Too Big to Fail: The Inside Story of How Wall Street and Washington Fought to Save the FinancialSystem--and Themselves

AFTERWORD

The people on Wall Street still don’t get it. They don’t get it. They’re still puzzled: Why is it that people are mad at the banks? Well, let’s see. You guys are drawing down ten-, twenty-million-dollar bonuses after America went through the worst economic year that it’s gone through in decades, and you guys caused the problem. And we’ve got ten percent unemployment. Why do you think people might be a little frustrated?

—President Barack Obama, December 7, 2009

Nearly two years have passed since the peak of the financial crisis, but the debate over its ultimate causes and the decisions that were made during those sleepless days in September 2008 to rescue the financial system is still raging. Disputes about how to fix the banking industry to prevent another crisis from occurring have become a fixture of global conversation. Although legislation to reform the financial industry is about to be signed by the president as of this writing, questions persist about whether it goes far enough. Indeed, the phrase “too big to fail” has become as common on Main Street as it is on Wall Street, as everyone from small businessmen to farmers finally have come to understand the dangers of a financial sector that has grown so large and interconnected.

The debate has been spurred, at least in part, by an ongoing disconnect between the public and the financial industry that, despite the damage left in the wake of the crisis, seemed to quickly return to business as usual while the rest of the nation struggled.

While unemployment in the United States hovered at almost 10 percent for much of 2009, Wall Street banks were seemingly minting money again. Goldman Sachs announced a record profit that year of $13.4 billion, due in large part to trading for its own account. The firm paid out $16.2 billion in bonuses, the equivalent of $498,000 per employee. Even troubled firms, like Citigroup and Bank of America, were successful enough that they hastened to pay back their TARP money, at least in part so that they, too, could reward their employees with large bonuses without the restrictions imposed if they had still owed money to the government.

In Washington, the rift between Wall Street and the public grew as legislation to reform the financial industry slowly wound its way through the House of Representatives and Senate. Despite lip service by many of the industry’s leaders to support reform, Wall Street swarmed Washington with some 1,400 lobbyists, paying the top ten lobbying firms $30 million to push back on most of the significant reform efforts.

The president, meanwhile, channeling the public’s rage, took to chastising the financial industry publicly. “I did not run for office to be helping out a bunch of fat-cat bankers on Wall Street,” he told CBS’s 60 Minutes.

Although many Wall Street bankers, like Jamie Dimon, had supported President Obama’s election—The New York Times called him “President Obama’s favorite banker”—he and others in the industry felt that the president had begun to use Wall Street as a convenient target to score political points.

The relationship between the financial industry and Washington started to deteriorate in earnest late January 2010. Two days after the Democrats surprisingly lost an election in Massachusetts for the late Ted Kennedy’s former Senate seat, President Obama, seemingly out of nowhere, announced a sweeping plan to overhaul Wall Street.

“I’m proposing a simple and common-sense reform, which we’re calling the ‘Volcker Rule’—after this tall guy behind me,” Obama announced, referring to Paul Volcker, the former chairman of the Federal Reserve. “Banks will no longer be allowed to own, invest, or sponsor hedge funds, private equity funds, or proprietary trading operations for their own profit, unrelated to serving their customers. If financial firms want to trade for profit, that’s something they’re free to do. Indeed, doing so—responsibly—is a good thing for the markets and the economy. But these firms should not be allowed to run these hedge funds and private equities funds while running a bank backed by the American people.”

The proposal, which would have a profound effect on the way the industry worked, was greeted with cheers from critics of the financial sector, but with dismay from those within it. “For a lot of Wall Street people, it was like, ‘Okay, first you slap us in the face, now you kick us in the balls. Enough is enough. I mean, we’re done,’” one banking CEO complained.

The choice was especially surprising because for many months Volcker, whom Obama had asked to chair the President’s Economic Recovery Advisory Board, had effectively been ignored by other members of the administration, like Timothy Geithner, the Treasury secretary.

