September 15th marks the 5th anniversary of one of the scariest events in investment history: the collapse and bankruptcy of Lehman Brothers, at the time one of the largest investment banking firms on Wall Street. Many date the market collapse and the start of the Great Recession to Lehman's fall on September 15, 2008.
As we look back at the string of debacles in the last quarter of that fateful year, it's fair to ask whether the conditions which caused the shock to the global economic system have been fixed or changed. The underlying question is: could something like that happen again?
Let's look at the problems one at a time.
1) One of the biggest problems in 2008 was that banks had found ways to borrow up to 50 times what they were worth in net capital, which meant that even small losses caused them to tumble into insolvency and a government bailout. If you and I tried to borrow 50 times what we're worth in order to play the stock market, we would be stopped at the door of the bank.
Have we imposed similar limits on Wall Street since 2008?
Alas, the answer is no. Since the crisis, according to an article in Time magazine, some of the largest U.S. banks have raised the amount of capital they hold on their books. But after furious lobbying efforts, Wall Street managed to stymie any efforts by Congress to put limits on their leverage. In the future, theoretically, they could borrow even more than they did in the last crisis.
2) This might not be so terrible, except that the investment banks used the money they borrowed to gamble in the stock market, and in the highly-risky derivatives market, and in the packaged mortgage pools that they were creating and selling to their customers. Former Federal Reserve Board Chairman Paul Volker has argued that investment banks should not be allowed to speculate or day-trade with borrowed money; they should earn their money by making loans and taking companies public. Others have argued that Wall Street firms should be forced to at least use their own money when they buy and sell investments for their own account--not other people's money.
Has Congress or the regulators restricted this risky behavior?
Alas, no. The so-called Volker Rule was removed from the Dodd-Frank legislation after a successful Wall Street lobbying effort. Today, investment banking firms and their traders buy and sell at a furious rate. The most recent notorious example came when a JP Morgan Chase trader, who was nicknamed The London Whale by his peers, managed to lose $7 billion of the company's (and shareholders') capital in 2012 before newspapers broke the story and alerted the company's sleeping risk management department.
3) A lot of the worst damage to the global financial system was done by complex derivatives investments that were created outside of the regulatory system, and distributed around the globe with zero oversight. When it was discovered that companies like AIG had made guarantees via these products that were many orders of magnitude higher than the net capital of the company itself, regulators were appalled--and at a loss to even calculate the extent of the exposure, much less unravel and repair the damage to bank and pension balance sheets across the globe.
Do we have a way to monitor and regulate these derivatives investments today?
Yes and no. Roughly half of the interest-rate-swaps market must now pass through central clearinghouses in the U.S., allowing the Commodities Futures Trading Commission to track who owes what to whom. But once again, relentless lobbying by Wall Street managed to carve out significant loopholes in this oversight, so that today banks and hedge funds do a brisk (and unregulated) trade in foreign exchange derivatives in international markets. There is nothing to stop another Whale, operating in the U.S., Japan or elsewhere, from playing havoc with Wall Street's balance sheets, and Wall Street can continue to sell guarantees across the globe, invisibly to the regulators.
4) Many of the toxic packaged mortgage products that Wall Street sold to its unfortunate customers had been rubber-stamped by the credit rating agencies as high-grade, safe bond investments. Later, it was pointed out that the ratings agencies who gave AA ratings to packages of junk securities were, as a normal part of their business model, paid by the companies whose products they were rating.
Have we fixed this problem?
No. The ratings agencies like Standard & Poors and Moody's are still paid for their services by the very Wall Street firms and bond underwriters that create the products they are rating.
5) Behind everything else, perhaps the biggest cause of the financial crisis was Wall Street incentive systems--the way that Wall Street brokers, traders and executives are compensated. To see why this is a problem, consider what actually happened in the years leading up to 2008: traders and Wall Street financial wizards knew that they could sell a lot of the products that they were creating, and the result would be a windfall for their companies and a big bonus of more than $1 million in their pockets. They sold a lot, then they sold more, and their bonuses went up accordingly. These products had the potential to blow up and ruin the company, or they might pay off big.
