What Has Changed Since Lehman Failed?

A week from Sunday, it will be five years since Lehman Brothers filed for bankruptcy, sparking the biggest financial crisis since the nineteen-thirties and a seven-hundred-billion-dollar bank bailout. In a recent interview with Andrew Ross Sorkin, of the Times and CNBC, Hank Paulson, the man who, as Treasury Secretary, was primarily responsible for the rescue of Wall Street, expressed outrage—or at least misgivings—about the fact that many of the bankers whom the taxpayers rescued promptly turned around and gave themselves huge bonuses. “To say I was disappointed is an understatement,” Paulson said. “My view has nothing to do with legality and everything to do with what was right, and everything to do with just a colossal lack of self-awareness as to how they were viewed by the American public.”

Set aside for a moment the irony of a former chief executive of Goldman Sachs lecturing the rest of Wall Street on ethics. Paulson has always played the role of an old-school investment banker in the Felix Rohatyn mold. A soft-spoken Midwesterner, he emerged alone atop the “giant vampire squid” in 1998, primarily because many of his colleagues had had their fill of his co-C.E.O. at the time, Jon Corzine. Banking is “not only a very honorable profession,” he told Ross Sorkin, “it’s a very necessary profession.”

Nobody could disagree with the latter statement: financial intermediation is an essential part of capitalism. The problem with the Wall Street banks, or most of them, is that in recent decades they have gone far beyond traditional intermediation, which involves channelling funds from depositors and investors to capital-investment projects, and turned themselves into trading houses on steroids, marketing and dealing in all manner of securities. During and after the great financial crisis, the consequences of this transformation were plain for all to see—from the demise of Lehman Brothers, which was leveraged more than thirty to one, to the ABACUS scandal at Goldman and the huge losses by the so-called London Whale at JPMorgan Chase.

What has changed in the past five years? In his published comments to Ross Sorkin, Paulson was more concerned with defending the 2008 bailout than with answering this question. That’s a pity. According to some metrics, the U.S. banking system looks a lot more solid than it was in 2007-08. But in other ways it’s almost as dysfunctional as ever, and possibly more so.

The problems going into 2007-08 can be summarized under four headings: excessive borrowing, flawed compensation structures, weak regulation, and moral hazard. In each of these areas, some necessary reforms have been introduced, but they haven’t gone far enough. As a result, there’s still the potential for another crisis, another bailout, and another angry populace.

The Treasury and the Fed often point out that the banks are not as highly leveraged as they were five years ago, and that’s true. But compared to most other industries, and to American banks a generation or two ago, they still borrow huge sums of money, much of which is used to purchase securities rather than being lent out to businesses and households. In recent months, Citigroup, Bank of America, and other banks have been boasting that they will soon have a dollar in equity for every twenty dollars in assets on their balance sheet: a leverage ratio of twenty to one. But how safe does that make a bank? In a Times Op-Ed that appeared the day before the interview with Paulson, Anat Admati, a financial economist at Stanford, pointed out that “even a tiny loss of 2 percent of its assets could prompt, in essence, a run on the bank” by its creditors. And “if too many banks are distressed at the same time, a systemic crisis results.”

It’s a similar story with compensation reform. In 2008-09, there was widespread agreement that paying traders huge bonuses and loading up senior executives with stock options incentivized banks to take on too much risk. Some significant changes have since been introduced. Under pressure from regulators, for example, Goldman and Morgan Stanley have implemented “clawback” provisions in their employment contracts, which enable them to force traders and managers to give back some of their remuneration if they go beyond the firms’ risk guidelines and generate big losses. But most traders are still evaluated on a quarterly basis, which gives them an incentive to focus all their efforts on generating short-term gains, even if that involves taking on significant risks in the longer term.

There have also been changes at the tops of the banks. These days, people like Lloyd Blankfein, the chairman and C.E.O. of Goldman, and Jamie Dimon, his counterpart at JPMorgan Chase, tend to get most of their hefty bonuses in the form of cash and stock, rather than stock options, which have little downside. But big grants of options haven’t been phased out entirely. Last year, Dimon received about five million dollars’ worth of options. James Gorman, the chief executive of Morgan Stanley, got $3.5 million. And, to some extent, whether or not the money comes in the form of stock or options is immaterial. Either way, the recipient has an incentive to ramp up the firm’s stock price before he quits or gets fired—and, in banking, that usually involves finding ways to take on more leverage and risk.

Down in Washington, regulators, legislators, and bank lobbyists are still squabbling over how the Dodd-Frank Act, which represents the principal political response to the banking crisis, will be converted into detailed rules that traders and C.E.O.s alike have to follow. Predictably enough, the banks are pressuring the government to soften the law’s impact. On Wednesday, industry lobbyists won a significant victory when the Federal Reserve agreed to change a new set of rules that was designed to force banks to eat some of their own cooking, making them keep books on some of the mortgage securities that they manufacture and market to investors. The details of the Fed’s concession are complicated, but it greatly expanded the types of mortgages, and the securities constructed from them, that are exempt from the new rule.

Finally, there is the issue of “too big to fail,” which practically everybody, including Paulson, agrees is an abomination. In a new prologue to his book about the financial crisis, which was originally published in 2010, he writes, “No bank should be too big or too complex to fail, but almost any bank is too big to liquidate quickly, particularly in the midst of a crisis.” Left unsaid is the uncomfortable fact that the bank takeovers engineered by Paulson and other government officials during the crisis, because they had no choice, have left the survivors bigger and more powerful than ever—and thus even less likely to be allowed to collapse without a bailout. An industry that was once greatly scattered is now dominated by six behemoths: Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley, and Wells Fargo.

It’s possible, of course, that bigger means better and safer. But does anybody really believe that? Huge banks are notoriously difficult to run, even for someone like Dimon, who is widely regarded as a first-rate manager. Moreover, they tend to copy each other like young siblings, with the result that when one gets into a pickle they all do. From their perspective, acting like sheep makes a weird kind of sense. If they get into trouble together, it’s practically certain that the government will bail them out, regardless of how unpopular such a move might be. What else can it do? Allow the entire banking system to collapse?

If you know you’ve got an ironclad insurance policy with a low deductible, you have an incentive to drive faster and be less careful parking. The logic of the banks is practically identical. As long as they know the taxpayers will bail them out if they get into trouble, they have an incentive to take too much risk. Economists call this problem a “moral hazard,” and the consolidation of the banking system has made it worse. A couple of years ago, Andy Haldane, a senior official at the Bank of England, gave it another name. Referring to the increasingly common sight of banks going for growth, coming a cropper, and getting bailed out, Haldane wrote, “In evolutionary terms, we have had survival not of the fittest but the fattest. I call this phenomenon the ‘doom loop.’ ”

Paulson isn’t that kind of wordsmith. In his interview with Ross Sorkin, he patted himself on the back for having acted quickly in the fall of 2008. That’s fair enough. The bailout worked well on its own terms, and the banks quickly repaid the government for the capital it invested in them. As I’ve said all along, Paulson deserves credit. But he and his successors in the Obama Administration haven’t done enough to preclude the possibility of a repeat performance. And next time around, the outcome could be even worse.

Original Article
Source: newyorker.com
Author: John Cassidy