Woof, 3rd Post;
Yes, our government is corrupt, both Party's, top to bottom and they've got us pointing fingers at eachother while they screw all of us.
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How Wall Street and Washington
Betrayed America
March 2009
Essential Information * Consumer Education Foundation
www.wallstreetwatch.org2 SOLD OUT
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How Wall Street and Washington
Betrayed America
March 2009
Essential Information * Consumer Education Foundation
www.wallstreetwatch.org4 SOLD OUT
Primary authors of this report are Robert Weissman and James Donahue. Harvey Rosenfield,
Jennifer Wedekind, Marcia Carroll, Charlie Cray, Peter Maybarduk, Tom Bollier and Paulo
Barbone assisted with writing and research.
Essential Information
PO Box 19405
Washington, DC 20036
202.387.8030
info@essential.org
www.essential.orgConsumer Education Foundation
PO Box 1855
Studio City, CA 91604
cefus@mac.com
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www.wallstreetwatch.orgTable of Contents
Introduction: A Call to Arms, by Harvey Rosenfield ..ccccc. 6
Executive Summary cccccccccccccccccc... 14
Part I: 12 Deregulatory Steps to Financial Meltdown ....................... 21
1. Repeal of the Glass-Steagall Act and the Rise of the Culture of cccc.. 22
Recklessness
2. Hiding Liabilities: Off-Balance Sheet Accounting cccccccccc 33
3. The Executive Branch Rejects Financial Derivative Regulation cccc.. 39
4. Congress Blocks Financial Derivative Regulation cccccccccc 47
5. The SECfs Voluntary Regulation Regime for Investment Banks cccc. 50
6. Bank Self-Regulation Goes Global: Preparing to Repeat the Meltdown? c 54
7. Failure to Prevent Predatory Lending ccccccccccccccc 58
8. Federal Preemption of State Consumer Protection Laws ccccccc.. 67
9. Escaping Accountability: Assignee Liability cccccccccccc 73
10. Fannie and Freddie Enter the Subprime Market ccccccccccc 80
11. Merger Mania cccccccccccccccccccccccc 87
12. Rampant Conflicts of Interest: Credit Ratings Firmsf Failure ccccc.. 93
Part II: Wall Streetfs Washington Investment ..cccccccc. 98
Conclusion and Recommendations:
Principles for a New Financial Regulatory Architecture ..cc... 109
Appendix: Leading Financial Firm Profiles of Campaign
Contributions and Lobbying Expenditures ...cccccccc 115
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Introduction:
A Call to Arms
by Harvey Rosenfield*
Americafs economy is in tatters, and the
situation grows dire by the day. Nearly
600,000 Americans lost their jobs in January,
for a total of 1.8 million over the last
three months.
Millions more
will lose theirs
over the next
year no matter
what happens.
Students can no
longer pursue a college education. Families
cannot afford to see a doctor. Many Americans
owe more on their homes than they are
worth. Those lucky enough to have had
pensions or retirement funds have watched
helplessly as 25 percent of their value
evaporated in 2008.
What caused this catastrophe? As this
report chronicles in gruesome detail, over
the last decade, Wall Street showered Washington
with over $1.7 billion in what are
prettily described as gcampaign contributions.h
This money went into the political
coffers of everyone from the lowliest mem-
* President, Consumer Education Foundation
1 Source: Center for Responsive Politics,
<
www.opensecrets.org>.
ber of Congress to the President of the
United States. The Money Industry spent
another $3.4 billion on lobbyists whose job
it was to press for deregulation . Wall
Streetfs license to steal from every American.
In return for the investment of more than
$5.1 billion, the Money Industry was able to
get rid of many of the reforms enacted after
the Great Depression and to operate, for
most of the last
ten years, without
any effective
rules or restraints
whatsoever.
The report,
prepared by
Essential Information and the Consumer
Education Foundation, details step-by-step
many of the events that led to the financial
debacle. Here are the ghighlightsh of our
economic downfall:
. Beginning in 1983 with the Reagan
Administration, the U.S. government
acquiesced in accounting rules
adopted by the financial industry
that allowed banks and other corporations
to take money-losing assets
off their balance sheets in order to
hide them from investors and the
public.
. Between 1998 and 2000, Congress
and the Clinton Administration repeatedly
blocked efforts to regulate
Industry1 $ to Politicians $ to Lobbyists
Securities $512 million $600 million
Commercial Banks $155 million $383 million
Insurance Cos. $221 million $1002 million
Accounting $81 million $122 million
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gfinancial derivativesh . including
the mortgage-related credit default
swaps that became the basis of trillions
of dollars in speculation.
. In 1999, Congress repealed the Depression-
era law that barred banks
from offering investment and insurance
services, and vice versa, enabling
these firms to engage in speculation
by investing money from
checking and savings accounts into
financial gderivativesh and other
schemes understood by only a handful
of individuals.
. Taking advantage of historically low
interest rates in the early part of this
decade, shady mortgage brokers and
bankers began offering mortgages
on egregious terms to purchasers
who were not qualified. When these
predatory lending practices were
brought to the attention of federal
agencies, they refused to take serious
action. Worse, when states
stepped into the vacuum by passing
laws requiring protections against
dirty loans, the Bush Administration
went to court to invalidate those reforms,
on the ground that the inaction
of federal agencies superseded
state laws.
. The financial industryfs friends in
Congress made sure that those who
speculate in mortgages would not be
legally liable for fraud or other illegalities
that occurred when the
mortgage was made.
. Egged on by Wall Street, two government-
sponsored corporations,
Fannie Mae and Freddie Mac,
started buying large numbers of
subprime loans from private banks
as well as packages of mortgages
known as gmortgage-backed securities.h
. In 2004, the top cop on the Wall
Street beat in Washington . the
Securities and Exchange Commission
. now operating under the
radical deregulatory ideology of the
Bush Administration, authorized investment
banks to decide for themselves
how much money they were
required to set aside as rainy day reserves.
Some firms then entered into
$40 worth of speculative trading for
every $1 they held.
. With the compensation of CEOs increasingly
tied to the value of the
firmfs total assets, a tidal wave of
mergers and acquisitions in the financial
world . 11,500 between
1980 and 2005 . led to the predominance
of just a relative handful
banks in the U.S. financial system.
