By Alison Fitzgerald and Christine Harper
Sept. 11 (Bloomberg) -- Less than 24 hours after his swearing-in ceremony, U.S. Treasury Secretary Timothy F. Geithner surprised Camden R. Fine with an invitation to a one- on-one meeting about the financial crisis.
“I about fell out of my chair,” said Fine, president of the Independent Community Bankers of America, a Washington-based trade group with about 5,000 members. He was in a corner office overlooking the White House at the Treasury Department the next morning, telling Geithner that behemoths such as Citigroup Inc. and Bank of America Corp. were a menace, he said.
“They should be broken up and sold off,” Fine, 58, said he declared, as Geithner scribbled notes before thanking him for his time and ushering him out into the January chill.
The Treasury secretary didn’t follow through on Fine’s suggestion, just as he didn’t act on the advice of former Federal Reserve Chairman Paul A. Volcker, or Federal Deposit Insurance Corp. head Sheila C. Bair, or the dozens of economists and politicians who pressed the White House for measures that would limit the size or activities of U.S. banks.
One year after the demise of Lehman Brothers Holdings Inc. paralyzed the financial system, “mega-banks,” as Fine’s group calls them, are as interconnected and inscrutable as ever. The Obama administration’s plan for a regulatory overhaul wouldn’t force them to shrink or simplify their structure.
Policy of Containment
“We could have another Lehman Monday,” Niall Ferguson, author of the 2008 book “The Ascent of Money” and a professor of history at Harvard University in Cambridge, Massachusetts, said in an interview. “The system is essentially unchanged, except that post-Lehman, the survivors have ‘too big to fail’ tattooed on their chests.”
After the deepest recession since the 1930s, which has seen the world’s largest economy shrink 3.9 percent since the second quarter of last year, and more than $1.6 trillion in worldwide losses and writedowns by banks and insurers, President Barack Obama decided on a policy of containment rather than a structural transformation.
His proposal for revamping the way the U.S. monitors and controls banks doesn’t include taking apart institutions, supported by taxpayer loans, that have grown in scope and size since Lehman imploded. The biggest, Charlotte, North Carolina- based Bank of America, had $2.25 trillion in assets as of June, 31 percent more than a year earlier, and about 12 percent of all U.S. deposits.
Creating Bedlam
Instead, the Obama plan would label Bank of America, New York-based Citigroup and others as “systemically important.” It would subject them to capital and liquidity requirements and stricter oversight, relying on the same regulators who didn’t understand the consequences of a Lehman failure. And while companies could be dismantled if they got into trouble, they, their creditors and shareholders could also be bailed out with taxpayer money, according to the plan.
The chief architects, Geithner, 48, and National Economic Council Director Lawrence H. Summers, 54, say they don’t think it would be practical to outlaw banks of a certain size or limit trading activities by deposit-taking banks, according to people familiar with their thinking. They said the two men, who declined to be interviewed, and others on Obama’s team believe the lines are too fuzzy between banking and investing products and that forcing the divestiture of units and assets would create bedlam.
“It’s a very difficult thing to say as a national policy goal that we’re going to limit the success of an American firm,” said Tony Fratto, 43, a spokesman for President George W. Bush and former Treasury Secretary Henry M. Paulson who now heads a Washington consulting firm.
System Failure
The lesson of Sept. 15, 2008, is that limits may be necessary, according to Fine and other critics of the government’s regulatory proposals.
Lehman, the leading underwriter of mortgage-backed securities in 2008, was done in by too much borrowing and too many real estate investments that couldn’t be sold easily. When the property market turned sour -- home prices fell by 20 percent in the two years preceding the bankruptcy, according to the S&P/Case-Schiller home-price index of 20 U.S. cities -- and creditors wanted more collateral for loans or their money back, the investment bank had to fold.
It had $613 billion in debt and so many deals with so many companies that its bankruptcy set off a chain reaction the government and other Wall Street firms didn’t anticipate. Simon H. Johnson, a former chief economist at the International Monetary Fund, likened it to the fictitious substance ice-nine in the 1963 Kurt Vonnegut Jr. novel “Cat’s Cradle,” one drop of which could crystallize all the water on Earth. The Chapter 11 filing froze the global financial infrastructure.
