Too Big to Jail?
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Capital City

Three years after the biggest bailout in US history, Wall Street lobbyists don't just have influence in Washington. They own it lock, stock, and barrel.

Illustration: Bill MayerIllustration: Bill MayerTHIS STORY IS NOT ABOUT THE origins of 2008's financial meltdown. You've probably read more than enough of those already. To make a long story short, it was a perfect storm. Reckless lending enabled a historic housing bubble; an overseas savings glut and an unprecedented Fed policy of easy money enabled skyrocketing debt; excessive leverage made the global banking system so fragile that it couldn't withstand a tremor, let alone the Big One; the financial system squirreled away trainloads of risk via byzantine credit derivatives and other devices; and banks grew so towering and so interconnected that they became too big to be allowed to fail. With all that in place, it took only a small nudge to bring the entire house of cards crashing to the ground.

But that's a story about finance and economics. This is a story about politics. It's about how Congress and the president and the Federal Reserve were persuaded to let all this happen in the first place. In other words, it's about the finance lobby—the people who, as Sen. Dick Durbin (D-Ill.) put it last April, even after nearly destroying the world are "still the most powerful lobby on Capitol Hill. And they frankly own the place."

But it's also about something even bigger. It's about the way that lobby—with the eager support of a resurgent conservative movement and a handful of powerful backers—was able to fundamentally change the way we think about the world. Call it a virus. Call it a meme. Call it the power of a big idea. Whatever you call it, for three decades they had us convinced that the success of the financial sector should be measured not by how well it provides financial services to actual consumers and corporations, but by how effectively financial firms make money for themselves. It sounds crazy when you put it that way, but stripped to its bones, that's what they pulled off.

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There's more to say about how they accomplished this, but to understand just how extravagant the finance lobby's power is, you need to understand some background first. There are a lot of places we could start: the election of Ronald Reagan and the beginning of the great era of financial deregulation. The collapse of Continental Illinois National Bank and Trust in 1984. The $100 billion bailout of the savings and loan industry. The Mexican crisis of 1994. The Asian crisis of 1997. But for our purposes, the best place to start is 1998. That was the year a hedge fund called Long-Term Capital Management imploded and very nearly took the global financial system down with it. It was, if you will, a dry run for 2008.

 

The Warning
At the time it was founded, LTCM was the biggest, most prestigious hedge fund ever created. The brainchild of John Meriwether, former head of bond trading at Salomon Brothers, it had two future Nobel Prize winners as partners, a staff of virtuoso traders and brilliant mathematicians, $10 million worth of fancy engineering workstations, and an initial capitalization somewhere north of $1 billion. It was the largest start-up hedge fund in history.

Leverage is a harsh mistress: It allows you to make lots of money when things go right, and to lose lots of money very quickly when they don't.

It was also one of the most successful. But LTCM didn't make its money by doing anything so crude as betting on things like the rise and fall of the stock market. In fact, like most big hedge funds, LTCM paid very little attention to stocks. The Dow Jones average might get all the attention, but Wall Street pros know two things: The market for debt is far larger than the market for equities, and it provides far more fertile ground for mathematical manipulation and epic profits.

But clever mathematics alone isn't enough to make Gatsbyesque fortunes. For that, you need to use leverage. You need to borrow other people's money. Lots of it.

It's easy to see why. A typical LTCM bet would start when someone noticed a spread that seemed a little out of whack. For example, two bonds might trade for slightly different prices even though they were nearly identical. So LTCM would go long in one bond and short in the other, essentially betting that the spread would narrow. Bond traders deal in basis points—hundredths of a percentage point—and a bet like this might depend on a spread of, say, 20 basis points narrowing to 10. That's a nearly invisible movement, and on a million-dollar trade it nets you a grand total of $1,000. Hardly worth bothering with unless you make it a billion-dollar bet instead. That's what LTCM did: It mastered a method that let it borrow huge sums of money practically for free and that turned thousand-dollar profits into million-dollar profits. Do that a few hundred times a year and you're talking real money.

Federal Campaign Cash From Financial Sector

But leverage is a harsh mistress: It allows you to make lots of money when things go right, but it also allows you to lose lots of money very quickly when they don't. And in 1998 things didn't go right. Spreads that were supposed to narrow kept widening, and LTCM was forced to dip into its own capital to pay back the huge short-term loans it had taken out to leverage its bets. Losses kept mounting, creditors called in their loans, and eventually everything came crashing down.

But a funny thing happened on the way to the crash: The New York Fed stepped in and arranged a bailout. Almost all of Wall Street's biggest firms participated, and they did so for one reason: The Fed convinced them that LTCM was too big to fail. An uncontrolled bankruptcy might set off a domino effect that could bring down dozens of banks. A few months later, an interagency report concluded, "The near collapse of LTCM illustrates the need for all participants in our financial system, not only hedge funds, to face constraints on the amount of leverage they assume." It was a bipartisan judgment, signed by Fed Chairman Alan Greenspan and by Robert Rubin, Bill Clinton's treasury secretary.