Successive administrations failed to
enforce antitrust laws to block these
mergers. The result: less competi8
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tion, higher fees and charges for
consumers, and a financial system
vulnerable to collapse if any single
one of the banks ran into trouble.
. Investors and even government authorities
relied on private gcredit ratingh
firms to review corporate balance
sheets and proposed investments
and report to potential investors
about their quality and safety.
But the credit rating companies had
a grave conflict of interest: they are
paid by the financial firms to issue
the ratings. Not surprisingly, they
gave the highest ratings to the investments
issued by the firms that
paid them, even as it became clear
that the ratings were inflated and the
companies were in precarious condition.
The financial lobby made sure
that regulation of the credit ratings
firms would not solve these problems.
None of these milestones on the road to
economic ruin were kept secret. The dangers
posed by unregulated, greed-driven financial
speculation were readily apparent to any
astute observer of the financial system. But
few of those entrusted with the responsibility
to police the marketplace were willing to
do so. And as the report explains, those
officials in government who dared to propose
stronger protections for investors and
consumers consistently met with hostility
and defeat. The power of the Money Industry
overcame all opposition, on a bipartisan
basis.
Itfs not like our elected leaders in Washington
had no warning: The California
energy crisis in 2000, and the subsequent
collapse of Enron . at the time unprecedented
. was an early warning that the
nationfs system of laws and regulations was
inadequate to meet the conniving and trickery
of the financial industry. The California
crisis turned out to be a foreshock of the
financial catastrophe that our country is in
today. It began with the deregulation of
electricity prices by the state legislature.
Greased with millions in campaign contributions
from Wall Street and the energy industry,
the legislation was approved on a bipartisan
basis without a dissenting vote.
Once deregulation took effect, Wall
Street began trading electricity and the
private energy companies boosted prices
through the roof. Within a few weeks, the
utility companies . unable because of a
loophole in the law to pass through the
higher prices to consumers . simply
stopped paying for the power. Blackouts
ensued. At the time, Californians were
chastised for having caused the shortages
through gover-consumption.h But the energy
shortages were orchestrated by Wall Street
rating firms, investment banks and energy
companies, in order to force Californiafs
taxpayers to bail out the utility companies.
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Californiafs political leadership and utility
regulators largely succumbed to the blackmail,
and $11 billion in public money was
used to pay for electricity at prices that
proved to be artificially manipulated by c
Wall Street traders. The state of California
was forced to increase utility rates and
borrow over $19 billion . through Wall
Street firms . to cover these debts.
Its electricity trading activities under investigation,
Enronfs vast accounting shenanigans,
including massive losses hidden in
off-balance sheet corporate entities, came to
light, and the company collapsed within a
matter of days. It looked at the time as
though the California deregulation disaster
and the Enron scandal would lead to
stronger regulation and corporate accountability.
But then 9/11 occurred. And for most of
the last decade, the American people have
been told that our greatest enemy lived in a
cave. The subsequent focus on external
threats, real and imagined, distracted attention
from deepening problems at home. As
Franklin Roosevelt observed seventy years
ago, gour enemies of today are the forces of
privilege and greed within our own borders.h
Today, the enemies of American
consumers, taxpayers and small investors
live in multimillion-dollar palaces and pull
down seven-, eight- or even nine-figure
annual paychecks. Their weapons of mass
destruction, as Warren Buffett famously put
it, were derivatives: pieces of paper that
were backed by other pieces of paper that
were backed by packages of mortgages,
student loans and credit card debt, the
complexity and value of which only a few
understood. Meanwhile, the lessons of
Enron were cast aside after a few insignificant
measures . the tougher reforms killed
by the Money Industry . and Wall Street
went back to business as usual.
Last fall, the house of cards finally collapsed.
For those who might have heard the
gblame the victimh propaganda emanating
from the free marketers whose philosophy
lies in a smoldering ruin alongside the
economy, the report sets the record straight:
consumers are not to blame for this debacle.
Not those of us who used credit in an attempt
to have a decent quality of life (as
opposed to the tiny fraction of people in our
country who truly got ahead over the last
decade). Nor can we blame the Americans
who were offered amazing terms for mortgages
but forgot to bring a Ph.D. and a
lawyer to their gclosing,h and later found out
that they had been misled and could not
afford the loan at the real interest rate buried
in the fine print.
Rather, Americafs economic system is
at or beyond the verge of depression today
because gambling became the financial
sectorfs principal preoccupation, and the pile
of chips grew so big that the Money Industry
displaced real businesses that provided real
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goods, services and jobs. By that time, the
amount of financial derivatives in circulation
around the world . $683 trillion by
one estimate . was more than ten times the
actual value of all the goods and services
produced by the entire planet. When all the
speculators tried to cash out, starting in
2007, there really wasnft enough money to
cover all the bets.
If we Americans are to blame for anything,
itfs for allowing Wall Street to do
what it calls a gleveraged buy outh of our
political system by spending a relatively
small amount of capital in the Capitol in
order to seize control of our economy.
Of course, the moment the Money Industry
realized that the casino had closed, it
turned . as it always does . to Washington,
this time for the mother of all favors: a
$700 billion bailout of the biggest financial
speculators in the country. Thatfs correct:
the people who lost hundreds of billions of
dollars of investorsf money were given
hundreds of billions of dollars more. The
bailout was quickly extended to insurance
companies, credit card companies, auto
manufacturers and even car rental firms. In
addition to cash infusions, the government
has blown open the federal bank vaults to
offer the Money Industry a feast of discount
loans, loan guarantees and other taxpayer
subsidies. The total tally so far? At least $8
trillion.
Panicked by Wall Streetfs threat to pull
the plug on credit, Congress rebuffed efforts
to include safeguards on how taxpayer
money would be spent and accounted for.
Thatfs why many of the details of the bailout
remain a secret, hiding the fact that no one
really knows why certain companies were
given our money, or how it has been spent.
Bankers used it pay bonuses, to buy back
their own bank stock, or to build their empires
by purchasing other banks. But very
little of the money has been used for the
purpose it was ostensibly given: to make
loans. One thing is certain: this last Washington
giveaway . the Greatest Wall Street
Giveaway of all time . has not fixed the
economy.
