One of the major conclusions to be drawn from the FCIC report is that almost all major financial institutions were in serious danger of collapse in the fall of 2008. This is why systemic risk is the paramount concern of regulators today. The report’s findings make clear that such risk is not just a consequence of the size of a firm. Firms are interconnected by buying securities from and selling them to one another, as well as by borrowing from and lending to one another.
In mid-September of that year, Ben Bernanke, the Federal Reserve chairman since early 2006, Treasury Secretary Henry Paulson, and New York Federal Reserve Bank President Timothy Geithner decided to let Lehman Brothers, which had invested heavily in mortgage securities and other real estate, go bankrupt. Financial markets froze and the businesses, money market funds, and banks that regularly lent money to Wall Street stopped doing so, fearing that they would not be repaid. The values of all debt securities except Treasury debt started to fall precipitously. On balance, Wall Street had no assets to sell to pay its debts. Bernanke told the FCIC:
As a scholar of the Great Depression, I honestly believe that September and October 2008 was the worst financial crisis in global history, including the Great Depression…. Out of maybe the 13, 13 of the most important financial institutions in the United States, 12 were at risk of failure within a period of a week or two.
Even the survival of Goldman Sachs, supposedly the strongest of the five major investment banks, was now in doubt. Goldman’s CEO, Lloyd Blankfein, later admitted in an interview with the FCIC that “there were systemic [my italics] events going on, and we were very nervous.” “We thought there was a real chance that [Goldman] would go under,” said Bernanke.
A prime example of the systemic dangers was the sale by insurance giant AIG of tens of billions of dollars of credit default swaps, a derivative that served as insurance for mortgage-backed securities. Because derivatives were unregulated and essentially traded in secret, triple-A-rated AIG was not required to hold capital or collateral against such liabilities. Because the swaps were traded secretly, there were also no open prices on their values. Goldman Sachs in particular bought a lot of derivative insurance from AIG.
But when mortgage-backed securities collapsed in value, AIG couldn’t pay off its commitments. Since so many firms were owed money by AIG—indeed, buying insurance encouraged these firms to take more risk—the Treasury and Fed decided to bail AIG out for a total of $180 billion, essentially nationalizing it, and covered all its liabilities, in the process bailing out Goldman and others as well. The inspector-general later appointed to analyze the federal bailout program, called the Troubled Asset Relief Program (TARP), severely criticized the Treasury for making whole the companies hurt by deals with AIG. Goldman, for example, got back the $14 billion it had at risk with AIG. The FCIC report says the claim made by Goldman that it had hedged its insurance purchases from AIG with other firms was shown to be dubious. The inspector-general argued forcefully that Goldman should have shared in the losses, and that taxpayers should not have accepted the full burden of Goldman’s errors.
Dodd-Frank’s answer to such systemic risk is the newly created oversight council led by the Fed, which is charged with anticipating such problems and reducing risks taken by the financial firms ahead of time. Will this prove to be more than a fantasy? When we consider how poorly the Fed and Treasury negotiated the AIG bailout, failing to stand up to Goldman Sachs and the other powers on Wall Street, there is little reason to have confidence that the new oversight institution will force the hands of the big banks and investment companies in the future, especially when times are good.
True, it would have taken some courage to have simply broken up today’s enormous banks or set high capital requirements by law. But there are other possibilities. Regulating Wall Street, a valuable, thoroughly researched book of essays on the crisis, proposes a direct tax on major financial institutions based on how much systemic risk they are creating, as measured by low-quality loans and inadequate services. Such a tax would encourage them to reduce such risk-taking. In an essay published in a short book edited by the economist Benjamin Friedman, Reforming US Financial Markets, the Yale economist Robert Shiller, who had long warned about the bubble in housing prices, criticizes Dodd-Frank for not establishing direct ways to mitigate future speculative bubbles. One reasonable suggestion he endorses would be to raise and lower capital requirements as financial conditions change.
For all the attention paid to Goldman Sachs, Citigroup provides the classic example of the efforts of Wall Street firms to circumvent existing capital requirements while regulators failed to oversee and supervise their activities, even with the tools they had. The story of Citigroup illustrates how difficult future regulations will be if they are simply left to the oversight council.
Citigroup was the banking behemoth run by Sandy Weill after a merger in 1998 between, on the one hand, Weill’s Travelers Group, which included the Travelers insurance company and Salomon Smith Barney, and, on the other, Citicorp, the giant international bank. The merger required lifting completely the restrictions of the 1933 Glass- Steagall Act, which forbade banks to act as investment houses; it had been signed by President Clinton.
Citigroup had been fined more than any other bank—some $400 million—because of its financial chicanery during the late 1990s and early 2000s. Even after Weill retired as CEO in 2003, it set out to take more risk, encouraged by former Treasury secretary Robert Rubin, the chair of Citigroup’s executive committee. It partly did so by skirting the regulations on how much it could borrow against capital, enabling it to become one of the two largest Wall Street participants in the mortgage market almost overnight. Among other things it did was lodge the assets it bought with the debt, often mortgage securities, in partnerships that did not appear on the Citigroup balance sheets. Citigroup also guaranteed $25 billion in loans to those who purchased the mortgage securities it underwrote, leaving it with a huge loss when these securities fell sharply in value.