Obama’s Fix
“This was a failure of the entire system,” Obama said on June 17 when he introduced his blueprint. “A regulatory regime basically crafted in the wake of a 20th-century economic crisis - - the Great Depression -- was overwhelmed by the speed, scope, and sophistication of a 21st-century global economy.”
The president’s fix is to empower the Fed to put the brakes on banks, hedge funds, insurers or other financial firms whose crash could have a crippling domino effect. About 25 companies may qualify based on their assets and on factors such as funding relationships, Fed Chairman Ben S. Bernanke told the House Financial Services Committee on July 24.
Potential Threats
“Most reform proposals acknowledge, perhaps with some consternation, that systemically important institutions are likely to be with us into the indefinite future,” said Daniel K. Tarullo, a member of the Fed’s board of governors, in an interview. “The proposed reforms are oriented toward forcing those institutions to internalize more of the risks they create and thus making it less likely they will create problems for the system as a whole.”
A Financial Services Oversight Council -- made up of the heads of the FDIC, the Securities and Exchange Commission, the Commodity Futures Trading Commission and other agencies -- would advise the Fed on potential threats.
The Treasury would be able to take over and wind down financial institutions with an authority modeled on powers held by the FDIC, which guarantees deposits and can close and sell failing banks under its jurisdiction. A Consumer Financial Protection Agency could restrict what it viewed as unsuitable products for Americans.
‘Crap Loans’
The existence of such a regulatory framework might have averted Lehman’s chaotic end -- and the economic crisis that followed -- because cheap money wouldn’t have been allowed to inflate a real estate bubble with questionable mortgages and mortgage derivatives, according to Austan Goolsbee, a member of the president’s Council of Economic Advisers.
“One of the fundamental principles of the plan is that if you’re menacing to the system, someone is going to regulate you very closely,” said Goolsbee, 40. “They’re going to be in there watching everything you do.”
If a consumer agency had existed, lenders wouldn’t have been able to sell so many complex and costly mortgages, said Ralph L. Schlosstein, chief executive officer of New York investment bank Evercore Partners Inc. and a supporter of Obama’s.
“There has never been decent regulation of the appropriateness of lending products as opposed to investment products, and the fact that that didn’t exist really allowed trillions of dollars of crap loans that were neither affordable nor understood to be made,” said Schlosstein, a co-founder and former president of asset management company BlackRock Inc.
Fatally Flawed
As much as it might mitigate some risks, the Obama strategy is fatally flawed because it fails to force the largest banks to change their behavior, said Johnson, the former IMF economist who is now a professor for finance at the Massachusetts Institute of Technology in Cambridge.
“The biggest problem is it doesn’t deal with too-big-to- fail,” Johnson said. “It doesn’t say anything.”
If constraints aren’t legislated, “complexity will multiply and take on new forms,” and regulators once again won’t be able to keep up, he said. “You have to make things a lot smaller.”
That too-big-to-fail predicament -- the theory that certain businesses can’t be allowed to go bankrupt because of the economic damage that would cause, and that the implicit government guarantee encourages risky behavior -- was discussed in conference rooms and watering holes during the Kansas City Fed’s annual symposium in Jackson Hole, Wyoming, in August.
‘Financial Oligarchy’
The chairman of the regional Fed and the event’s host, Thomas M. Hoenig, 63, had set the tone with speeches over the past year that warned against allowing power to be concentrated in a “financial oligarchy.” Hoenig played on the theme at the opening steak-and-salmon dinner on Aug. 20 at Jackson Lake Lodge, a National Historic Landmark in Grand Teton National Park. Access had to be limited, he said, for fear the group would grow “too big to feed.”
That thread of humor spread as speakers tried to work references to size and failure into their remarks, with varying degrees of success, according to Mark Gertler, 58, a New York University economist and former research partner of Bernanke’s who attended the conference.