Meanwhile, at this very moment of national
threat, the banks, hedge funds and
other parasite firms that crippled our economy
are pouring money into Washington to
preserve their privileges at the expense of
the rest of us. The only thing that has
changed is that many of these firms are
using taxpayer money . our money . to do
so.
Thatfs why you wonft hear anyone in
the Washington establishment suggest that
Americans be given a seat on the Board of
Directors of every company that receives
bailout money. Or that Americafs economic
security is intolerably jeopardized when
pushing paper around constitutes a quarter
or more of our economy. Or that credit
default swaps and other derivatives should
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be prohibited, or limited just like slot machines,
roulette wheels and other forms of
gambling.
In most of the United States, you can go
to jail for stealing a loaf of bread. But if you
have paid off Washington, you can steal the
life-savings, livelihoods, homes and dreams
of an entire nation, and you will be allowed
to live in the fancy homes you own, drive
multiple cars, throw multi-million dollar
birthday parties. Punishment? You might not
be able to get your bonus this year or, worst
come to worst, if you are one of the very
unlucky few unable to take advantage of the
loopholes in the plan announced by the
Treasury Secretary Geithner, you may end
up having to live off your past riches because
you can only earn a measly $500,000
while you are on the dole. (More good news
for corporate thieves: this flea-bitten proposal
is not retroactive . it does not apply
to all the taxpayer money already handed
out).
Like their predecessors, Presidentelected
Obamafs key appointments to the
Treasury, the SEC and other agencies are
veterans of the Money Industry. They are
unlikely to challenge the narrow boundaries
of the debate that has characterized Washingtonfs
response to the crisis. So long as
the Money Industry remains in charge of the
federal agencies and keeps our elected
officials in its deep pockets, nothing will
change.
Here are seven basic principles that
Americans should insist upon.
Relief. Itfs been only five months since
Congress authorized $700 billion to bail out
the speculators. Congress was told that the
bailout would alleviate the gcredit crunchh
and encourage banks to lend money to
consumers and small businesses. But the
banks have hoarded the money, or misspent
it. If the banks arenft going to keep their end
of the bargain, the government should use its
power of eminent domain to take control of
the banks, or seize the money and let the
banks go bankrupt. On top of the $700
billion bailout, the Federal Reserve has been
loaning public money to Wall Street firms
money at as little as .25 percent. These
companies are then turning around and
charging Americans interest rates of 4
percent to 30 percent for mortgages and
credit cards. There should be a cap on what
banks and credit card companies can charge
us when we borrow our own money back
from them. Similarly, transfers of taxpayer
money should be conditioned on acceptance
of other terms that would help the public,
such as an agreement to waive late fees, and
an agreement not to lobby the government.
And, Americans should be appointed to sit
on the boards of directors of these firms in
order to have a say on what these companies
do with our money . to keep them from
wasting it and to make sure they repay it.
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Restitution. Companies that get taxpayer
money must be required to repay it on terms
that are fair to taxpayers. When Warren
Buffett acquired preferred shares in Goldman
Sachs, he demanded that Goldman
Sachs pay 10 percent interest; taxpayers are
only getting back 5 percent. The Congressional
Oversight Panel estimates that taxpayers
received preferred shares worth about
two-thirds of what was given to the initial
bailout recipients. Even worse are the taxpayer
loan guarantees offered to Citigroup.
For a $20 billion cash injection plus taxpayer
guarantees on $306 billion in toxic
assets . likely to impose massive liabilities
on the public purse . the government
received $27 billion in preferred shares,
paying 8 percent interest. Now the Obama
administration has suggested that it might
offer a dramatically expanded guarantee
program for toxic assets, putting the taxpayer
on the hook for hundreds of billions
more.
Regulation. The grand experiment in letting
Wall Street regulate itself under the assumption
that free market forces will police the
marketplace has failed catastrophically.
Wall Street needs to operate under rules that
will contain their excessive greed. Derivatives
should be prohibited unless it can be
shown that they serve a useful purpose in
our economy; those that are authorized
should be traded on exchanges subject to
full disclosure. Further mergers of financial
industry titans should be barred under the
antitrust laws, and the current monopolistic
industry should be broken up once the
country has recovered.
Reform. It is clear that the original $700
billion bailout was a rush job so poorly
constructed that it has largely failed and
much of the money wasted. The federal
government should revise the last bailout
and establish new terms for oversight and
disclosure of which companies are getting
federal money and what they are doing with
it.
Responsibility. Americans are tired of
watching corporate criminals get off with a
slap on the wrist when they plunder and
loot. Accountability is necessary to maintain
not only the honesty of the marketplace but
the integrity of American democracy. Corporate
officials who acted recklessly with
stockholder and public money should be
prosecuted and sentenced to jail time under
the same rules applicable to street thugs.
State and local law enforcement agencies,
with the assistance of the federal government,
should join to build a national network
for the investigation and prosecution of the
corporate crooks.
Return . to a real economy. In 2007, more
than a quarter of all corporate profits came
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from the Money Industry, largely based on
speculation by corporations operating in
international markets and whose actions call
into question their loyalty to the best interests
of America. To recover, America must
return to the principles that made it great .
hard work, creativity, and innovation . and
both government and business must serve
that end. The spectacle of so many large
corporations lining up for government
assistance puts to rest the argument made by
the corporate-funded think tanks and talking
heads over the last three decades that government
is gthe problem, not the solution.h
In fact, as this report shows, government has
been the solution for the Money Industry all
along.
Now Washington must serve America,
not Wall Street. Massive government intervention
is not only appropriate when it is
necessary to save banks and insurance
companies. For the $20 billion in taxpayer
money that the government gave Citigroup
in November, we could have bought the
company lock, stock and barrel, and then we
would have our own credit card, student
loan and mortgage company, run on careful
business principles but without the need to
turn an enormous profit. Think of the assistance
that that would offer to Main Street,
not to mention the competitive effect it
would have on the market. And massive
government intervention is whatfs really
needed in the health care system, which
private enterprise has plundered and then for
so many Americans abandoned.
Revolt. Things will not change so long as
Americans acquiesce to business as usual in
Washington. Itfs time for Americans to
make their voices heard.
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Executive Summary
Blame Wall Street for the current financial
crisis. Investment banks, hedge funds and
commercial banks made reckless bets using
borrowed money. They created and trafficked
in exotic investment vehicles that
even top Wall Street executives . not to
mention firm directors . did not understand.