In any sane world, it would have been a call to arms. After all, LTCM was only worth a few billion dollars. If a relative minnow like that could pose a risk to the global economy merely through the use of profligate leverage, what might happen if a money-center bank worth 100 times as much did the same thing?

But we don't live in a sane world. We live in a world where leverage—as well as Wall Street's nearly endless stream of new contrivances for exploiting it—is largely controlled not by regulators or congressional committees, but by the finance lobby. And the last thing the finance lobby wants is constraints of any kind. So Wall Street promised solemnly to take the lessons of LTCM to heart and then got right down to the business of ignoring them. In fact it spent the next decade not merely blocking reform, but making things worse by lobbying relentlessly to expand leverage, complexity, regulatory forbearance, and risk.

Leverage—as well as Wall Street's nearly endless stream of new contrivances for exploiting it—is largely controlled not by regulators or congressional committees, but by the finance lobby.

Now if the aerospace lobby had told us after the 1986 Challenger disaster that the key to better performance was to turbocharge the engines and quit performing preflight inspections, everyone would have agreed that they were crazy. Yet that's essentially what the finance lobby has done over the past decade, and in some weird way we were too mesmerized to recognize it. Within months of a near catastrophe caused by one of the industry's brightest stars, the lobbyists were busily making certain that it would happen again—and that when it did happen, it would be bigger and more disastrous than ever.

 

Unleashing the Banks
It's hard to directly observe any lobby at work—by nature, it's not business typically done out in the open—but in the same way that a meteor leaves behind a crater that lets you know its size and force of impact, so does the finance lobby. Sometimes these are laws passed by Congress. Sometimes they're tax breaks kept in place by friendly senators. Sometimes they're rulings by the Federal Reserve. Sometimes they're green lights from federal watchdog agencies. All of these are part of our story, but it starts with Congress, which left behind the two biggest craters of them all in 1999 and 2000, a little more than a year after the LTCM collapse. The first was the Financial Services Modernization Act. The follow-up was the Commodity Futures Modernization Act.

The FSMA was designed to tear down a Depression-era law, the Glass-Steagall Act, that had set up the FDIC to guarantee commercial bank deposits and put up a fire wall between commercial banking and investment banking. The idea behind the 1933 law was pretty simple: Commercial banks should use their government-backed funds only for reasonably safe activities. Investment banks could take more risks, but they were on their own if things fell apart.

But starting in the 1980s, that became increasingly intolerable to Wall Street. Commercial banks were sitting on an enormous pile of money that they were prohibited from investing in anything more interesting than business and home loans. So they lobbied Congress. They lobbied the Fed. They lobbied the Treasury. They lobbied tirelessly for 20 years, and finally, after spending $209 million in 1998 alone, they got what they wanted: The wall was torn down and they were free to gamble customers' funds in any way they wanted. In essence they became the world's biggest hedge funds. And if LTCM was too big to fail, suddenly Citigroup and JPMorgan Chase were way too big to fail.

By itself, this was dangerous enough. But then Congress made things even worse. In the previous decade the world of derivatives—swaps, futures, and options—had become ever more complex and lucrative. The finance lobby was eager to make sure they remained largely unregulated, and in 2000 the Commodity Futures Modernization Act granted their wish. Long-standing state laws against "bucket shops"—informal exchanges that allowed investors to gamble on securities they didn't actually own—were preempted, and Wall Street was officially turned into a casino. Banks could literally bet on anything.

When bankers  decide that a million dollars doesn't go as far as it used to, they  start up a hedge fund. The only threat to their riches is the IRS.

Like so much else about the finance lobby, this was a bipartisan binge. The FSMA is also known as the Gramm-Leach-Bliley Act, and it's true that all three of those gentlemen were Republicans dedicated to the cult of deregulation. Alan Greenspan was a keen advocate too. But the law was passed by a big bipartisan majority in the House, signed into law by Bill Clinton, and had been eagerly supported by Treasury Secretary Robert Rubin.

By the time it was passed, however, Rubin was long gone. He had taken a top job at Citigroup, one of the banks that had lobbied hardest for the deregulation that would eventually be its downfall. Deregulation would help Rubin earn over $100 million in the following decade. Not bad.

 

The Paycheck Lobby
The finance lobby isn't just banks. Technically it's known as the FIRE lobby—Finance, Insurance, and Real Estate—and it includes basically anyone who makes money by handling money. That means big money-center supermarket banks, small community banks, Wall Street investment banks, insurance companies, mortgage brokers, hedge funds, credit card issuers, trade groups like the International Swaps and Derivatives Association, private equity firms, credit unions, and more. Some of them, like the hedge funds, didn't lobby heavily for the big deregulation of 1999 and 2000, because they were already pretty lightly regulated. Instead, they lobbied for other things. Like protecting bigger paychecks.

Wall Street bankers may seem like a pretty well-off bunch, but when they decide that a million dollars doesn't go as far as it used to, they leave and start up a hedge fund. Hedge fund managers typically get paid 2 percent of the value of the assets under their control plus 20 percent of the investment profits, and for a successful manager this can add up to tens or even hundreds of millions of dollars a year. Aside from market reversals, the only real threat to their riches is the IRS.

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