Rebuilding Wall Street

Easily the most significant of a mountain of laws now being drawn up in the backrooms of Congress and the Senate with the vigorous intervention of the White House is one that decrees no bank will be so big that it will not be allowed to fail. In short, no more bail-outs.

The so-called “resolution authority” described in the banking reforms working their way through the Senate will see to that. As the US Treasury’s trouble-shooter on banking reform, deputy secretary Neal S Wolin, said late April, this authority means: “No firm will be insulated from the consequences of its action, no firm will be protected from failure, and taxpayers will never [again] foot the bill for Wall Street’s mistakes.”

Here’s the future scenario for firms that get themselves into trouble, as described by Wolin. They will be shut down or broken up and sold to competitors. Management will be kicked out. Creditors and shareholders will suffer losses, just like in a normal commercial failure. And the average citizen will hardly notice a thing.
Given the determination of the White House, Treasury, Fed Res and every other relevant authority to make this happen, it’s a done deal that the Obama financial-sector reforms will go through in the US and that they will set the model for the rest of the world.

The process for the euthanasia of troubled firms is only part of the reform process that will surely reshape big, interconnected firms. Also in the legislative pipeline are specific procedures for the regulation of derivatives – the credit default swaps that nearly brought down AIG, for the management of systemic risk through a council of regulators, for much higher capital and liquidity standards especially for the biggest firms, and for the prohibition against banks investing in hedge or private equity funds.

Not much, if anything, is left out. On top of all this, there will be obligatory provisions allowing shareholders to claw back bonuses deemed to be unjustified. The credit rating agencies will have their very own watchdog in the form of a special division inside a much more aggressive SEC.

Although the big picture won’t change, negotiations are still going on over the detail as the reform package enters the final stretch. Wolin, a veteran Treasury official and former CIA staffer, is monitoring every meeting, every objection and every move by Wall Street.

“I think this is picking up momentum,” he told reporters in April. “There’s a clear understanding of the importance of enacting legislation sooner rather than later.”

Loose ends tying nooses
Actually, there are two separate legislative packages. The House of Representatives version known as the Wall Street Reform Act is already done and dusted while the Senate is refining its Restoring American Financial Stability Act that runs to over 1,300 pages. The debate is occurring along party lines, with Obama’s Democrats in one corner and the Republicans in the other. The main sticking point, especially with the Republicans, is whether big firms should be reduced to a size that doesn’t threaten innocent parties. Namely, whether banks should be shrunk under law before they turn into King Kongs that can destabilise an entire economy.

The next stage is for the two versions have to be harmonised. A highly symbolic date for the president to put his signature to the laws would be around the time of the collapse of Lehman Brother in October 2008.

Meantime Wolin is very much on a mission, reminding audiences of the damage done far beyond Wall Street.

When Obama took office in January 2009, he pointed out: “Americans were losing jobs at a rate of 750,000 a month. Home prices were plummeting. Businesses large and small were closing their doors. At the height of the crisis, American families had lost trillions of dollars in household wealth. Median losses at public and corporate pension funds in 2008 exceeded 25 percent. “He’s been hitting key constituencies with the message: “I believe we have an historic opportunity to fix the broken rules that govern our financial system,” he says.

Balancing books
As the figures come in, the true and staggering cost of supporting the financial sector becomes clearer. The bill will run to nearly $3.5trn over the next three fiscal years, according to Treasury’s office of debt management which has had to be extremely nimble-footed to find the funds. Last year, for example, it had to raise nearly six times the sovereign debt of 2008 in order to keep the economy going and to stabilise the banks.

And this came at a time of collapsing government receipts, with corporate taxes slumping by 55 percent, and fast-rising welfare costs. As Treasury points out, it “had to manage a $950bn financing swing in just one year.”

As the laws take shape, Wall Street is mounting an unprecedented offensive. According to Treasury sources, there are four lobbyists walking the corridors of Capitol Hill for every Congressman while the trade associations are spending $1.5m a day in lobbying costs to thwart, block or at least soften the terms of the legislation. The big-banking sector has not invested so much money, time and resources on legislation since the Gramm-Wiley laws of just over a decade ago that effectively annulled the 50 year-old Glass-Steagall Act and made it legal once again to combine commercial (retail) and investment-banking activities under the one roof.

Wall Street’s main fear is that the big firms will be reduced to the equivalent of boutique operations specialising either in plain-vanilla deposits and lending, or in investment banking’s M&A, non-proprietary trading, securities and other fee-building business. And if this were to happen, America would lose its banking dominance and may be destabilised all over again.