Volcker had been the most outspoken member of Obama’s inner circle about the need for reform. To him, Wall Street had grown far too complicated with fancy new products like collateralized debt obligations and had veered away from its core purpose of helping the economy through responsible lending.

At a gathering of bank CEOs in late 2009, he famously chided its leaders.

“Wake up, gentlemen,” he declared. “I wish that somebody would give me some shred of neutral evidence about the relationship between financial innovation recently and the growth of the economy, just one shred of information.” He added, “The most important financial innovation that I have seen the past twenty years is the automatic teller machine. That really helps people.”

In early June 2010 Warren Buffett was subpoenaed to testify before the Financial Crisis Inquiry Commission. The commission, which had been appointed by the president, had been mandated “to examine the causes of the financial crisis that has gripped the country and to report our findings to the Congress, the President, and the American people.”

As part of its investigation, it summoned Buffett to a hearing about the role of rating agencies, including Moody’s, of which his Berkshire Hathaway was the largest shareholder.

But the commission wasn’t strictly interested in Buffett’s views on the agencies. What the panelists, like much of the public, really wanted to know was who exactly was to blame for the crisis.

Buffett’s response spoke to the essential truth of both the boom—which was fueled by speculation in the housing market—and the bust:

When there’s a delusion, a mass delusion, you can say everybody is to blame. I mean, you can say I should have spotted it, you can say the Feds should have spotted it, you can say the mortgage brokers should have, Wall Street should have spotted it and blown the whistle.

I’m not sure if they had blown the whistle how much good it would have done. People were having so much fun.

And it’s a little bit like Cinderella at the ball. People may have some feeling that at midnight it’s going to turn to pumpkin and mice, but it’s so darn much fun, you know, when the wine is flowing and the guys get better looking all the time and the music sounds better and you think you’ll leave at five of twelve and all of a sudden you look up and you see there are no clocks on the wall and—bingo, you know? It does turn to pumpkins and mice. It’s hard to blame the band. It’s hard to blame the guy you’re dancing with.

There’s plenty of blame to go around. There’s no villain.

However accurate his assessment, Buffett’s answer was hardly satisfying to those still eager for the sight of some executive—any executive—being hauled away in handcuffs.

Despite months of effort, however, a viable culprit had yet to be identified.

In March 2010, a court-appointed examiner in the bankruptcy of Lehman Brothers, Anton R. Valukas, issued a report that, at over 2,200 pages and a cost of more than $36 million, was the closest thing to an autopsy of Lehman. The report had been highly anticipated by the Justice Department and Securities and Exchange Commission, whose own probes had stalled. Despite the voluminous amount of information it had gathered, however, it did not appear to have produced a smoking gun, for while it raised questions about the firm’s behavior, it also appeared to exonerate its board.

Mr. Valukas stated that, while Lehman’s directors should have exercised greater caution, they did not cross the line into “gross negligence.” Instead, he concluded, “Lehman was more the consequence than the cause of a deteriorating economic climate.”

The report did, however, include some new revelations that could still lead to government action. Its most interesting and controversial discovery concerned an accounting practice called Repo 105, which the public was learning about for the first time. As the report explained it, “Lehman did not disclose … that it had been using an accounting device (known within Lehman as ‘Repo 105’) to manage its balance sheet—by temporarily removing approximately $50 billion of assets from the balance sheet at the end of the first and second quarters of 2008… .Lehman’s own accounting personnel described Repo 105 transactions as an ‘accounting gimmick’ and a ‘lazy way of managing the balance sheet as opposed to legitimately meeting balance sheet targets at quarter end.’”

The report found that there were “colorable claims” (a legalism for a civil case) against certain members of Lehman’s management—Richard Fuld, Chris O’Meara, Erin Callan, and Ian Lowitt—for breaching “their fiduciary duties by exposing Lehman to potential liability for filing materially misleading periodic reports” and against Lehman’s auditor, Ernst & Young, for “ being professionally negligent in allowing those reports to go unchallenged.”

