill Clinton from 1993 to 1997. Reich is currently Chancellor's Professor of Public Policy at the Goldman School of Public Policy at the University of California, Berkeley. He was formerly a professor at Harvard University's John F. Kennedy School of Government and professor of social and economic policy at the Heller School for Social Policy and Management of Brandeis University. He has also been a contributing editor of The New Republic, The American Prospect (also chairman and founding editor), Harvard Business Review, The Atlantic, The New York Times, and The Wall Street Journal.
[viii] Securities Industry Association v. Board of Governors of the Federal Reserve System, 627 F.Supp. 695 (D.D.C. 1986); Kathleen Day, “Reinventing the Bank; With Depression-Era Law about to Be Rewritten, the Future Remains Unclear,” Washington Post, October 31, 1999.
[ix] Edward Yingling, quoted in “The Making of a Law,” ABA Banking Journal, December 1999.
[x] Thereafter, banks were only required to lend on collateral and set terms based upon what the market was offering. They also could not lend more than 10% of their capital to one subsidiary or more than 20% to all subsidiaries. Order Approving Applications to Engage in Limited Underwriting and Dealing in Certain Securities,” Federal Reserve Bulletin 73, no. 6 (June 1987): 473–508; “Revenue Limit on Bank-Ineligible Activities of Subsidiaries of Bank Holding Companies Engaged in Underwriting and Dealing in Securities,” Federal Register 61, no. 251 (Dec. 30, 1996), 68750–56.
[xi] Senate Lobbying Disclosure Act Database (www.senate.gov/legislative/Public_Disclosure/LDA_reports.htm); figures on employees and PACs compiled by the Center for Responsive Politics from Federal Elections Commission data.
[xii] FCIC staff computations based on data from the Center for Responsive Politics. “Financial sector” here includes insurance companies, commercial banks, securities and investment firms, finance and credit companies, accountants, savings and loan institutions, credit unions, and mortgage bankers and brokers.
[xiii] U.S. Department of the Treasury, Modernizing the Financial System (February 1991); Fed Chairman Alan Greenspan, “H.R. 10, the Financial Services Competitiveness Act of 1997,” testimony before the House Committee on Banking and Financial Services, 105th Cong., 1st sess., May 22, 1997.
[xiv] These were the largest banks as of 2007. See FCIC, “Preliminary Staff Report: Too-Big-to-Fail FinancialInstitutions,” August 31, 2010, p. 14.
[xv] Data from SNL Financial (www.snl.com/).
[xvi] FCIC staff calculations.
[xvii] John Reed, interview by FCIC, March 24, 2010.
[xviii] Katrina Brooker, “Citi’s Creator, Alone with His Regrets,” New York Times, January 2, 2010 - http://www.nytimes.com/2010/01/03/business/economy/03weill.html?_r=0
[xix] “AIGFP also participates as a dealer in a wide variety of financial derivatives transactions” (AIG, 2007 Form 10-K, p. 83). AIG’s notional derivatives outstanding were $2.1 trillion at the end of 2007, including $1.2 trillion of interest rate swaps, $0.6 trillion of credit derivatives, $0.2 trillion of currency swaps, and $0.2 trillion of other derivatives (p. 163).
[xx] FCIC staff calculations using data from Office of the Comptroller of the Currency; call reports.
[xxi] Glenn Loney, interview by FCIC, April 1, 2010.
[xxii]“Community Reinvestment Act Regulations and Home Mortgage Disclosure; Final Rules,” Federal Register 60, no. 86 (May 4, 1995): 22155–223.
[xxiii] Ed Parker, interview by FCIC, May 26, 2010.
[xxiv] David Gussmann, interview by FCIC, March 30, 2010.
[xxv] William H. Brewster, interview by FCIC, October 29, 2010.
[xxvi] Henry Pontell, written testimony for the FCIC, Hearing on the Impact of the Financial Crisis—Miami, Florida, session 1: Overview of Mortgage Fraud, September 21, 2010, p. 1.
[xxvii] Data provided to the FCIC by Goldman Sachs.
[xxviii] The FCIC final report came out in 2011 and thirty years refers to the period 1981-2011 I guess
[xxix] In Greek mythology, Icarus is the son of the master craftsman Daedalus, the creator of the Labyrinth. Icarus and his father attempted to escape from Crete by means of wings that his father had constructed from feathers and wax. Icarus's father warns him first of complacency and then of hubris, asking that he fly neither too low nor too high, so the sea's dampness would not clog his wings or the sun's heat melt them. Icarus ignored his father's instructions not to fly too close to the sun, whereupon the wax in his wings melted and he fell into the sea.
[xxx] Goldman Sachs, 2006 and 2009 10-K; Morgan Stanley, 2008 10-K; Merrill Lynch, 2005 and 2008 10-K.
[xxxi] “Gutfreund’s Pay Is Cut,” New York Times, December 23, 1987.
[xxxii] Merrill Lynch, “2007 Proxy Statement,” p. 38.
[xxxiii] Goldman Sachs, “Proxy Statement for 2008 Annual Meeting of Shareholders,” March 7, 2008, p. 16: Blankfein received $600,000 base salary and a 2007 year-end bonus of $67.9 million.
[xxxiv] Lehman Brothers, “Proxy Statement for Year-end 2007,” p. 28; JP Morgan Chase, “2007 Proxy
Statement,” p. 16.
[xxxv] New York State Office of the State Comptroller, “New York City Securities Industry Bonus Pool,”
February 23, 2010. The bonus pool is for securities industry (NAICS 523) employees who work in New
[xxxvi] “Banks Set for Record Pay, Top Firms on Pace to Award $145 Billion for 2009, Up 18%, WSJ Study
Finds,” WSJ.com, January 14, 2010.
[xxxvii] FCIC Report
[xxxviii] Henry M. Paulson Jr., testimony before the FCIC, Hearing on the Shadow Banking System, day 2, session 1: Perspective on the Shadow Banking System, May 6, 2010, transcript, p. 22.
[xxxix] Henry M. Paulson Jr., written testimony for the FCIC, Hearing on the Shadow Banking System,
day 2, session 1: Perspective on the Shadow Banking System, May 6, 2010, p. 2.
[xl] Goldman Sachs, 2005 and 2006 10-K (appendix 5a to Goldman’s March 8, 2010, letter to the
[xli] Appendix 5c to Goldman’s March 8, 2010, letter to the FCIC.
[xlii] Goldman’s March 8, 2010, letter to the FCIC, p. 28 (subprime securities).