The single most stunning finding of the FCIC report is that if all Citigroup’s assets had been accounted for accurately, its ratio of assets to capital would have been forty-eight to one in 2007, not the twenty-two to one it had been reporting that year. The ratio of forty-eight to one was irresponsible—higher than the capital ratios at the most aggressive investment banks, such as Bear Stearns, and far higher than the capital ratios of other banks. The Fed apparently had no idea of this.
But the main source of irresponsible risk—which some observers and academic economists view as the major cause of the crisis—was investment in triple-A-rated packages, or tranches, based on mortgage-backed securities of collateralized debt obligations (CDOs) that never deserved their triple-A ratings at all. Companies such as Goldman, Morgan, Merrill, Citigroup, and even Countrywide, which had its own huge capital markets operation, convinced Moody’s, Standard & Poor’s, and Fitch to rate three quarters of these packages of bonds triple-A, even when they were entirely composed of subprime mortgages. When a bank’s assets are rated triple-A, regulators require less capital in order to safeguard against downturns in value.
When divided into tranches, the highest-rated bonds were paid off first; thus, it was claimed that a high default rate would be needed to endanger these bonds. But this simply wasn’t so, as many bankers realized. Even small increases in defaults damaged the high-rated bonds of CDOs that were, quite irresponsibly, made up entirely of sub-primes. Eventually as much as 60 percent of the securities originally rated triple-A were reduced to junk bonds by the credit ratings agencies. These agencies bear heavy responsibility for playing the banks’ game.
Citigroup and others didn’t sell off all these triple-A securities to their unwary investors; but they sold enough for many of them, including pension funds, to take big losses when housing collapsed. Citigroup kept many CDOs on their own books or in the off- balance-sheet entities I have mentioned so it could earn the handsome interest they paid, suspiciously higher than the interest on other triple-A-rated securities. Citigroup also often had to buy some of them because it couldn’t sell all the CDOs it underwrote to customers.
The Republican minority on the commission, along with other observers, contend that repealing the Glass- Steagall Act was not a factor in the crisis even though the institutions grew unprecedentedly large. But Citigroup used the size of its balance sheet—more than $2 trillion in 2007—to guarantee its ever-growing purchases of mortgage-backed securities and to support other lines of business, including both conventional lending and trading securities. As the Fed put it in 2008, Citigroup’s “senior management allowed business lines largely unchallenged access to the balance sheet to pursue revenue growth.”
Citigroup along with Merrill Lynch had written more CDOs than anyone else by 2006. Citigroup lost $40 billion in the fourth quarter of 2007, and overall its losses and writedowns came to $130 billion, the largest among commercial banks. Merrill’s total losses came to nearly $56 billion, more than any other investment bank. Their CEOs claimed (as did Robert Rubin) that they had no idea the triple-A-rated CDOs were risky. Citigroup received $45 billion in funds from the government’s Troubled Asset Relief Program, more than any other bank, and was given guarantees on some assets, but no one was removed from management.
Where was the Fed? The legislation repealing Glass-Steagall, the Gramm-Leach-Bliley Act of 1999, had one other subtle but highly significant consequence, as the FCIC report explains. It diluted the government’s regulatory authority over the new financial conglomerates such as Citigroup. Under the legislation, the Fed, the strongest of the regulators when it did its job properly, now oversaw only bank holding companies, the umbrella organizations under which the bank subsidiaries operated. The 1999 act mandated that the Fed rely on the SEC to oversee bank subsidiaries that dealt in securities, and that the Office of the Comptroller of the Currency oversee commercial banks. The practical result was that much of importance thus fell through the cracks of the 1999 bill. The FCIC report refers to this stripped-down authority as “Fed-Lite.” The Fed failed to do its job in any case. It made no adequate analysis of the risky CDOs. As far back as 2005, a peer review by other Federal Reserve banks criticized the New York Fed, then under Tim Geithner, for inadequate oversight.
Greenspan, as head of the Fed, comes off worse than anyone else in the FCIC report. In 1999, when the Commodities Futures Trading Commission wanted to regulate derivatives, Greenspan led the attack against it. He wholeheartedly endorsed eliminating the Glass-Steagall restrictions that prevented major banks from engaging in all financial transactions, claiming that competition was the real regulator. As late as 2005, he stated that a housing bubble was unlikely. Most glaring was his refusal to regulate the suspicious mortgages being issued by Countrywide and others, even though the Fed had the authority to do so, and was warned time and again, even by the FBI, that mortgage brokers were writing deceptive and fraudulent mortgages to unsuspecting homeowners. As the report also notes, some 10,500 mortgage salesmen in Florida had criminal records.