In particular, the report said of Fuld that, “There is sufficient credible evidence to support a determination that Fuld’s failure to make a deliberate decision about Lehman’s disclosure obligations was grossly negligent or demonstrated a conscious disregard of his duties.”

For his part, Fuld (who has since returned to work by setting up a small advisory firm several blocks from Lehman’s old headquarters) insisted he was unaware of Repo 105. “I have absolutely no recollection whatsoever of hearing anything about or seeing documents related to Repo 105 transactions while I was the CEO of Lehman.”

Outside of his home in Sun Valley, the week before the first anniversary of Lehman’s collapse, he said, “You know what, people are saying all sorts of crap, and it’s a shame that they don’t know the truth, but they’re not going to get it from me.” He added, “You know Freud in his lifetime was challenged, but you know what he always said: ‘You know what, my mother loves me.’ And you know what, my family loves me, and I’ve got a few close friends who understand what happened, and that’s all I need.”

As of this writing, several government investigations into Lehman remain ongoing, though it is unclear how they will be resolved.

Despite serving for so long as the public face of the crisis, Fuld and Lehman were relegated to the background as the spotlight seemed to turn again onto Goldman Sachs, the firm that had managed to weather the crisis more successfully than its peers. While its success had long made it the target of the public’s ire, it only exacerbated the situation with a number of ill-considered gaffes, the most notable of which was an off-handed joke Lloyd Blankfein made to a reporter that he was just a banker “doing God’s work.”

That comment led to an enormous amount of scorn being heaped on the firm as it demonstrated the emerging disconnect between Wall Street and Main Street, quickly becoming a running punch line on late-night television. Warren Buffett, a longtime Goldman fan, observed of the public outrage, “I mean, they’re going to rewrite Genesis and have Goldman Sachs offering the apple.”

In April 2010 the Securities and Exchange Commission brought its only major case against Wall Street since the crisis, filing securities fraud charges against Goldman Sachs and one of its employees, Fabrice Tourre, a vice president, accusing them of selling securities that were intended to fail. The suit alleged that Goldman had created a synthetic CDO purposely filled with low-quality mortgages on behalf of one of its clients, Paulson & Co., a hedge fund that had made $3.7 billion by shorting the mortgage market. Paulson (unrelated to Henry M. Paulson Jr.) had likewise planned to short the CDO in question, called Abacus. The SEC asserted that Goldman had purposely not disclosed to buyers of Abacus that Paulson had helped create it with the goal of having it fail. The investors who bet it would rise in value wound up losing $1 billion.

Despite the headline-grabbing claims, legal experts described the case as “thin,” and raised questions about whether it was politically motivated to help gain support for the president’s financial regulatory reform bill. The SEC’s five commissioners had voted along party lines, 3-2, to pursue the case.

For its part, Goldman, which claimed it was blindsided by the suit, said it planned to defend itself and that it, too, lost money on the Abacus deal. The firm stated that it had disclosed all of the material information that an investor would have needed to properly evaluate the deal, including which mortgages were being referenced in the CDO.

Wall Street is expecting that Goldman will ultimately settle the civil case, with some analysts predicting that it could pay a fine as high as $1 billion and others speculating that Blankfein could be forced to step down. The Justice Department has also opened its own criminal inquiry into the firm’s practices.

Irrespective of the merits of the suit, it did offer the American public a window into the world of how investment banks really work and the various conflicts of interest that seem to be embedded into their business model.

Senator Carl Levin quizzed Goldman’s CFO, David Viniar, at one of many hearings about the financial crisis. During a heated exchange, Levin asked Viniar why Goldman had sold a CDO called Timberwolf to its clients, even though it was betting against the security itself. Levin had found an e-mail in which one Goldman colleague had observed to another, “Boy that timeberwof [sic] was one shitty deal.”

When asked about that assessment, Viniar only made the situation worse by responding, “I think that’s very unfortunate to have on e-mail.” (After lots of laughter in the gallery, he tried to correct himself. “Please don’t take that the wrong way, ” he added. “I think it’s very unfortunate for anyone to have said that in any form.”)