Bank of Israel Governor Stanley Fischer, Bernanke’s thesis adviser at MIT, addressed the topic more seriously at lunch on Aug. 21.
“At this stage, we seem to be taking it for granted that we should go back to the structure of the financial system as it was on the eve of the crisis,” Fischer, 65, a former Citigroup vice chairman, told his audience in the lodge’s Grizzly Room. “Even for the largest economies, there is a case for discouraging financial institutions from growing excessively.”
‘Fragile’ System
Fischer’s comments echoed those of Volcker. The 82-year-old head of the president’s Economic Recovery Advisory Board began his campaign for restructuring the basics of U.S. banking 17 months ago in a speech to the New York Economic Club. It was April 8, 2008, three weeks after the Fed helped New York-based JPMorgan Chase & Co. buy Bear Stearns Cos. by extending a $30 billion backstop.
The “demonstrably fragile financial system that has produced unimaginable wealth for some, while repeatedly risking a cascading breakdown of the system as a whole, needs repair and reform,” the 6-foot-7-inch (2.01-meter) Volcker said, grasping a podium that reached only to his waist. Before the speech at the Grand Hyatt New York, he belatedly celebrated his 80th birthday by blowing out a candle on a cake shaped like a stack of gift boxes.
Volcker’s Plan
Volcker’s ideas for overhauling the system -- including strict regulation of over-the-counter derivatives trading -- were outlined in an 82-page report prepared by the Group of 30, an organization of current and former central bankers, finance ministers, economists and financiers that Volcker heads.
When he made the document public on Jan. 15, Volcker told reporters that he “sent a copy to some of the people in the new administration that would have an interest in it.” Since then, Volcker, an adviser to Obama during the presidential race, has lobbied Geithner and Summers, according to people familiar with the discussions. The former Fed chairman is taking his case on the road this month, starting with a speech on Sept. 16 to the Association for Corporate Growth in Beverly Hills, California.
Volcker would subject money market funds to the same regulatory burdens as banks, demanding they hold capital to protect against losses like those suffered by the Reserve Primary Fund when Lehman’s bankruptcy touched off a run and more than 60 percent of its assets were withdrawn in two days.
‘Molotov Cocktail’
Another critical change, according to Volcker, would be to prohibit big, interconnected companies that handle essential services such as deposit-taking and business payments from making high-risk bets with their own money in so-called proprietary trading. Volcker also wouldn’t allow non-financial firms to own government-insured deposit-taking companies. The proposals, intended to prevent another ice-nine episode, are similar in some respects to restrictions in place in the U.S. for more than 60 years until the Glass-Steagall Act was overturned by Congress in 1999.
“Does anyone think it’s a coincidence that less than 10 years after they repealed Glass-Steagall, the financial markets collapsed?” said Fine of the community bankers group. He called current rules for banking a recipe for a “Molotov cocktail.”
Bair, the FDIC chairman, has taken a different tack: She wants to check growth by charging fees based on the risks banks take. If Lehman had to pay for its gambles, it might not have held $84 billion in mortgage investments and loaded up on mortgage-backed securities in early 2008, after the subprime crisis began.
Bair, Geithner
“A financial system characterized by a handful of giant institutions with global reach and a single regulator is making a huge bet that those few banks and their regulator over a long period of time will always make the right decisions,” Bair told the Senate Banking Committee in May. She and Geithner have clashed because of her public opposition to his plan to make the Fed the chief overseer of systemically important financial institutions.
For the executives and government officials who met at the New York Fed the weekend before Lehman went bust last September, the right decisions weren’t obvious.
Their focus was on mitigating damage from about 1 million over-the-counter derivatives trades that Lehman had participated in, according to people who attended the meetings. The men and women in the room weren’t prepared when panic struck the $3.6 trillion money market industry, which provides short-term loans called commercial paper used by corporations such as General Electric Co. to pay everyday bills.
Espresso Shot
“They didn’t know who Lehman was intertwined with because they hadn’t done their homework,” said Joseph Stiglitz, a Columbia University economics professor who won the Nobel Prize in economics in 2001 for his analysis of markets with asymmetric information.
