The Frontline special on Wall Street had all the usual suspects: credit default swaps, “too big to fail,” Goldman Sachs CEO Lloyd Blankfein. But perhaps the most sobering is the persistence of a culture of greed, the worrying systemic problems that...
You hear a lot of people talk about the financial meltdown as if it’s something we’ve already moved past. We haven’t. The huge collapse of the financial industry, spurred largely by shady lending practices and proprietary trading — in which banks were more concerned about making money for themselves than their customers — and its subsequent propping up with tax money from the people who’d lost everything, is still making itself felt worldwide. Think about the budget crisis of last year (and the one sure to come right after this year’s election): We, as a country, wouldn’t be nearly as worried about axing funding for health care, schools, and defense if the entire financial foundation of our country wasn’t ripped right out from under us. The kicker? Even as we’re still struggling, nothing — nothing — has changed in the way big banks go about their business.
This week, PBS's Frontline concluded its 4 hour special, Money, Power, and Wall Street, an illuminatingly digestible look at the financial crisis leading up to the Great Recession, the devices that rendered our self destruction, the culture that bred and amplified such pathological catastrophe, and the major players and insiders who architected the game, one that wiped out trillions in shareholder value.
It was the usual suspects: credit default swaps, "too big to fail," Goldman Sachs CEO Lloyd Blankfein. But perhaps the most sobering is the persistence of a culture of greed, the worrying systemic problems that remain, and the lack of political will for true bank reform.
Bankers still want to rip your face off, now more than ever
“I think it’s probably not an overexaggeration to say Wall Street kind of lost its senses. It was the rise of trading that shifted the culture and with that came this much more short term profit generating competitive mentality. There was just this kind of cult of "more more more, grow grow grow" and I think now the culture on wall street is fundamentally unhealthy. I grew less happy about my work and what I was doing everyday. Candidly, I felt it was beginning to change my own values, how I looked at myself and how I valued myself.” – John Fullerton, former banker and Founder and President of Capital Institute (Frontline)
Capitalism is a system based on incentives. Back when banks still did boring banking stuff, like take deposits, make loans, and maybe if you're a more prestigious investment bank, oversee the odd merger or acquisition, there was a clear incentive for bankers to do the right thing. Commercial bankers were integrated in the community, they had to be to properly assess credit risk for the mortgages they doled. For investment bankers, loyalty and reputation were their life blood. If you fucked anyone over, people knew about it.
The transition to trading from these traditional businesses has coincided with a clear shift in culture, as noted by Fullerton, perfectly embodied by the trading floor term "ripped their face off," a proclamation made when a sales guy has pulled off a stupendously profitable deal at the expense of dim-witted clients. Guys doing it on the regular are revered as "big swinging dicks." Screwing people over has become a celebration.
Such finangling of finance isn't just respected, it's richly rewarded with star traders often getting a piece of the total bounty, with payouts in the millions being the norm, sometimes handed to freshly graduated 20-somethings. To exacerbate the issue, the compensation plans set in place encourage reckless short-term risk-taking in the name of a cushy year-end bonus. Who cares about tomorrow? "I'll be gone, you'll be gone," as any well-versed Wall Street insider would say.
In the last 10 years, Goldman CEO Lloyd Blankfein (who started out as a commodities trader in 1981) has gone all in on trading. "[Goldman Sachs is] a hybrid hedge fund and bookie, with an investment bank and asset management business thrown in for good measure," said Rolfe Winkler in his blog at Reuters.
In 2007, trading accounted for 68% of all Goldman Sachs revenue versus a mere 15% for bread and butter investment banking, in part due to financial acronyms ("innovations" as they're called) like CDS and CDOs, but also because of the acceleration of technological advancement breeding business lines known as "high frequency trading," where computerized systems make billion dollar trades in the blink of an eye (or more likely much much faster than that).
"It's become a technological arms race, and what separates winners and losers is how fast they can move," Joseph M. Mecane of NYSE Euronext, which operates the New York Stock Exchange, told the New York Times.
"This is where all the money is getting made," William H. Donaldson, former chairman and chief executive of the New York Stock Exchange and today an adviser to a big hedge fund, said in the same story. "If an individual investor doesn't have the means to keep up, they're at a huge disadvantage."