Another sequence of e-mails uncovered since the height of the crisis revealed that Washington Mutual’s CEO, Kerry Killinger, had been nervous about doing business with Goldman precisely because of such conflicts.

“I don’t trust Goldy on this,” Killinger wrote to a colleague. “They are smart, but this is swimming with the sharks. They were shorting mortgages big time while they were giving CfC [Countrywide Financial Corporation] advice.”

The Goldman suit also brought into stark relief larger questions about the dangers of derivatives and whether they had much social utility. What the public learned was that many derivatives like synthetic CDOs were simply bets without anything underlying them. Nobody was able to get a mortgage as a result of the sale of synthetic CDOs. An investor in a synthetic CDO is simply gambling on what is going to happen to a series of mortgages that he doesn’t even own.

“Synthetics became the chips in a giant casino, one that created no economic growth even when it thrived, and then helped throttle the economy when the casino collapsed,” Senator Levin said.

Despite the attacks against it, however, many of Goldman’s clients rushed to its defense, denouncing the outrage in Washington and elsewhere as politically motivated.

“People need to tone down the rhetoric around financial services and stop the populism and be adults,” Jeffrey Immelt, CEO of General Electric, stated. Warren Buffett was even more vociferous in his defense of Goldman and, specifically, of the Abacus deal.

“I don’t have a problem with the Abacus transaction at all, and I think I understand it better than most,” said Buffett, whose Berkshire still held a $5 billion stake in Goldman. “For the life of me, I don’t see whether it makes any difference whether it was John Paulson on the other side of the deal, or whether it was Goldman Sachs on the other side of the deal,” he observed, adding, “It’s very strange to say, at the end of the transaction, that if the other guy is smarter than you, that you have been defrauded. It seems to me that that’s what they are saying.”

For all the anger directed at Wall Street, there was still a portion left over for the government and its own handling of the crisis. A U.S. Congressional Oversight Panel report was critical of the roles of Henry M. Paulson, Ben Bernanke, and Timothy Geithner. In particular, it took issue with their decision to bail out AIG which, the report contended, “demonstrated that Treasury and the Federal Reserve would commit taxpayers to pay any price and bear any burden to prevent the collapse of America’s largest financial institutions and to assure repayment to the creditors doing business with them.”

The Federal Reserve also came under scrutiny for being too close to Wall Street, as members of Congress questioned whether the agency had acted appropriately in making some of its secret middle-of-the-night decisions and whether more disclosure was necessary. Several congressmen, led by Ron Paul, sought to audit the Fed, which Ben Bernanke resisted, adamant that the Fed remain independent of political interference. As of this writing, it appears that proponents of regular audits have backed down in their demands.

Paulson, who published his own account of the financial crisis, On the Brink: Inside the Race to Stop the Collapse of the Global Financial System, in February 2010, spent much of the year traveling the globe, in part to defend his actions. “We did things that were unpopular at the time, are even more unpopular today as the public has gotten angry,” he acknowledged. In explaining his actions, he said, “I didn’t think a lot about theory. I just understood how bad it could be. And so I just felt like I was racing against time with inadequate tools and authorities, to try to stave off disaster.” The Paulsons recently put their Washington, D.C., home up for sale and are planning to move back to the home they bought in the 1970s in Barrington, Illinois. Since completing his book, Paulson has not yet announced what he might do next.

Timothy Geithner, who has done very little redecorating of Paulson’s former office since becoming Treasury secretary, spent the past year trying to push through regulatory reform legislation. He has been credited with helping stabilize the economy, but he continued to be criticized for not pressing for harsh enough regulatory legislation to fundamentally alter the sector. That led to charges he was too close to the financial industry. In Washington, his critics spread false rumors that Geithner once worked at Goldman Sachs. The rumor was so pervasive that the wife of Rahm Emanuel, the White House chief of staff, once said to Geithner at a dinner that he “must be looking forward to going back to that nice spot you have waiting for you at Goldman.”