They hid risky investments in offbalance-
sheet vehicles or capitalized on their
legal status to cloak investments altogether.
They engaged in unconscionable predatory
lending that offered huge profits for a time,
but led to dire consequences when the loans
proved unpayable. And they created, maintained
and justified a housing bubble, the
bursting of which has thrown the United
States and the world into a deep recession,
resulted in a foreclosure epidemic ripping
apart communities across the country.
But while Wall Street is culpable for
the financial crisis and global recession,
others do share responsibility.2
For the last three decades, financial
regulators, Congress and the executive
branch have steadily eroded the regulatory
system that restrained the financial sector
from acting on its own worst tendencies.
The post-Depression regulatory system
2 This report uses the term gWall Streeth in the
colloquial sense of standing for the big players
in the financial sector, not just those located
in New Yorkfs financial district.
aimed to force disclosure of publicly relevant
financial information; established limits
on the use of leverage; drew bright lines
between different kinds of financial activity
and protected regulated commercial banking
from investment bank-style risk taking;
enforced meaningful limits on economic
concentration, especially in the banking
sector; provided meaningful consumer
protections (including restrictions on usurious
interest rates); and contained the financial
sector so that it remained subordinate to
the real economy. This hodge-podge regulatory
system was, of course, highly imperfect,
including because it too often failed to
deliver on its promises.
But it was not its imperfections that led
to the erosion and collapse of that regulatory
system. It was a concerted effort by Wall
Street, steadily gaining momentum until it
reached fever pitch in the late 1990s and
continued right through the first half of
2008. Even now, Wall Street continues to
defend many of its worst practices. Though
it bows to the political reality that new
regulation is coming, it aims to reduce the
scope and importance of that regulation and,
if possible, use the guise of regulation to
further remove public controls over its
operations.
This report has one overriding message:
financial deregulation led directly to the
financial meltdown.
It also has two other, top-tier messages.
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First, the details matter. The report documents
a dozen specific deregulatory steps
(including failures to regulate and failures to
enforce existing regulations) that enabled
Wall Street to crash the financial system.
Second, Wall Street didnft obtain these
regulatory abeyances based on the force of
its arguments. At every step, critics warned
of the dangers of further deregulation. Their
evidence-based claims could not offset the
political and economic muscle of Wall
Street. The financial sector showered campaign
contributions on politicians from both
parties, invested heavily in a legion of
lobbyists, paid academics and think tanks to
justify their preferred policy positions, and
cultivated a pliant media . especially a
cheerleading business media complex.
Part I of this report presents 12 Deregulatory
Steps to Financial Meltdown. For
each deregulatory move, we aim to explain
the deregulatory action taken (or regulatory
move avoided), its consequence, and the
process by which big financial firms and
their political allies maneuvered to achieve
their deregulatory objective.
In Part II, we present data on financial
firmsf campaign contributions and disclosed
lobbying investments. The aggregate data
are startling: The financial sector invested
more than $5.1 billion in political influence
purchasing over the last decade.
The entire financial sector (finance, insurance,
real estate) drowned political
candidates in campaign contributions over
the past decade, spending more than $1.7
billion in federal elections from 1998-2008.
Primarily reflecting the balance of power
over the decade, about 55 percent went to
Republicans and 45 percent to Democrats.
Democrats took just more than half of the
financial sectorfs 2008 election cycle contributions.
The industry spent even more . topping
$3.4 billion . on officially registered
lobbying of federal officials during the same
period.
During the period 1998-2008:
. Accounting firms spent $81 million
on campaign contributions and $122
million on lobbying;
. Commercial banks spent more than
$155 million on campaign contributions,
while investing nearly $383
million in officially registered lobbying;
. Insurance companies donated more
than $220 million and spent more
than $1.1 billion on lobbying;
. Securities firms invested nearly
$513 million in campaign contributions,
and an additional $600 million
in lobbying.
All this money went to hire legions of
lobbyists. The financial sector employed
2,996 lobbyists in 2007. Financial firms
employed an extraordinary number of
former government officials as lobbyists.
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This report finds 142 of the lobbyists employed
by the financial sector from 1998-
2008 were previously high-ranking officials
or employees in the Executive Branch or
Congress.
These are the 12 Deregulatory Steps to
Financial Meltdown:
1. Repeal of the Glass-Steagall Act and
the Rise of the Culture of Recklessness
The Financial Services Modernization Act
of 1999 formally repealed the Glass-Steagall
Act of 1933 (also known as the Banking Act
of 1933) and related laws, which prohibited
commercial banks from offering investment
banking and insurance services. In a form of
corporate civil disobedience, Citibank and
insurance giant Travelers Group merged in
1998 . a move that was illegal at the time,
but for which they were given a two-year
forbearance . on the assumption that they
would be able to force a change in the
relevant law at a future date. They did. The
1999 repeal of Glass-Steagall helped create
the conditions in which banks invested
monies from checking and savings accounts
into creative financial instruments such as
mortgage-backed securities and credit
default swaps, investment gambles that
rocked the financial markets in 2008.
2. Hiding Liabilities:
Off-Balance Sheet Accounting
Holding assets off the balance sheet generally
allows companies to exclude gtoxich or
money-losing assets from financial disclosures
to investors in order to make the
company appear more valuable than it is.
Banks used off-balance sheet operations .
special purpose entities (SPEs), or special
purpose vehicles (SPVs) . to hold securitized
mortgages. Because the securitized
mortgages were held by an off-balance sheet
entity, however, the banks did not have to
hold capital reserves as against the risk of
default . thus leaving them so vulnerable.
Off-balance sheet operations are permitted
by Financial Accounting Standards Board
rules installed at the urging of big banks.
The Securities Industry and Financial Markets
Association and the American Securitization
Forum are among the lobby interests
now blocking efforts to get this rule reformed.
3. The Executive Branch Rejects
Financial Derivative Regulation
Financial derivatives are unregulated. By all
accounts this has been a disaster, as Warren
Buffetfs warning that they represent gweapons
of mass financial destructionh has
proven prescient.3 Financial derivatives have
3 Warren Buffett, Chairman, Berkshire
Hathaway, Report to Shareholders, February
21, 2003. Available at:
<http://www.berkshirehathaway.com/letters/
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amplified the financial crisis far beyond the
unavoidable troubles connected to the
popping of the housing bubble.