Last year, such programs accounted for 60 percent of all trading volume, 7 billion shares in total, across all US markets. Since the banks have better information and quicker systems, they're able to take advantage of microscopic moves in the market, whatever profits they make, essentially a tax on everyone else who wasn't fast enough, or from the banker perspective, a fee for the liquidity they provide. In a way, they've become the ultimate ticket scalpers.
“Everybody knows in their heart that something isn’t right, but once you start making money for a while you never want to stop making money.” Caitlin Kline, a math major at New York University and former investment banker (Frontline)
As Cathy O'Neil, a math-professor-turned-hedge-fund-quant-turned-Occupy-the-SEC activist, noted in episode 4 of Frontline, her job as a quant at hedge fund D.E. Shaw was to predict when pension funds would buy or sell assets so her traders could "frontrun" the trade, essentially skimming off the top of some elderly couple's retirement money.
“I just felt like I was doing something immoral,” she said on Frontline. "I was taking advantage of people I don’t even know whose retirements were in these funds. We all put money into our 401ks and Wall Street just takes this money and skims off a certain percentage every quarter. At the every end of someones career, they get some of that back. This is this person’s money and it’s basically just going to Wall Street. this doesn’t seem right
That's why this Goldman guy decided to quit in the most public way possible:
How did we get here? The firm changed the way it thought about leadership. Leadership used to be about ideas, setting an example and doing the right thing. Today, if you make enough money for the firm (and are not currently an ax murderer) you will be promoted into a position of influence.
What are three quick ways to become a leader? a) Execute on the firm's "axes," which is Goldman-speak for persuading your clients to invest in the stocks or other products that we are trying to get rid of because they are not seen as having a lot of potential profit. b) "Hunt Elephants." In English: get your clients — some of whom are sophisticated, and some of whom aren't — to trade whatever will bring the biggest profit to Goldman. Call me old-fashioned, but I don't like selling my clients a product that is wrong for them. c) Find yourself sitting in a seat where your job is to trade any illiquid, opaque product with a three-letter acronym.
Today, many of these leaders display a Goldman Sachs culture quotient of exactly zero percent. I attend derivatives sales meetings where not one single minute is spent asking questions about how we can help clients. It's purely about how we can make the most possible money off of them. If you were an alien from Mars and sat in on one of these meetings, you would believe that a client's success or progress was not part of the thought process at all.
And despite all the financial wizardry, trading remains a zero-sum game. Somebody loses, and as history has shown, it's usually the rest of us.
The unfettered derivative market remains a ticking nuclear time-bomb
"In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal." – Warren Buffet, in the 2002 Berkshire Hathaway annual report (PDF)
During the Cold War, the idea that some guy pressing a single button could spark nuclear war was terrifying. Today, any multitude of bankers around the world have access to such buttons, the all-too-easy ability to unleash what Warren Buffett refers to as "financial weapons of mass destruction."
Derivatives, apparently, can destroy the world, a notion Treasury Secretary Tim Geithner grappled with in the midst of the worst financial crisis since the Great Depression.
What makes the derivatives market so goddamn scary? For starters, its sheer magnitude. In October of 2008, the entire world stock market was estimated at about $36.6 trillion. The world derivatives market? Somewhere in the region of $800 trillion by some estimates, 11 times the size of the entire world economy.
The use of over-the-counter (read: under-the-table) derivatives has exploded over the last decade.
But that's only an educated guess. Just as we're in the dark over the earth's remaining oil reserves, even the smart guys in charge have no idea how huge this derivatives beast actually is because of the market's inherent opacity. The majority of the deals are confidential and completely unregulated: we have no idea what the terms and conditions are. It's the reason why our leaders were clueless when it all went south — except of course, to do whatever it takes to maintain the status quo. The alternative was too horrific to even contemplate. "Too big to fail" was born.
All of this is made much worse by the insidious nature of derivatives themselves. For financiers, derivatives are the ultimate skeleton key, prized for their power to unlock loopholes and skirt regulation, the very rules put in place to protect society. Bankers call this "regulatory arbitrage."
"This is a sort of esoteric term but basically what it means is figuring out a way to get around the law and Wall Street has become very good at regulatory arbitrage, very good at figuring out a complicated financial structure that achieves some objective that you couldn't otherwise achieve in a legal way," said Frank Partnoy, George E. Barrett Professor of Law and Finance at the University of San Diego School of Law and author of Infectious Greed: How Deceit and Risk Corrupted the Financial Markets.