So, two years after the greatest financial crisis of modern times, are we any closer to solving the Too Big to Fail conundrum?

Yes—and no.

The new reform legislation that is expected to be passed goes a long way toward fixing the way certain parts of Wall Street are regulated. The government is planning to create a Consumer Financial Protection Agency to be a watchdog over how mortgages and other products are sold by banks. It is also putting together a systemic risk council made up of various agencies to better share information in hopes of being able to spot a potential crisis before it turns into a real one. In addition, the legislation will likely push derivative trading at big banks into better-capitalized subsidiaries. And the government will finally be given resolution authority so it can wind down a big investment bank or insurance company—as in the case of Lehman or AIG—without the risks associated with a bankruptcy that could cascade through the system.

But the legislation still doesn’t go far enough. It has no provisions to deal with Fannie Mae and Freddie Mac, which have cost taxpayers some $130 billion. Derivatives will still be allowed to live, at least partially, in an opaque world. And big banks will still be big banks and they are still as interconnected as ever.

Early in the process Senator Bernie Sanders of Vermont responded to the legislation’s shortcomings by introducing the “Too Big to Fail, Too Big to Exist Act,” giving the government power to break up systemically important institutions. Senators Maria Cantwell of Washington and John McCain of Arizona, meanwhile, introduced a bill to reinstate Glass-Steagall. Neither proposal gained much enthusiasm, in part because of arguments made by the industry that it would make the United States less competitive in the global marketplace.

“The fact is that some businesses require size in order to make necessary investments, take extraordinary risks, and provide vital support globally,” Jamie Dimon said. “America’s largest companies operate around the world and employ millions. This includes companies that can make huge investments—as much as $10 billion to $20 billion a year—and compete in as many as fifty to one hundred countries to assure America’s long-term success.”

Perhaps the most disquieting development that has taken place during the past year hasn’t been on Wall Street or in Washington. It is that the phrase “too big to fail”is no longer being associated with banks alone. It is now being used to describe municipalities and countries that, like many home borrowers, have become overleveraged. Much recent concern has focused on Greece, but Spain, Italy, Portugal, and Ireland are all considered vulnerable. In the United States, worries persist about whether the state of California will ultimately meet its day of reckoning.

“We cannot control ourselves. You have to step in and control The Street.”

John Mack, standing next to his wife, Christie, made this remarkably candid and poignant comment about the need for regulation in the fall of 2009, just a month after Too Big to Fail was originally published. Mack had been sitting in the audience of a panel on the financial crisis on which I was appearing when he surprised the group by offering a viewpoint that was contrary to that of most of his peers, who had been lobbying against any serious reform.

Mack offered an anecdote about why Wall Street’s culture—and perhaps our global culture of risk taking—would make self-policing nearly impossible.

At the height of the economic boom, he recounted, he had turned down an opportunity to make a highly leveraged loan, which would have likely included enormous fees, out of fear that it would later blow up.

“I missed a piece of business,” he acknowledged. “I can live with that, but as soon as I hung up the phone someone else put up ten times leverage.”

It is the ultimate truism: In the race for profits on Wall Street and elsewhere—and perhaps more important, as a matter of personal pride—someone is always willing to stick his neck out just a little farther than the next guy.

While that sort of heedless risk-taking has led to lucrative returns for many financiers in recent decades, the vulnerabilities in the financial system that have been exposed by the crisis must at some point lead to an accounting—not only of the practices that have become common on Wall Street but of the principles that underlie them. As Harvard’s Elizabeth Warren, chair of the Congressional Oversight Panel, has observed, “This generation of Wall Street CEOs could be the ones to forfeit America’s trust. When the history of the Great Recession is written, they can be singled out as the bonus babies who were so shortsighted that they put the economy at risk and contributed to the destruction of their own companies. Or they can acknowledge how Americans’ trust has been lost and take the first steps to earn it back.”

Andrew Ross Sorkin

June 18, 2010