Inside Job (5 page)

WHEN REAGAN TOOK
office, the American financial sector was still organized according to laws enacted in response to the Great Depression—the
so-called “New Deal”.

Banks and bankers had compiled a terrible record in the 1920s—creating financial bubbles, misdirecting deposits for their own personal benefit, and off-loading bad
loans onto their customers in the form of fraudulent investment funds.
¹
Excessive leverage, fraud, and Ponzi-like behaviour were widely regarded as having
contributed to the 1920s bubble and the Great Depression.

The New Deal laws were intended to remove such temptations, or at least limit their damage. The 1933 Glass-Steagall Act forbade any bank accepting customer deposits to also underwrite or sell
any kind of financial securities.
²
The Securities Act of 1933 and the Securities Exchange Act of 1934 required extensive financial disclosure by
publicly-held companies and investment banks, and created the US Securities and Exchange Commission to police them. Also in response to the Depression, in 1938 the US government created Fannie Mae
to purchase and insure mortgages issued by banks and savings and loan institutions (S&Ls), once again under strict regulation. The Investment Company Act of 1940 regulated asset managers such
as mutual funds.

As late as 1980, this structure remained in place. Commercial banking, investment banking, residential mortgage lending, and insurance were distinct industries, tightly regulated at both the
national and local levels, and also very fragmented, with no single firm or even group of firms dominating any sector. Commercial banking was a stable, dull industry. Most bank branches closed at 3
p.m.; “banker’s hours” allowed for lots of time on the golf course. There were strict limits on branches outside a bank’s home state; interest rates were tightly regulated.
The industry was divided roughly between a few big “money centre” banks, headquartered primarily in New York City and Chicago, and thousands of small local and regional banks scattered
across the country.

And then there were the S&Ls, small, usually local firms in the sole business of taking savings deposits and selling fixed-rate long-term residential mortgages. As late as 1980, most
S&Ls were trusts—they had no shareholders, but rather were cooperatively owned by their local “passbook” depositors. (The same was true of credit unions and
most large insurance companies.) Like banks, the S&Ls were tightly regulated, and their retail deposits were insured. They were explicitly permitted by regulators to pay slightly
higher interest rates on savings accounts than commercial banks, in order to encourage mortgage lending.

The world on the other side of the Glass-Steagall wall—the securities industry—was divided between retail brokerages and investment banks. Brokerage firms, the largest of which was
Merrill Lynch, sold stocks and bonds to wealthy individual customers. Merrill Lynch was a large firm for this period. It was also one of the first to go public, in 1971.

True investment banks, such as Goldman Sachs, Morgan Stanley, Bear Stearns, Dillon Read, and Lehman Brothers, provided financial advice to big companies and managed and distributed new issues of
stocks and bonds. It was a fragmented but still clubby industry, informally divided between Protestant and Jewish firms, with women and minorities welcomed by neither. There were dozens of firms,
all of them small but very stable, with low personnel turnover. In 1980 Goldman Sachs, the largest, had a total of 2,000 employees (versus 34,000 in 2011); most of the others had only a few
hundred, some only a few dozen. They were all private partnerships, and the capital they used was their own. If they underwrote (guaranteed the sale of) a new issue of stock, the partners were
literally risking their own personal money, which constituted the entire capital base of the firm. Their franchises depended on reputation and trust—though also, realistically, on golf,
squash at the Harvard Club, and old-school ties.

BANKERS’ PAY HAD
reached stratospheric levels in the 1920s but then contracted sharply with the Depression and, even more importantly, with the
tightening of regulation in its wake. After passage of the New Deal reforms, pay in the American financial sector settled down. For forty years, average financial sector pay stayed at about double
the average
worker’s income. Executive compensation, while comfortable, was hardly exorbitant; nobody had private planes or gigantic yachts.
³

Equally important was the
structure
of financial sector pay. Most commercial bankers were paid straight salaries. Investment bankers lived well and received annual bonuses, but through
deliberate policy practised universally within the industry, most of the partners’ total wealth was required to remain invested in their firm, usually for decades. Partners could only take
their money out when they retired, so partners and their firms exhibited very long time horizons and a healthy aversion to catastrophic risk taking.