The Commodity Futures Trading Commission
(CFTC) has jurisdiction over futures,
options and other derivatives connected
to commodities. During the Clinton
administration, the CFTC sought to exert
regulatory control over financial derivatives.
The agency was quashed by opposition from
Treasury Secretary Robert Rubin and, above
all, Fed Chair Alan Greenspan. They challenged
the agencyfs jurisdictional authority;
and insisted that CFTC regulation might
imperil existing financial activity that was
already at considerable scale (though nowhere
near present levels). Then-Deputy
Treasury Secretary Lawrence Summers told
Congress that CFTC proposals gcas[t] a
shadow of regulatory uncertainty over an
otherwise thriving market.h
4. Congress Blocks Financial Derivative
Regulation
The deregulation . or non-regulation . of
financial derivatives was sealed in 2000,
with the Commodities Futures Modernization
Act (CFMA), passage of which was
engineered by then-Senator Phil Gramm, RTexas.
The Commodities Futures Modernization
Act exempts financial derivatives,
including credit default swaps, from regulation
and helped create the current financial
2002pdf.pdf>.
crisis.
5. The SECfs Voluntary Regulation
Regime for Investment Banks
In 1975, the SECfs trading and markets
division promulgated a rule requiring investment
banks to maintain a debt-to-netcapital
ratio of less than 12 to 1. It forbid
trading in securities if the ratio reached or
exceeded 12 to 1, so most companies maintained
a ratio far below it. In 2004, however,
the SEC succumbed to a push from the big
investment banks . led by Goldman Sachs,
and its then-chair, Henry Paulson . and
authorized investment banks to develop their
own net capital requirements in accordance
with standards published by the Basel
Committee on Banking Supervision. This
essentially involved complicated mathematical
formulas that imposed no real limits,
and was voluntarily administered. With this
new freedom, investment banks pushed
borrowing ratios to as high as 40 to 1, as in
the case of Merrill Lynch. This superleverage
not only made the investment
banks more vulnerable when the housing
bubble popped, it enabled the banks to
create a more tangled mess of derivative
investments . so that their individual
failures, or the potential of failure, became
systemic crises. Former SEC Chair Chris
Cox has acknowledged that the voluntary
regulation was a complete failure.
18 SOLD OUT
6. Bank Self-Regulation Goes Global:
Preparing to Repeat the Meltdown?
In 1988, global bank regulators adopted a set
of rules known as Basel I, to impose a
minimum global standard of capital adequacy
for banks. Complicated financial
maneuvering made it hard to determine
compliance, however, which led to negotiations
over a new set of regulations. Basel II,
heavily influenced by the banks themselves,
establishes varying capital reserve requirements,
based on subjective factors of agency
ratings and the banksf own internal riskassessment
models. The SEC experience
with Basel II principles illustrates their fatal
flaws. Commercial banks in the United
States are supposed to be compliant with
aspects of Basel II as of April 2008, but
complications and intra-industry disputes
have slowed implementation.
7. Failure to Prevent Predatory Lending
Even in a deregulated environment, the
banking regulators retained authority to
crack down on predatory lending abuses.
Such enforcement activity would have
protected homeowners, and lessened though
not prevented the current financial crisis.
But the regulators sat on their hands. The
Federal Reserve took three formal actions
against subprime lenders from 2002 to 2007.
The Office of Comptroller of the Currency,
which has authority over almost 1,800
banks, took three consumer-protection
enforcement actions from 2004 to 2006.
8. Federal Preemption of State Consumer
Protection Laws
When the states sought to fill the vacuum
created by federal nonenforcement of consumer
protection laws against predatory
lenders, the feds jumped to stop them. gIn
2003,h as Eliot Spitzer recounted, gduring
the height of the predatory lending crisis, the
Office of the Comptroller of the Currency
invoked a clause from the 1863 National
Bank Act to issue formal opinions preempting
all state predatory lending laws, thereby
rendering them inoperative. The OCC also
promulgated new rules that prevented states
from enforcing any of their own consumer
protection laws against national banks.h
9. Escaping Accountability:
Assignee Liability
Under existing federal law, with only limited
exceptions, only the original mortgage
lender is liable for any predatory and illegal
features of a mortgage . even if the mortgage
is transferred to another party. This
arrangement effectively immunized acquirers
of the mortgage (gassigneesh) for any
problems with the initial loan, and relieved
them of any duty to investigate the terms of
the loan. Wall Street interests could purchase,
bundle and securitize subprime loans
. including many with pernicious, predatory
terms . without fear of liability for
SOLD OUT 19
illegal loan terms. The arrangement left
victimized borrowers with no cause of
action against any but the original lender,
and typically with no defenses against being
foreclosed upon. Representative Bob Ney,
R-Ohio . a close friend of Wall Street who
subsequently went to prison in connection
with the Abramoff scandal . was the
leading opponent of a fair assignee liability
regime.
10. Fannie and Freddie Enter the
Subprime Market
At the peak of the housing boom, Fannie
Mae and Freddie Mac were dominant purchasers
in the subprime secondary market.
The Government-Sponsored Enterprises
were followers, not leaders, but they did end
up taking on substantial subprime assets .
at least $57 billion. The purchase of subprime
assets was a break from prior practice,
justified by theories of expanded access to
homeownership for low-income families and
rationalized by mathematical models allegedly
able to identify and assess risk to newer
levels of precision. In fact, the motivation
was the for-profit nature of the institutions
and their particular executive incentive
schemes. Massive lobbying . including
especially but not only of Democratic
friends of the institutions . enabled them to
divert from their traditional exclusive focus
on prime loans.
Fannie and Freddie are not responsible
for the financial crisis. They are responsible
for their own demise, and the resultant
massive taxpayer liability.
11. Merger Mania
The effective abandonment of antitrust and
related regulatory principles over the last
two decades has enabled a remarkable
concentration in the banking sector, even in
advance of recent moves to combine firms
as a means to preserve the functioning of the
financial system. The megabanks achieved
too-big-to-fail status. While this should have
meant they be treated as public utilities
requiring heightened regulation and risk
control, other deregulatory maneuvers
(including repeal of Glass-Steagall) enabled
these gigantic institutions to benefit from
explicit and implicit federal guarantees, even
as they pursued reckless high-risk investments.