If they paid off big, the bonuses would be astronomical. If they blew up, well, the traders, executives and wizards might be laid off. But they could console themselves for their bad luck by counting the bonus dollars in their retirement accounts, which would be far more money than the average American investor is ever likely to see. Heads they win big, tails they win not quite so big. Where is the incentive for them to actually worry about whether the products they created and sold would blow up and wreck the company, the balance sheets of banks and pension funds, and the global economy?
Have we changed the incentive structure for Wall Street?
Alas, no. There were proposals to create so-called "clawback" provisions, where, if the derivatives or packaged investments were to blow up in the future, traders, brokers, wizards and other responsible executives would have to give back some or all of the bonuses they received. But the proposals went nowhere.
Indeed, it appears that the moral code on Wall Street has actually gotten worse, not better. As evidence, consider a recent poll of 250 Wall Street traders, portfolio managers, investment bankers and brokers (who call themselves investment advisors), where 23% said that "they had observed or had firsthand knowledge of wrongdoing in the workplace." 24% of the respondents said that they would "engage in insider trading to make $10 million if they could get away with it." 26% said they "believed the compensation plans or bonus structures in place at their companies incentivize employees to compromise ethical standards or violate the law." And 17% said they expected "their leaders were likely to look the other way if they suspected a top performer engaged in insider trading."
And these are the people who are integral to the safe and healthy functioning of our financial system.
6) The financial crisis problem that got the most public attention was the "Too big to fail" problem, where the government felt it had no choice but to reach into the taxpayers' pockets and bail out the companies that caused the problem in the first place. People talked about the moral hazard when a company knows that its failure is too painful to contemplate. The company can make huge risky bets, and if it wins those bets, it puts enormous sums of money into its own pockets. If it loses them, the government will bail it out. Once again, heads they win, tails they don't lose--which is not how the economy is supposed to operate.
Have we fixed the "too big to fail" problem?
No. In fact, it has gotten worse, as the healthy companies were given government incentives to buy the less healthy ones on Wall Street.
7) In the aftermath of the global financial crisis, some observers pointed out that banks should ideally function as utilities in the U.S. economy. Their function is to provide capital for companies and individuals who build or create businesses (and jobs). When Wall Street is using that capital instead for its own purposes, to day-trade for their own accounts and create complex investment products that are highly-profitable but serve no economic purpose, they are diverting valuable capital into their own pockets.
Can anything be done about this?
Not currently. Wall Street lobbyists have successfully beaten back all efforts to change their corporate behavior. Meanwhile, an article written by the former chief economist of the International Monetary Fund notes that the financial sector--chiefly the largest Wall Street firms--now earns more than 41% of all domestic corporate profits. That means that Wall Street has used the valuable capital that should be made available to the corporate sector to generate profits for itself that roughly equal the profits of all the aerospace and defense firms, pharmaceutical and oil companies, electric utilities, housing and construction, TV, radio, the movie industry, computer and software companies and the entire health care industry--combined.
Of course, none of this means that another global financial meltdown is going to happen; what happened in 2008 was a perfect storm of unfortunate events. But it is hard to be encouraged by how Congress and regulators have gone about fixing the problems that were exposed by the financial crisis. The anniversary of the Lehman collapse suggests that our elected officials and regulators still haven't learned the lessons of 2008.
Sources:
Time cover story, Sept. 23, 2013
http://dealbook.nytimes.com/2013/07/15/on-wall-st-a-culture-of-greed-wont-let-go/?_r=0
http://www.theatlantic.com/magazine/archive/2009/05/the-quiet-coup/307364/?single_page=true)
Sincerely,
William T. Morrissey and Tammy Prouty
Sound Financial Planning Inc.
wtmorrissey@soundfinancialplanning.net
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Mount Vernon, WA 98273
Phone: (360) 336-6527
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