Too big to jail

Sept. 15 is the 10th anniversary of Lehman Brothers declaring bankruptcy. It was a day after the global money markets seized up, turning a worldwide daisy chain of financial institutions into a ticking bomb. In the wake of the bankruptcy, it seemed likely that the United States financial system as a whole would cease to operate, a financial blackout that would render paychecks, credit cards, and ATMs useless.

Lenders, including large companies, financial institutions, and money market funds, suddenly hoarded cash in the face of growing losses and threats to their own sources of credit. They no longer knew which borrower was a good risk, so they treated all of them as bad risks.

The world experienced the worst financial crisis since the Great Depression of the 1930s and the economy plunged into deep recession. The Federal Reserve and Treasury Department misjudged the scale of the fallout from Lehman’s bankruptcy.

The failure of Lehman Brothers started a chain reaction in financial markets, as it was the first true test of the “too big to fail” hypothesis. Whereas Bear Stearns was sold to JP Morgan in March 2008, Lehman failed to find a buyer in time. The federal government refused to provide financial assistance and the company was forced into bankruptcy. Lehman was the fourth largest investment bank, and its failure sent huge waves across global financial markets. Market volatility peaked, and for some time it seemed that no bank was safe.

Merrill Lynch, the third-largest investment bank, rushed to sell itself to Bank of America that same weekend. Even Goldman Sachs and Morgan Stanley felt the shock and quickly tried to raise capital. The Federal Reserve allowed those two banks to change their charters and become bank holding companies which facilitated their funding via the discount window at the Federal Reserve.

On September 16, the federal government rushed forward with an initial $85 billion in taxpayer cash to bail out AIG, the nation’s largest insurance company. The very next day the nation’s largest money market fund was forced to “break the buck”, that is, report a share value of less than a dollar. The firm’s stake in debt securities issued by Lehman Brothers, with a face value of $785, million was essentially worthless. As a result, the share value fell to 97 cents. (Gasp.)

In the biggest bank failure in United States history, federal regulators seized the assets of Washington Mutual, the sixth largest U.S. bank, on September 27. JP Morgan acquired Washington Mutual’s bank deposits, assets, and their troubled mortgage portfolio from the Federal Deposit Insurance Corporation for $1.9 billion, making it the largest U.S. depository institution.

The crash brought together many forces: stagnant wages, widening inequality, anger about immigration and, above all, a deep distrust of elites and government. The road to recovery has been long for ordinary workers since those white-knuckle days of September 2008, resulting in a wave of nationalism, protectionism, and populism.

The ordinary American scraped by in the aftermath of the crisis, while Wall Street bankers soon returned to wealth and profitability, continuing their well-upholstered lives. The bankers were able to avoid accountability for the financial institutions they ran crashing the economy by trading trillions in fraudulent securities tied to risky or even certain-to-fail mortgages. No senior executive ever had to plea to criminal charges.

Policymakers and prosecutors took the view that prosecuting senior bank executives would cause too much collateral damage to employees, customers, other banks, and the economy. In 2013, then-Attorney General Eric Holder told the Senate Judiciary Committee that he was “concerned that the size of some of these (financial institutions) becomes so large that it… become[s] difficult… to prosecute them when we are hit with indications that… if you do bring a criminal charge, it will have a negative impact on the national economy, perhaps even the world economy.”

In short, they were too big to jail.

Originally Published: September 8, 2018

For big banks, crime pays

Last month federal authorities fined three European banks and arrested eight traders they say tried to manipulate the market in gold, silver, and certain financial products. This allegedly included a practice called “spoofing,” or placing thousands of bids to buy or sell a stock for the sole purpose of moving the stock. The orders are then quickly cancelled.

As usual, the case against Deutsche Bank, HSBA, and UBS was settled for a total of $46.6 million in fines without any of them admitting guilt. The money comes from shareholders, not individual bankers.

While the full extent of the wrongdoing is unknown, these and others of the world’s largest banks have broken the law over and over again, settling with the government each time. Fines don’t deter big banks, which are still out of control almost nine years after the financial crash.