All of this—the industry structure, regulation, culture, and compensation practices—remained in place until the early 1980s. Then the wheels came off.

IN THE EARLY
1980s, three forces converged in a perfect storm of pressure and opportunity: the upheavals of the 1970s, which destabilized and devastated
the financial markets, forcing bankers to seek new forms of income; the information technology revolution, which integrated previously separate markets and vastly increased the complexity and
velocity of financial flows; and deregulation, which placed the inmates in charge of the asylum.

The first driver of change was severe financial pressure. In the wake of the 1973 and 1979 oil shocks, the stock market and all financial institutions suffered badly. Inflation grew so severe
that in 1981 three-month US Treasury bills briefly paid 16 percent interest.

The second driver of change was technology. The US financial sector did need some deregulation, or more accurately, different and modernized regulation, in the computer age. The tight control
over interest rates on consumer deposits, the somewhat artificial division between banks and S&Ls, and the prohibition on interstate banking caused significant inefficiencies. Information
technology and the rise of electronic financial
transactions created opportunities for productivity gains through nationwide and global integration of previously distinct
markets.

At the same time, however, information technology posed dangers that required
tighter
regulation in some areas. The advent of frictionless, instant electronic transactions introduced new
volatility and market instability. Information technology also made it easy to construct and trade increasingly complicated and opaque financial products, through increasingly complex financial
supply chains. But that same complexity also made it easier to hide things—things like risk, or fraud, or who really stood to gain and lose.

In this context—oil shocks, recession, inflation, new technologies and financial products—much of the staid, rigid financial sector performed badly. In particular, by the early 1980s
US regulators were faced with the potential collapse of the entire S&L industry.

The S&Ls had been destroyed by the interest-rate volatility and inflation caused by the second oil shock. Their business of collecting deposits and financing long-term, fixed-rate mortgages
assumed an environment of steady, low interest rates. By the early 1980s, depositors fled low-interest S&L accounts for money market funds. At the same time, the value of the S&Ls’
low-interest, fixed-rate mortgage loans declined sharply as a result of inflation and higher interest rates.

The Reagan administration’s publicly stated response to the S&L problem was to make the S&L industry a star test case for deregulation. But what
really
happened was that
deregulatory economic ideology was used as political cover for a highly corrupt process of letting the S&Ls, and their investment bankers, run wild. What followed was a film we’ve been
watching ever since.

HAD THE GOVERNMENT
simply shut down the S&L industry, the cost to taxpayers would have been in the range of $10 billion. But the industry was
politically well connected, and was one of the first to make aggressive
use of political campaign contributions and lobbying. Senator William Proxmire, chairman of the US
Senate Banking Committee, later called it “sheer bribery” on national television. But it worked. With bipartisan support, a supposed “rescue” bill, the Garn–St.
Germain Act, was quickly passed by the Congress and signed by Reagan.

The real killer was the appointment of Richard Pratt, an industry lobbyist, as head of the Federal Home Loan Bank Board, the S&Ls’ regulator. Pratt proceeded to gut the regulations
against self-dealing. For the first time, an S&L could be controlled by a single shareholder, could have an unlimited number of subsidiaries in multiple businesses, and could lend to its own
subsidiaries. Loans could be made against almost any asset. S&Ls could now raise money by selling government insured certificates of deposit (CDs) through Wall Street brokers. The shakier the
S&L, the higher the interest rates paid by their CDs, and the larger the investment banking fees.

It was a licence to steal. The people running S&Ls started to play massively with other people’s money. They loaned money to themselves, they loaned money to gigantic property
development projects that they owned, they loaned money to their relatives, they bought cars, planes, mansions, and assorted other toys.