"And we regret that people lost money. Whatever we did, it was according to the standard of the times. It didn't work out well." – Lord Blankfein on the financial collapse (Frontline)
It's why Wall Street has been so diligent in hiring the best and the brightest, the “brain drain” if you will, to help find solutions to big picture (big profit) questions like: How can we turn shit (worthless subprime morgages) into gold (AAA-rated synthetic collateralized debt obligations) and more recently how can we legally help Greece borrow way beyond their means (sounds like predatory lending)? As it turns out, derivatives are really great for cooking the books:
Greece’s debt managers agreed a huge deal with the savvy bankers of US investment bank Goldman Sachs at the start of 2002. The deal involved so-called cross-currency swaps in which government debt issued in dollars and yen was swapped for euro debt for a certain period — to be exchanged back into the original currencies at a later date.
Such transactions are part of normal government refinancing. Europe’s governments obtain funds from investors around the world by issuing bonds in yen, dollar or Swiss francs. But they need euros to pay their daily bills. Years later the bonds are repaid in the original foreign denominations.
But in the Greek case the US bankers devised a special kind of swap with fictional exchange rates. That enabled Greece to receive a far higher sum than the actual euro market value of 10 billion dollars or yen. In that way Goldman Sachs secretly arranged additional credit of up to $1 billion for the Greeks.
This credit disguised as a swap didn’t show up in the Greek debt statistics. Eurostat’s reporting rules don’t comprehensively record transactions involving financial derivatives. “The Maastricht rules can be circumvented quite legally through swaps,” says a German derivatives dealer.
Wall Street may not have created Europe's debt problem but they seemingly had no problem exacerbating it. As long as it's legal, right? In the meantime, Europe and, more pressingly, Greece are on the precipice of colossal collapse.
In spite of catastrophic failure, not much has changed
"I know of no set of supervisory actions we can take that will prevent people from making dumb mistakes. I know of no piece of legislation that can be passed by Congress which would require us to prevent them from making dumb mistakes. I think it's very important for us not to introduce regulation for regulations sake." – Alan Greenspan, former Fed Chairman (Frontline)
Greenspan made these comments before a Congressional committee (well before it all came crumbling down in 2008) in the wake of the collapse of uber hedge fund Long Term Capital Management (LTCM), a damning indication of the destructive power of unregulated derivatives and in retrospect, perhaps the first incidence of "too big too fail" in recent history.
At the start of 1998, the firm had equity of $4.72 billion and had borrowed over $124.5 billion, giving it total assets of $129 billion. But thanks to derivatives, which were hidden off the fund's balance sheet, they actually had positions with a notional value of approximately $1.25 trillion, over half of Apple's market cap today. If LTCM were to go down, catastrophic losses would ripple throughout the global system.
And go down it did. By then, the Fed had been forced to organized a bailout worth $3.62 billion with cooperation from participating banks, including Goldman Sachs, Morgan Stanley, and even Warren Buffett so they could wind down the positions in an orderly fashion and prevent potential disaster.
It was a clear warning sign: the system had gone awry. In its aftermath, Merrill Lynch observed that mathematical risk models “may provide a greater sense of security than warranted; therefore, reliance on these models should be limited.” The highly compensated geniuses, including some Nobel winners, concocting these complex strategies weren't so smart after all. In spite of all this, the guys in charge did nothing, choosing instead to embrace the status quo. This was a one-off, Greenspan assured us. It was an opportunity lost.
Since then, the country's largest banks have grown substantially and consolidated power. With the repeal of Glass-Steagall in 1999, these same banks could now start speculating with depositor money with the help of derivatives.
This last financial crisis is of course, the latest shot fired (perhaps more realistically, bomb dropped). Despite well-articulated promises from Obama, the only serious attempt at reform has been the Dodd-Frank Act, a bill most find utterly inadequate and deeply flawed, including a select group of Occupy Wall Streeters featured on Frontline working to bring attention to possible loopholes and ponder potential fixes.
Meanwhile, the banks continue to grow in size, thanks to an extremely generous taxpayer-funded bailout and an open channel of easy cheap cash from the Fed, programs put in place to avert disaster. With disaster averted, the banks paid record bonuses year after year:
With third-quarter figures from JP Morgan expected to begin a bumper profit reporting season today, a study of more than three dozen banks, hedge funds, money-management and securities firms estimates they will pay $144bn (£90bn) in salary and benefits this year, a 4% increase on 2009.