Regulators take a different view, pointing out that big firms can’t be trusted not to get themselves into trouble. Indeed before the crisis the average capital to assets ratio of the world’s 50 biggest institutions was a skimpy four percent. None had a ratio above eight percent. This, they argue, is manifestly too low.

Shapiro Shapiro
While the Treasury leads the charge, the SEC under tough-minded Mary Schapiro is very much on song as its recent bombshell action against Goldman Sachs process. The case alleges the firm deliberately designed a mortgage-based product – a synthetic CDO or collateralised debt obligation – so that it would fall to the benefit of third parties that wanted to short it. Whatever the merits of the case (and Goldman Sachs is vigorously defending it), it came as a shock to Wall Street and can safely be seen as the White House firing a shot across the bows of the big banks in the run-up to the reforms.

And clearly the SEC under Schapiro, who’s only been in the job a year, is on the warpath. New York-born Schapiro is a regulatory veteran who has served on the SEC commission under three presidents. Although Bernard Madoff once described her as a “dear friend”, the feeling isn’t mutual. In just one year at the helm, she has turned the commission into an offensive weapon. For instance, she strengthened the investigative division that was so infamously hoodwinked by one of the oldest tricks in the investment book – the $50bn Ponzi scheme run by Madoff Securities and the $7bn one of the Stanford Financial Group. Among other reforms considered overdue, the SEC has also proposed specific rules for credit rating agencies – another White House target because of their indiscriminate use of triple-A credit ratings.

Outside Wall Street, the new-look SEC gets high marks. “We’re seeing a resolve in the enforcement division that was lacking a year and a half or two years ago, and even 10 years ago,’’ says James D Cox, a Duke University law professor.

Behind all these offensives by the White House, Treasury and SEC is the conviction that the financial sector can’t be trusted to regulate itself. The guiding light of earlier administrations when Alan Greenspan was chairman of the US Fed, “regulation lite” has gone the way of toxic assets.

As Schapiro observed: “I think everybody a few years ago got caught up in the idea that the markets are self-correcting and self-disciplined, and that the people in Wall Street will do a better job protecting the financial system than the regulators would,’’ she said. “I do think the SEC got diverted by that philosophy.’’

One new face that Wall Street can expect to see a lot is Robert Khuzami, the SEC’s director of enforcement. A former federal prosecutor, he was parachuted into the commission in January from a top position at Deutsche Bank and he clearly means business. In his first speech to a packed Bar Association of New York, he dropped a number of bombshells, among them the revelation that his division will henceforth have the power to subpoena documents without the consent of the SEC’s five commissioners, a long-standing inhibition to the agency’s nimble-footedness.

Khuzami clearly wants to speed up the search process. If defence counsels aren’t “complete and timely in responses [to SEC requests for information]”, he warned, “there will likely be a subpoena on your desk in the morning.”  

Right on cue, skeletons keep coming out of the cupboard. According to yet another congressional investigation issued in April, this time into Washington Mutual, the firm continued to hustle high-risk mortgages despite its own reports showing that many of these securities were “likely to fail”. One internal probe estimates fraud rates of up to 83 percent in these securities – and WaMu and its affiliates securitised over $190bn of these loans in various forms.

The investigating committee is also on the warpath as it continues a round of hearings on the role of investment banks, regulators and credit rating agencies in the crisis. We must “hold perpetrators accountable,” insists its spokesman. So far, he lamented, blame had been attached to “very few people”.

Mainly behind the scenes, legendary central banker Paul Volcker has emerged as the president’s big thinker on banking reform. It was Volcker who first raised the “too big to fail” issue when he addressed the House of Representatives banking and financial services committee last September with the ominous observation:

“As a general matter, I would exclude from commercial banking institutions, which are potential beneficiaries of official (i.e., taxpayer) financial support, certain risky activities entirely suitable for our capital markets.

Ownership or sponsorship of hedge funds and private equity funds should be among those prohibited activities. There are deep-seated, almost unmanageable, conflicts of interest with normal banking relationships.”
In so many words he was foreshadowing the repeal of Gramm-Wiley and a new era in big banking.

The president is determined to set the global agenda for banking reform and the new rules are certain to trickle down to other nations in the dollar zone as well into western Europe where regulatory thinking broadly coincides with that of US Treasury secretary Tim Geithner.

There’s no doubt this is a sea-change, as UK regulatory specialist and academic Peter Hahn points out. “This [reform process] is no longer a technocratic exercise. By proposing legislation, the American authorities and government are taking an axe to everything that has gone before,” he explains. “The discussion about the future look of global banking has been brought out of the closet.”

The last time this debate raged was in 1933 when Glass-Steagall split the banks in two. Oddly enough, for the next 50 years the US banking sector as a whole never performed better. And apart from occasional lapses like the savings and loan debacle, it stayed honest.


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