Get that dog back on its leash
“I’m being called Mr. Bailout,” U.S. Treasury Secretary Henry Paulson declared on a conference call in September, 2008, with Bernanke, now Federal Reserve Board chairman, and Timothy Geithner, president of the New York branch of the Fed. “I can’t do it again.” That call occurred a few days before Paulson, the former Goldman Sachs CEO, failed to persuade his fellow Wall Street Masters of the Universe to rescue Lehman. He had had greater success earlier, in March, when he arranged for JPMorgan Chase & Co. to buy troubled Bear Stearns Cos. Inc. But the Paulson-Geithner-Bernanke troika had provoked outrage in Congress by providing a $29-billion loan from the Fed to seal the deal (all currencies in U.S. dollars except where otherwise noted).
Lehman was to be the end of Paulson’s innocence. Without government help, no one would touch Lehman. He and the bank CEOs could see the obvious — Lehman’s structure was fundamentally and dangerously flawed, as was the rest of the U.S. banking system.
The 1990s had witnessed the loosening of a symbolic tether that Washington had placed on banks to rein in the excesses that had caused the Great Crash of 1929. The Glass-Steagall Act of 1933 had been passed to halt a wave of thousands of bank failures during the Depression. Among other things, it set up federal deposit insurance and created the Federal Reserve’s powerful Open Market Committee to oversee monetary policy. The act also split conventional commercial banking and investment banking. The business of taking in deposits and making loans was to be kept separate from trading stocks, bonds and other securities.
But in the 1990s, Washington was gripped by deregulation fever, and much of that barrier had eroded, so Congress eliminated it altogether. Banks went from big to massive, like New York-based Citigroup, which turned itself into the Walmart of financial institutions. Citi and its competitors started generating eye-popping profits by making high-stakes trades on their own accounts, much of them in elaborate and highly leveraged mortgage-backed securities and derivatives. Leverage meant that they could make bets many times greater than the value of the capital they risked, even though that capital could be wiped out almost instantly in a sharp market downturn.
Lehman’s fall brought inevitable recantations. Alan Greenspan, Fed chairman during the go-go 1990s and early 2000s, admitted that he had been wrong to believe that financial firms’ instinct for self-preservation would keep rogue elements in check. Sanford Weill, Citigroup chairman until 2006, now says the biggest banks should be shrunk. Arthur Levitt, chairman of the Securities and Exchange Commission from 1993 to 2001, says he was wrong to advocate for light supervision of derivatives trading. In Europe, governments and regulators also admitted that they had let their banks get out of hand.
There have been genuine reforms since 2008. Authorities the world over are telling their banks to hold more capital against their loan and securities portfolios, and to keep their exposure to risky bets under control. Governments also still appear to be determined to move derivatives trading onto public exchanges. In the U.S., the so-called Dodd-Frank Act, passed in 2010, didn’t re-erect barriers between deposit-taking and investment banking, but it included new measures to monitor institutions deemed “too big to fail” and to break them up if they get too large, or restructure or sell them off quickly if they get in trouble.
There are no ideologues in a foxhole
As the Group of Seven finance ministers arrived at the White House to meet with President Bush on Oct. 11, 2008, the signs of a potential global cataclysm were already clear. U.S. stocks had plunged by almost 30% since Lehman’s downfall on Sept. 15. Central banks were frantically injecting billions into crumbling economies. Bush had already rushed to expand government deposit insurance to forestall any Depression-style run on banks. “In my country, it is important for our citizens to have understood that that which affects Wall Street affects Main Street as well,” he said.
Although the regimes in power in the U.S., Germany, Britain, France, Italy and Canada were predominantly of a free-market bent, they quickly agreed that if governments didn’t create demand by running massive deficits, no one would. For Canadian Finance Minister Jim Flaherty, this was like swallowing Buckley’s Mixture: “It tastes awful. And it works.”
That was only the beginning. The fiscally conservative regimes in Washington and Ottawa soon found themselves meddling directly in the banking system, and in troubled companies. Both governments provided billions to General Motors and Chrysler to save the Detroit-based auto makers from certain bankruptcy. Treasury Secretary Paulson took equity stakes in the country’s biggest banks. After telling shareholders of Fannie Mae (the Federal National Mortgage Association) and Freddie Mac (the Federal Home Loan Mortgage Corp.) that the government would not take over the agencies, the Bush administration assumed control of both and bailed them out — just as investors had always assumed that the government would.