12. Rampant Conflicts of Interest:
Credit Ratings Firmsf Failure
Credit ratings are a key link in the financial
crisis story. With Wall Street combining
mortgage loans into pools of securitized
assets and then slicing them up into
tranches, the resultant financial instruments
were attractive to many buyers because they
promised high returns. But pension funds
and other investors could only enter the
game if the securities were highly rated.
The credit rating firms enabled these
20 SOLD OUT
investors to enter the game, by attaching
high ratings to securities that actually were
high risk . as subsequent events have
revealed. The credit ratings firms have a bias
to offering favorable ratings to new instruments
because of their complex relationships
with issuers, and their desire to maintain
and obtain other business dealings with
issuers.
This institutional failure and conflict of
interest might and should have been forestalled
by the SEC, but the Credit Rating
Agencies Reform Act of 2006 gave the SEC
insufficient oversight authority. In fact, the
SEC must give an approval rating to credit
ratings agencies if they are adhering to their
own standards . even if the SEC knows
those standards to be flawed.
Wall Street is presently humbled, but not
prostrate. Despite siphoning trillions of
dollars from the public purse, Wall Street
executives continue to warn about the perils
of restricting gfinancial innovationh . even
though it was these very innovations that led
to the crisis. And they are scheming to use
the coming Congressional focus on financial
regulation to centralize authority with industry-
friendly agencies.
If we are to see the meaningful regulation
we need, Congress must adopt the view
that Wall Street has no legitimate seat at the
table. With Wall Street having destroyed the
system that enriched its high flyers, and
plunged the global economy into deep
recession, itfs time for Congress to tell Wall
Street that its political investments have also
gone bad. This time, legislating must be to
control Wall Street, not further Wall Streetfs
control.
This reportfs conclusion offers guiding
principles for a new financial regulatory
architecture.
SOLD OUT 21
Part I:
12 Deregulatory Steps to
Financial Meltdown
22 SOLD OUT
REPEAL OF THE GLASSSTEAGALL
ACT AND THE RISE OF
THE CULTURE OF RECKLESSNESS
Perhaps the signature deregulatory move of
the last quarter century was the repeal of the
1933 Glass-Steagall Act4 and related legislation.
5 The repeal removed the legal prohibi-
4 Glass-Steagall repealed at Pub. L. 106.102,
title I, ˜ 101(a), Nov. 12, 1999, 113 Stat.
1341.
5 See amendments to the Bank Holding Company
Act of 1956, 12 U.S.C. ˜˜ 1841-1850,
1994 & Supp. II 1997 (amended 1999).
tion on combinations between commercial
banks on the one hand, and investment
banks and other financial services companies
on the other. Glass-Steagallfs strict
rules originated in the U.S. Governmentfs
response to the Depression and reflected the
learned experience of the severe dangers to
consumers and the overall financial system
of permitting giant financial institutions to
combine commercial banking with other
financial operations.
Glass-Steagall and related laws advanced
the core public objectives of protecting
depositors and avoiding excessive risk
for the banking system by defining industry
structure: banks could not maintain investment
banking or insurance affiliates (nor
affiliates in non-financial commercial activity).
As banks eyed the higher profits in
higher risk activity, however, they began to
breach the regulatory walls between commercial
banking and other financial services.
Starting in the 1980s, responding to a steady
drumbeat of requests, regulators began to
weaken the strict prohibition on crossownership.
In 1999, after a long industry
campaign, Congress tore down the legal
walls altogether. The Gramm-Leach-Bliley
Act6 removed the remaining legal restrictions
on combined banking and financial
service firms, and ushered in the current
hyper-deregulated era.
6 Pub. L. No. 106-102.
1
IN THIS SECTION:
The Financial Services Modernization Act of
1999 formally repealed the Glass-Steagall
Act of 1933 (also known as the Banking Act
of 1933) and related laws, which prohibited
commercial banks from offering investment
banking and insurance services. In a form of
corporate civil disobedience, Citibank and
insurance giant Travelers Group merged in
1998 . a move that was illegal at the time,
but for which they were given a two-year
forbearance . on the assumption that they
would be able to force a change in the
relevant law at a future date. They did. The
1999 repeal of Glass-Steagall helped create
the conditions in which banks invested
monies from checking and savings accounts
into creative financial instruments such as
mortgage-backed securities and credit
default swaps, investment gambles that
rocked the financial markets in 2008.
SOLD OUT 23
The overwhelming direct damage inflicted
by Glass-Steagall repeal was the
infusion of investment banking culture into
the conservative culture of commercial
banking. After repeal, commercial banks
sought high returns in risky ventures and
exotic financial instruments, with disastrous
results.
Origins
Banking involves the collection of funds
from depositors with the promise that the
funds will be available when the depositor
wishes to withdraw them. Banks keep only a
specified fraction of deposits in their vaults.
They lend the rest out to borrowers or invest
the deposits to generate income. Depositors
depend on the bankfs stability, and communities
and businesses depend on banks to
provide credit on reasonable terms. The
difficulties faced by depositors in judging
the quality of bank assets has required
government regulation to protect the safety
of depositorsf money and the well being of
the banking system.
In the 19th and early 20th centuries, the
Supreme Court prohibited commercial banks
from engaging directly in securities activities,
7 but bank affiliates . subsidiaries of a
7 See California Bank v. Kennedy, 167 U.S. 362,
370-71 (1897) (holding that national bank
may neither purchase nor subscribe to stock
of another corporation); Logan County Natfl
Bank v. Townsend, 139 U.S. 67, 78 (1891)
(holding that national bank may be liable as
shareholder while in possession of bonds
holding company that also owns banks .
were not subject to the prohibition. As a
result, commercial bank affiliates regularly
traded customer deposits in the stock market,
often investing in highly speculative
activities and dubious companies and derivatives.
The Pecora Hearings
The economic collapse that began with the
1929 stock market crash hit Americans hard.
By the time the bottom arrived, in 1932, the
Dow Jones Industrial Average was down 89
percent from its 1929 peak.8 An estimated
15 million workers . almost 25 percent9 of
the workforce . were unemployed, real
output in the United States fell nearly 30
percent and prices fell at a rate of nearly 10
percent per year.10
obtained under contract made absent legal
authority); National Bank v. Case, 99 U.S.