That came home to Fratto the Saturday morning before Lehman fell apart. He sat in his West Wing office at the White House, adorned with pictures of his children and an inscribed photograph of Bono, monitoring the negotiations when he got a call from a friend at a New York bank.
Sipping from a cup of Starbucks coffee with an extra shot of espresso, Fratto asked what she was doing at work.
“She told me that every bank in New York City had their back offices filled with people trying to figure out their counterparty risk to Lehman,” Fratto recalled. “I was stunned. Everyone knew that Lehman had been listing for six months.”
‘Web of Counterparties’
Richard Bookstaber, a former trader and risk manager who warned a crisis was likely in his 2007 book “A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation,” testified in Congress in October 2007 and June 2008 that regulators didn’t have adequate information to understand the dependencies between companies. The White House proposal to move over-the-counter derivatives onto clearinghouses and exchanges would help by giving regulators and companies involved in transactions better information, he said.
“You have to know the web of counterparties,” he said in an interview. “Nobody knew that, so they’re really shooting in the dark in terms of what the impact would be of Lehman not being saved and what would be necessary to save Lehman.”
Global Sprawl
By the middle of September 2008, it was too late to save the company, and when profits were rolling in it would have been too early, said Ron Feldman, senior vice president in charge of bank supervision at the Minneapolis Fed and co-author of “Too Big to Fail: The Hazards of Bank Bailouts,” published in 2004.
“When the firms are making a lot of money, it’s very difficult to tell them to stop doing certain things,” Feldman said in an interview. “That’s when all the risks are taken.”
Once losses are overwhelming, regulators may have trouble closing down businesses with depositors and creditors in far- flung places. Lehman was an international company based in New York, and people in cities as distant as Hong Kong lost their savings without any inkling their securities were linked to the investment bank.
Citigroup, the bank that has received the most support from the U.S. government, had $494 billion in deposits at foreign branches on June 30 compared with $317 billion in U.S. deposits, according to the company’s latest regulatory filing. That kind of global sprawl at Citigroup and other big financial institutions would make it difficult for U.S. authorities to wind them down.
Goldman Sachs
“Unless we get an internationally agreed-upon insolvency regime, which I cannot believe is ever going to happen in our lifetime, then you just can’t deal with it,” said Bradley K. Sabel, a partner at Shearman & Sterling LLP in New York who spent 18 years at the New York Fed.
Four U.S. companies -- Bank of America, JPMorgan Chase, Citigroup and San Francisco-based Wells Fargo & Co., which bought Wachovia Corp. eight months ago -- have grown to command 46 percent of the assets of all FDIC-insured banks, up from 37.7 percent a year ago. Bank of America, which agreed to acquire Merrill Lynch & Co. the day before Lehman filed for bankruptcy, has 13.3 percent of the total.
New York-based Goldman Sachs Group Inc., the world’s biggest securities firm before converting to a bank seven days after Lehman went under, ratcheted up its trading risks to a record in the first six months of this year, leading to a 67 percent jump in revenue from trading and principal investments over the same period last year. Goldman Sachs also has international reach, with more than 900 subsidiaries in places including the Cayman Islands, Mauritius, Panama and Liberia, according to an SEC filing for the year 2008.
Restoring Discipline
“Nothing has changed except that we have larger players who are more powerful, who are more dependent on government capital and who are harder to regulate than they were to begin with,” said Nomi Prins, who was a managing director at Goldman Sachs before leaving in 2002 and becoming a writer. “We’re in a far less stable environment.”
The ability to wind down big banks would help restore discipline, according to Deputy Treasury Secretary Neal S. Wolin.
“Special resolution authority would give the government the tools it needs to let firms fail in times of severe economic distress without destabilizing the entire financial system,” Wolin said.
The Treasury would also retain the power to save a company and turn to taxpayers to recapitalize it or pay creditors or shareholders, according to the Obama plan.
‘Permanent TARP’
That bothers Philip L. Swagel, an assistant Treasury secretary under Paulson and now an economics professor at McDonough School of Business at Georgetown University in Washington. He said the White House isn’t doing much to convince investors -- or executives -- that the next bank to wobble won’t be propped up too.