The shameful legacy of the 2008 financial crisis continues. If a bank is “too big to fail,” the worst thing that will befall its senior executives is a comparatively minor fine that will be paid with shareholders’ money.

The 2008 financial crisis devastated the global economy and cost American workers their jobs and homes. After the financial meltdown and subsequent Great Recession, the government did not charge any top bankers or pursue corporate prosecutions for the widespread malfeasance and mortgage fraud that fueled the bubble and led to the crisis.

Some believe bankers control the government. Others believe the banks did nothing wrong. Still others believe there was insufficient evidence to prove beyond a reasonable doubt that any specific individual committed a crime.

Then there are those who believe that prosecuting big banks will result in “collateral consequences” to financial markets and the economy. They argue that too-big-to-fail banks had to be rescued by the government to stave off total economic collapse and this should be considered in deciding whether to file charges. The latter view has prevailed, with the government settling for cash rather than seeking prison sentences. Softball tactics.

In addition to being paid for by shareholders, the settlements lack transparency. They are sealed. The government does not spell out what the company did wrong or how the amount of the fine was determined. How can the public ever know how tough the government really was?

This was not always the case. After the savings and loan scandals of the 1980s, when hundreds of banks failed due to reckless real estate loans, the Department of Justice prosecuted and convicted over a thousand bankers for their transgressions.

But if you are a small family owned bank in Chinatown that’s a different story.

Abacus Federal Saving Bank a small Chinatown-based bank wedged between two noodle shops and catering to poor immigrants in New York, New Jersey and Connecticut – along with 19 of its former employees were charged by the Manhattan District Attorney in a massive mortgage fraud scheme. It was the only bank indicted for mortgage fraud related to the 2008 financial crisis. The 240-count indictment handed down in 2012 claimed that the bankers allegedly falsified loan applications to secure hundreds of millions of dollars in loans for unqualified borrowers through the Federal National Mortgage Association, known as Fannie Mae.

At the time, Abacus was the nation’s 2,651st largest bank with about $300 million in assets. During the trial, it was learned that the bank’s default rate was 0.3 percent during the period covered by the indictment, from May 2005 to February 2010, far below the national average.

After a four-month trial in 2015 that cost the bank more than $10 million, a jury found Abacus and its senior officers not guilty of grand larceny, conspiracy, falsifying business records, mortgage fraud and other charges.

You don’t have to be Sherlock Homes to conclude big banks get away with their crimes for a pittance. No one goes to jail and no one ever gets prosecuted. The fines are just a cost of doing business.

Originally Published: Feb 17, 2018

AIG’s $180 billion bailout still stings


Eight years ago this month the global financial system seemed on the verge of collapse, and its rescue led to the greatest depredation on the public purse in American history. There were many crucial events during the month of the long knives, but no corporation was more central to the mess than AIG.

On Sept. 7, 2008, the federal government took control of Freddie Mac and Fannie Mae and injected $100 billion to ensure the troubled mortgage lenders could pay their debts. On September 15, Lehman Brothers announced it would file for Chapter 11 bankruptcy and Bank of America acquired Merrill Lynch for $50 billion.

Then, in the biggest bank failure in U.S. history, the Federal Deposit Insurance Corporation (FDIC) seized the assets of Washington Mutual, the sixth largest U.S. bank, and JPMorgan acquired the bank’s deposits, assets, and troubled mortgage portfolio from the FDIC. On Sept. 21, the Federal Reserve approved Morgan Stanley and Goldman Sachs transition to commercial banks.

While many blamed the investment banks for high leverage, bad risk management and overreliance on faulty internal models, not to be overlooked is the role AIG, the nation’s largest insurance company, played in the crisis. AIG was once one of the largest and most profitable companies in corporate America, with a gold-plated “AAA” credit rating.

But on September 16, the federal government provided an initial $85 billion in taxpayer cash to bail out the firm. In return, AIG became a ward of Uncle Sam, which acquired 79.9 percent ownership of the company. This was only the first of four bailouts for AIG, totaling an estimated $180 billion.