628, 633 (1878) (holding that national bank
may be liable for stock held in another
bank).
8 Floyd Norris, gLooking Back at the Crash of
f29,h New York Times on the web, 1999,
available at:
<http://www.nytimes.com/library/financial/i
ndex-1929-crash.html>.
9 Remarks by Federal Reserve Board Chairman
Ben S. Bernanke, gMoney, Gold, and the
Great Depression,h March 2, 2004, available
at:
<http://www.federalreserve.gov/boarddocs/s
peeches/2004/200403022/default.htm>.
10 Remarks by Federal Reserve Board Chairman
Ben S. Bernanke, gMoney, Gold, and the
Great Depression,h March 2, 2004, available
at:
<http://www.federalreserve.gov/boarddocs/s
peeches/2004/200403022/default.htm>.
24 SOLD OUT
The 1932-34 Pecora Hearings,11 held
by the Senate Banking and Currency Committee
and named after its chief counsel
Ferdinand Pecora, investigated the causes of
the 1929 crash. The committee uncovered
blatant conflicts of interest
and self-dealing by commercial
banks and their
investment affiliates. For
example, commercial banks
had misrepresented to their
depositors the quality of
securities that their investment
banks were underwriting
and promoting, leading
the depositors to be overly
confident in commercial banksf stability.
First National City Bank (now Citigroup)
and its securities affiliate, the National City
Company, had 2,000 brokers selling securities.
12 Those brokers had repackaged the
bankfs Latin American loans and sold them
to investors as new securities (today, this is
known as gsecuritizationh) without disclosing
to customers the bankfs confidential
findings that the loans posed an adverse
11 The Pecora hearings, formally titled gStock
Exchange Practices: Hearings Before the
Senate Banking Committee,h were
authorized by S. Res. No. 84, 72d Cong., 1st
Session (1931). The hearings were convened
in the 72d and 73d Congresses (1932-1934).
12 Federal Deposit Insurance Corporation
website, gThe Roaring 20s,h Undated,
available at:
<http://www.fdic.gov/about/learn/learning/
when/1920s.html>.
risk.13 Peruvian government bonds were sold
even though the bankfs staff had internally
warned that gno further national loan can be
safely madeh to Peru. The Senate committee
found conflicts when commercial banks
were able to garner confidential
insider information
about their corporate
customersf deposits and
use it to benefit the bankfs
investment affiliates. In
addition, commercial
banks would routinely
purchase the stock of
firms that were customers
of the bank, as opposed to
firms that were most financially stable.
The Pecora hearings concluded that
common ownership of commercial banks
and investment banks created several distinct
problems, among them: 1) jeopardizing
depositors by investing their funds in the
stock market; 2) loss of the publicfs confidence
in the banks, which led to panic
withdrawals; 3) the making of unsound
loans; and 4) an inability to provide honest
investment advice to depositors because
banks were conflicted by their underwriting
relationship with companies.14
13 Federal Deposit Insurance Corporation
website, gThe Roaring 20s,h Undated,
available at:
<http://www.fdic.gov/about/learn/learning/
when/1920s.html>.
14 Joan M. LeGraw and Stacey L. Davidson,
gGlass-Steagall and the eSubtle Hazardsf of
The Pecora hearings
concluded that common
ownership of commercial
banks and investment banks
created several distinct
problems.
SOLD OUT 25
Congress Acts
The Glass-Steagall Act consisted of four
provisions to address the conflicts of interest
that the Congress concluded had helped
trigger the 1929 crash:
. Section 16 restricted commercial national
banks from engaging in most
investment banking activities;15
. Section 21 prohibited investment
banks from engaging in any commercial
banking activities;16
. Section 20 prohibited any Federal
Reserve-member bank from affiliating
with an investment bank or other
company gengaged principallyh in
securities trading;17 and
Judicial Activism,h 24 New Eng. L. Rev.
225, Fall 1989.
15 12 U.S.C. ˜ 24, Seventh (1933) (provided that
a national bank gshall not underwrite any
issue of securities or stockh ).
16 12 U.S.C. ˜ 378(a) (1933) (git shall be
unlawful - (1) For any person, firm,
corporation, association, business trust, or
other similar organization, engaged in the
business of issuing, underwriting, selling, or
distributing, at wholesale or retail, or
through syndicate participation, stocks,
bonds, debentures, notes, or other securities,
to engage at the same time to any extent
whatever in the business of [deposit
banking].h
17 12 U.S.C. ˜ 377 (1933) (prohibited affiliations
between banks that are members of the
Federal Reserve System and organizations
gengaged principally in the issue, flotation,
underwriting, public sale, or distribution at
wholesale or retail or through syndicate
participation of stocks, bonds, debentures,
notes, or other securities.....h). Federal
Reserve member banks include all national
banks and some state-chartered banks and
are subject to regulations of the Federal
Reserve System, often referred to as the
. Section 32 prohibited individuals
from serving simultaneously with a
commercial bank and an investment
bank as a director, officer, employee,
or principal.18
One exception in Section 20 permitted
securities activities by banks in limited
circumstances, such as the trading of municipal
general obligation bonds, U.S.
government bonds, and real estate bonds. It
also permitted banks to help private companies
issue gcommercial paperh for the purpose
of obtaining short-term loans. (Commercial
paper is a debt instrument or bond
equivalent to a short-term loan; companies
issue gcommercial paperh to fund daily (i.e.,
short-term) operations, including payments
Federal Reserve or simply gthe Fed.h The
Fed, created in 1913, is the central bank of
the United States comprised of a central,
governmental agency . the Board of
Governors . in Washington, D.C., and
twelve regional Federal Reserve Banks,
located in major cities throughout the nation.
The Fed supervises thousands of its member
banks and controls the total supply of money
in the economy by establishing the rate of
interest it charges banks to borrow. It is
considered an independent central bank
because its decisions do not have to be
ratified by the President and Congress.
Federal Reserve member banks must
comply with the Fed's minimum capital
requirements. (See gThe Structure of the
Federal Reserve System,h Federal Reserve,
available at:
<http://federalreserve.gov/pubs/frseries/frser
i.htm>.)