“Their answer is basically a permanent TARP,” Swagel said referring to the $700 billion Troubled Asset Relief Program.
One evening in Jackson Hole, central bankers and economists, sipping cocktails on a patio with a view of the Teton Range, talked about what was really worrying them, according to Gertler, the New York University professor. It was that politicians wouldn’t have the mettle to enact significant changes, he said.
“The broader concern was not so much shaping the details of the policy, but whether the legislation would die in Congress,” he said.
Bank Lobbying
The House Financial Services and Senate Banking committees began holding hearings on regulatory proposals before the August recess. Representative Barney Frank of Massachusetts, the Democrat who heads the House panel, has said it will consider the consumer agency first before moving on to other provisions. In the Senate, the entire package will be taken up as one bill, which is unlikely to reach the floor before next year.
Goldman Sachs, JPMorgan and Citigroup were three of the five biggest donors to federal candidates and political parties in last year’s election cycle, according to data compiled by the Center for Responsive Politics, a Washington research group.
Banking industry trade groups are pushing to kill the consumer agency, which they contend will make it impossible to offer the variety of loans and accounts that customers demand and deserve. Banks are also fighting the Treasury’s proposal to move the $592 trillion over-the-counter derivatives market onto clearinghouses and exchanges.
Capital Ratios
While pieces of the administration’s plan may help stave off future crises, the lesson of the Lehman collapse is that big, global financial institutions can create risks that even experienced regulators and bankers won’t always anticipate or understand, according to critics such as Christopher Whalen, managing director of Torrance, California-based Institutional Risk Analytics, which evaluates banks for investors.
At talks in London that concluded on Sept. 5, finance officials from the Group of 20 agreed that banks should be forced to hold more capital, raise the quality of assets they keep in reserve and curtail leverage. The Financial Stability Board, a committee of regulators based in Basel, Switzerland, will flesh out the details before leaders of G-20 countries, which include the U.S., Japan, China and members of the European Union, meet in Pittsburgh on Sept. 24.
“Our objective is to reach agreement by the end of next year on a new standard that will raise capital and liquidity requirements and dampen rather than amplify future credit and asset-price bubbles,” Geithner said in London.
Changing Behavior
The G-20 proposal doesn’t address the right issues, according to Institutional Risk Analytics’ Whalen.
Every big firm that got into trouble last year had a ratio of capital to risk-weighted assets exceeding government minimums, regulatory filings show.
Fifteen days before its bankruptcy, Lehman estimated its Tier 1 capital ratio was 11 percent, up from 10.7 percent at the end of May, the investment bank said in a Sept. 10, 2008, press release. SEC rules obliged Lehman to notify the agency if its total ratio, of which Tier 1 was just a piece, slipped under 10 percent or was expected to do so.
“It was the activities of the banks -- not their lack of capital -- that caused the problem,” Whalen said. “We have to change the behavior of these institutions, and higher capital requirements are not going to change their behavior.”
Some financial executives have applauded the Geithner proposals. Walid Chammah, co-president of Morgan Stanley, said at a banking conference this week in Frankfurt that he doesn’t believe breaking up banks is the right approach. Instead, they should be required to hold more capital and liquid assets.
‘Break the Power’
The White House proposals are meek compared with what the U.S. did under President Franklin Delano Roosevelt, according to Charles R. Geisst, a finance professor at Manhattan College in Riverdale, New York, and author of “Wall Street: A History.”
The Glass-Steagall Act of 1933 forced then-mighty J.P. Morgan & Co. to split in two, creating Morgan Stanley as a standalone investment bank.
Roosevelt’s effort was “antitrust legislation to break the power of the New York City money-center banks,” Geisst said. While today’s titans such as JPMorgan Chase and Goldman Sachs “have the same sort of influence, for some reason most people here do not want to alienate them.”
To contact the reporters on this story: Alison Fitzgerald in Washington at afitzgerald2@bloomberg.net; Christine Harper in New York at charper@bloomberg.net.
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