The research, by the Wall Street Journal, found pay was rising faster than revenue, which gained 3% to $433bn, despite a slowdown in stock trading.
And while profits have fallen from their 2007 peak, the percentage directed to compensation has increased by 23%.
Wall Street is doing just fine, by the looks of it. On November 4, 2011, the Financial Stability Board released a list of 29 banks worldwide that they considered to be “systemically important financial institutions,” in other words "too big to fail." Of the list, eight banks are in the U.S. including Bank of America, Goldman Sachs, JPMorgan Chase, Morgan Stanley, Citigroup, Wells Fargo, State Street, and Bank of New York Mellon. What is to prevent these banks from holding the world hostage again if and when something goes wrong? Something like Greece?
Finding moral hazard
“Taxpayers will never again be asked to foot the bill for Wall Street’s mistakes," President Obama promises upon signing the Frank-Dodd bill. "There will be no more taxpayer-funded bailouts. Period.” Harry Reid, the Democrat majority leader in the Senate, said that the reform bill sent a clear message to Wall Street that they could not “recklessly gamble away other people’s money”. “It says the days of too big to fail are behind us. It says to those who game the system – the game is over.” Reid said that night.
For all of their callousness and misguided jugdements, none of the CEOs of any of the major banks have been fired. Above all there is a deep sense of unfairness. The guys paying themselves exorbitant bonuses are the same guys wrecking the system and in the end, it is everyone else that is forced to bail them out. Without a doubt, any well-oiled economy needs a robust financial system to support and fuel growth, but not one grounded in "moral hazard", described by Nobel Prize-winning economist Paul Krugman as "any situation in which one person makes the decision about how much risk to take, while someone else bears the cost if things go badly." For economist Mark Zandi of Moody's Analytics, it was the root cause of the subprime mortgage crisis:
“The risks inherent in mortgage lending became so widely dispersed that no one was forced to worry about the quality of any single loan. As shaky mortgages were combined, diluting any problems into a larger pool, the incentive for responsibility was undermined.”
“Finance companies weren’t subject to the same regulatory oversight as banks. Taxpayers weren’t on the hook if they went belly up [pre-crisis], only their shareholders and other creditors were. Finance companies thus had little to discourage them from growing as aggressively as possible, even if that meant lowering or winking at traditional lending standards.”
Then Treasury Secretary Hank Paulson reminded us that he tended to agree, after he let Lehmann Brothers go down. “Moral hazard is something I don’t take lightly,” Paulson said the Monday after its bankruptcy. “I never once considered that it was appropriate to put taxpayer money on the line in resolving Lehman Brothers.”
This was of course before he knew the true extent of the damage.
The passing of Frank-Dodd was intended to address many of these issues, but amid rising profits, bank spending on lobbying has reached record highs in an effort to dilute many of the bills protective restrictions. No wonder Brian Hurst, a principal of the hedge fund AQR Capital Management, told The Economist, "My guess is that when the actual rules are in place, it's going to be underwhelming."
And so for now at least, the machine continues to hum, unabated, running a game that is rigged to make those running it rich, at the risk of global meltdown, and surely at the expense of the 99%. It's an understandably arduous proposition, attempting to regulate the beast, a feverish game of cat and mouse. Bankers are the hackers of the financial world, perpetually seeking out vulnerabilities in the system to exploit. They will, by definition, always be one step ahead. But that has never stopped those in the tech world to invest in security and prepare for the worst.
As we look to the troubles in Europe, Spain with their 50% youth unemployment, the UK and Ireland with their misguided attempts at austerity, and Greece with their overwhelming deficits, we have to wonder, how far away is the next crisis? How much European exposure, in the form of derivatives, do U.S. banks even have? It's impossible to know. Does Greece then become "too big to fail" (The Eurozone seems to think so)? In the end, there's only one way to find out.
After nearly two years of complete silence, Lloyd Blankfein popped his head out, a day after PBS’s special aired arguing that there was no fundamental flaw, this was merely a PR problem (although you have to admit, vampire squid is a catchy nickname). “We haven’t gotten everything right in how we deal with the public,” Blankfein told CNBC, while equally quick to remind us that, despite everything that’s happened, he’s isn’t going away anytime soon. “It’s a terrific job,” he mused.
For Blankfein, it seems, there is no greater joy than doing “God’s work”.
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