18 12 U.S.C. ˜ 78 (1933) (provided that no
officer, director, or employee of a bank in
the Federal Reserve System may serve at the
same time as officer, director, or employee
of an association primarily engaged in the
activity described in section 20).
26 SOLD OUT
to employees and financing inventories.
Most commercial paper has a maturity of 30
days or less. Companies issue commercial
paper as an alternative to taking out a loan
from a bank.)
Glass-Steagall was a
key element of the Roosevelt
administrationfs
response to the Depression
and considered
essential both to restoring
public confidence in a
financial system that had
failed and to protecting
the nation against another
profound economic
collapse.
While the financial
industry was cowed by
the Depression, it did not
fully embrace the New
Deal, and almost immediately sought to
maneuver around Glass-Steagall. A legal
construct known as a gbank holding companyh
was not subject to the Glass-Steagall
restrictions. Under the Federal Reserve
System, bank holding companies are gpaperh
or gshellh companies whose sole purpose
is to own two or more banks. Despite
the prohibitions in Glass-Steagall, a single
company could own both commercial and
investment banking interests if those interests
were held as separate subsidiaries by a
bank holding company. Bank holding companies
became a popular way for financial
institutions and other corporations to subvert
the Glass-Steagall wall separating commercial
and investment banking. In response,
Congress enacted the Bank Holding Company
Act of 1956 (BHCA)
to prohibit bank holding
companies from acquiring
gnon-banksh or engaging in
gactivities that are not
closely related to banking.h
Depository institutions were
considered gbanksh while
investment banks (e.g. those
that trade stock on Wall
Street) were deemed gnonbanksh
under the law. As
with Glass-Steagall, Congress
expressed its intent to
separate customer deposits
in banks from risky investments
in securities. Importantly, the BHCA
also mandated the separation of banking
from insurance and non-financial commercial
activities. The BHCA also required
bank holding companies to divest all their
holdings in non-banking assets and forbade
acquisition of banks across state lines.
But the BHCA contained a loophole
sought by the financial industry. It allowed
bank holding companies to acquire nonbanks
if the Fed determined that the nonbank
activities were gclosely related to
banking.h The Fed was given wide latitude
Glass-Steagall was a key
element of the Roosevelt
administrationfs response to
the Depression and considered
essential both to restoring
public confidence in
a financial system that had
failed and to protecting the
nation against another
profound economic collapse.
SOLD OUT 27
under the Bank Holding Company Act to
approve or deny such requests. In the decades
that followed passage of the BHCA, the
Federal Reserve frequently invoked its
broad authority to approve bank holding
company acquisitions of investment banking
firms, thereby weakening the wall separating
customer deposits from riskier trading
activities.
Deference to regulators
In furtherance of the Fedfs authority under
BHCA, the Supreme Court in 1971 ruled
that courts should defer to regulatory decisions
involving bank holding company
applications to acquire non-bank entities
under the BHCA loophole. As long as a
Federal Reserve Board interpretation of the
BHCA is greasonableh and gexpressly
articulated,h judges should not intervene, the
court concluded.19 The ruling was a victory
for opponents of Glass Steagall because it
increased the power of bank-friendly regulators.
It substantially freed bank regulators to
authorize bank holding companies to conduct
new non-banking activities without
judicial interference,20 rendering a significant
blow to Glass-Steagall. As a result,
banks whose primary business was managing
customer deposits and making loans
began using their bank holding companies to
19 Investment Company Inst. v. Camp, 401 U.S.
617 (1971).
20 Jonathan Zubrow Cohen, 8 Admin. L.J. Am.
U. 335, Summer 1994.
buy securities firms. For example, Bank-
America purchased stock brokerage firm
Charles Schwab in 1984.21 The Federal
Reserve had decided that Schwabfs service
of executing buy and sell stock orders for
retail investors was gclosely related to
bankingh and thus satisfied requirements of
the BHCA.
In December 1986, the Fed reinterpreted
the phrase gengaged principally,h in
Section 20 of the BHCA, which prohibited
banks from affiliating with companies
engaged principally in securities trading.
The Fed decided that up to 5 percent of a
bankfs gross revenues could come from
investment banking without running afoul of
the ban.22
Just a few months later, in the spring of
1987, the Fed entertained proposals from
Citicorp, J.P Morgan and Bankers Trust to
loosen Glass-Steagall regulations further by
allowing banks to become involved with
commercial paper, municipal revenue bonds
and mortgage-backed securities. The Federal
Reserve approved the proposals in a 3-2
vote.23 One of the dissenters, then-Chair
Paul Volcker, was soon replaced by Alan
21 Securities Industry Association v. Federal
Reserve System, 468 U.S. 207 (1984).
22 gThe Long Demise of Glass-Steagall,h PBS
Frontline, May 8, 2003, available at:
<http://www.pbs.org/wgbh/pages/frontline/s
hows/wallstreet/weill/demise.html>.
23 gThe Long Demise of Glass-Steagall,h PBS
Frontline, May 8, 2003, available at:
<http://www.pbs.org/wgbh/pages/frontline/s
hows/wallstreet/weill/demise.html>.
28 SOLD OUT
Greenspan, a strong proponent of deregulation.
In 1989, the Fed enlarged the BHCA
loophole again, at the request of J.P. Morgan,
Chase Manhattan, Bankers Trust and
Citicorp, permitting banks to generate up to
10 percent of their revenue from investment
banking activity.
In 1993, the Fed approved an acquisition
by a bank holding company, in this case
Mellon Bank, of TBC Advisors, an administrator
and advisor of stock mutual funds. By
acquiring TBC, Mellon Bank was authorized
to provide investment advisory services to
mutual funds.
By the early 1990s, the Fed had authorized
commercial bank holding companies to
own and operate full service brokerages and
offer investment advisory services. Glass
Steagall was withering at the hands of
industry-friendly regulators whose free
market ideology conflicted with the Depression-
era reforms.
The Financial Services Modernization Act
While the Fed had been progressively
undermining Glass-Steagall through deregulatory
interpretations of existing laws, the
financial industry was simultaneously
lobbying Congress to repeal Glass-Steagall
altogether. Members of Congress introduced
major deregulation legislation in 1982,
1988, 1991, 1995 and 1998.
Big banks, securities firms and insurance
companies24 spent lavishly in support
of the legislation in the late 1990s. During
the 1997-1998 Congress, the thre