From 1980 through mid-1983, an operator named Charles Knapp ballooned a California S&L’s assets from $1.7 billion to $10.2 billion, and then kept going at an annual rate of about $20
billion until he finally hit the wall in 1985. When the government moved in, the assets were worth about $500 million. The Vernon Savings Bank in Texas ran its assets from $82 million to $1.8
billion in about a year. The owner bought six Learjets, and when the Feds finally looked, they found that 96 percent of its loans were delinquent. As late as 1988, 132
insolvent
Texas
S&Ls were still growing rapidly.

Charles Keating was another S&L pioneer—an expert hypocrite, famous for being an antipornography crusader. He claimed that pornography was part of “the Communist
conspiracy”, and made really awful films about the horrors of perversion for profit. The SEC had charged him with fraud in the 1970s, but Keating was still allowed to take over a relatively
healthy S&L in 1984. He quickly racked up $1 billion-plus in costs to the government, while making (or rather, taking) a fortune for himself. Keating played Congress and
the regulators like a violin, fending off investigators with eighty law firms and the famous Keating Five—the five US senators he persuaded to help him, via $300,000 in campaign
contributions. (They were Alan Cranston, John Glenn, John McCain, Donald Riegle, and Dennis DeConcini.) For $40,000, Keating hired Alan Greenspan, then a private economist, to write letters and
walk around Washington, DC, with him, telling regulators about Keating’s good character and solid business methods. Noting Greenspan’s excellent judgement, Reagan later appointed
Greenspan to be chairman of the Federal Reserve Bank. Keating was eventually sent to prison.

Then there was Silverado, on whose board of directors sat Neil Bush, son of George H. W. Bush and brother of George W. Bush. Bush approved $100 million in loans to Silverado executives, and
loans to himself too. Silverado’s collapse cost the taxpayers $1.3 billion. Neil Bush was sued by two US government regulators; he paid fines and was banned from banking but avoided criminal
prosecution.

There were many others. The US government established the Resolution Trust Corporation to take over bankrupt S&Ls and sell off their assets. The cost to the taxpayers was about $100 billion,
which seemed like an enormous amount at the time.

But there was one important regard in which the US system had not yet been completely corrupted. Although many perpetrators got away with it—particularly those who worked for major
investment banks, law firms, and accounting firms—many did not. As a result of the S&L scandals, several thousand financial executives were criminally prosecuted, and hundreds were sent
to prison. Altogether, the episode was a pointed, but in retrospect very mild, foreshadowing of the outbreak of massive financial criminality in subsequent decades.

But it wasn’t just the S&Ls who partied hard in the 1980s. The investment bankers, leveraged buyout firms, lawyers, accountants, and insider trading people had a good time too.

Indeed the first truly disturbing signal about deregulation was that
the proudest names in American investment banking, law, and accounting had eagerly participated in the
S&Ls’ looting. Merrill Lynch earned a quick $5 million by shovelling more than a quarter billion dollars in high-rate deposits into two S&Ls in the six months before they were shut
down. The law firms that later paid multimillion-dollar settlements included Jones, Day, Reavis, and Pogue; Paul, Weiss, Rifkind; and Kaye Scholer. The accounting profession was just as bad. Ernst
& Young and Arthur Andersen (later of Enron fame) paid especially big settlements for having allowed the S&Ls to fake their books; Ernst & Young alone paid more than $300 million. The
total taxpayer cost, of course, was many, many times the recoveries.
⁴

But the real party was with the boys who played with junk bonds.

PRIOR TO THE
1980s, only a very few highly rated companies could raise capital by issuing corporate bonds. But years of research convinced an ambitious
young man named Michael Milken that ordinary companies could also do so, and in 1977 he and his employer, the investment bank Drexel Burnham Lambert, began to underwrite bond issues for previously
unrated companies. Interest rates were higher than in the blue-chip bond market but compared favourably with bank loans. Initially, the availability of so-called junk bonds was a useful service to
midsize companies that needed capital for growth. But then things went crazy.