AIG was in worse shape than Lehman Brothers had been. Yet unlike Lehman, the feds chose to save it. The explanation: AIG was regarded as too big, too global, and too interconnected to fail.

After the 1999 repeal of Glass-Steagall, the law that had regulated financial markets for over six decades, President Clinton signed the Commodity Futures Modernization Act (CFMA) in 2000, which effectively removed derivatives such as Credit Default Swaps (CDS) from federal and state regulation, proving once again that regulators exist to protect the interests of the regulated.

CDS are essentially a bet on whether a company will default on its bonds and loans. AIG was a huge player in the CDS business, which allowed the firm to insure asset-based securities containing sub-prime mortgages against default.

Although swaps behave similarly to insurance policies, they were not covered by the same regulations as insurance after passage of the CFMA. When an insurance company sells a policy, it is required to set aside a reserve in case of a loss on the insured object. But since credit default swaps were not classified as insurance contracts, there was no such requirement.

AIG’s CDS business caused it serious financial difficulties in 2007, when the housing bubble burst, home values dropped and holders of sub-prime mortgages defaulted on their loans. By selling these contracts without reserves, the firm left itself unprotected if the assets insured by the swaps defaulted. AIG had insured bonds whose repayments were dependent on sub-prime mortgage payments. Yet it never bothered to put money aside to pay claims, leaving the company without sufficient resources to make good on the insurance.

Taxpayers stepped in to pay in full the dozens of banks whose financial products were insured with AIG swaps. Unlike in corporate bankruptcies, none of these counterparties were forced to take a haircut, requiring the government to pump more public money into the banks.

To add insult to injury, two weeks after the government provided its fourth bailout to AIG in 2009, it was revealed that the firm was paying $165 million in bonuses to retain key employees to unwind the toxic financial waste. Most people understand that if you go to government for a handout, executives should forgo bonuses. Then again, so much of what happened eight years ago this month defied common sense.

Originally Published: Sep 16, 2016.

Remembering a day that was too big to forget

This month marks the anniversary of the collapse of Bear Stearns, once Wall Street’s fifth-largest investment bank. The demise of the 85-year old institution signaled the real start of the 2008-2009 financial crisis. Eight years later, we can only hope our leaders learned something from the experience.

The collapse and Bear’s subsequent bailout by the Federal Reserve, with the support of the Treasury Department and JPMorgan Chase sent shockwaves throughout the financial system. Bear’s incredibly rapid demise raised serious questions about the banking industry’s use of leverage, inadequate oversight of commercial and investment banks, and the role of the Fed and other regulators in preventing the failure of major financial institutions.

Late on Sunday afternoon, March 16, 2008, Bear’s board of directors accepted JPMorgan Chase’s offer to purchase the company. Less than 18 months after its stock was trading at an all-time high of $172.61 a share, Bear Stearns had little choice but to accept the humiliating offer of $2 a share.

JPMorgan Chase later raised the bid to $10 per share and the Fed provided $30 billion in collateral guarantees to facilitate the deal. The Fed considered Bear too large and too interconnected to fail and saw no choice but to arrange a bailout to prevent a global market crisis. It was hoped that the Bear rescue would nip the problem in the bud and avoid the damage to the larger financial world that many policymakers thought would result from the failure of a major investment bank.

The precise nature of the transaction seemed unclear, but the Fed appeared to be accepting responsibility for the toxic, illiquid assets on Bear’s balance sheet if their eventual liquidation resulted in a loss. In this sense, it appeared that the Fed became the residual owner of these securities and put the federal taxpayer on the hook for Bear’s reckless risk taking activities. Some believe that this action exceeded the Fed’s power.

The first sign of trouble at Bear was the July 2007 collapse of two of its hedge funds. The funds had invested heavily in collateralized debt obligations backed by subprime mortgages, and their failure alerted the rest of the financial system to this contagion.

The hedge funds’ collapse also raised concerns about the firm’s own exposure to mortgage-related securities. It damaged the firm’s reputation, weakened its finances and served as the precursor to Bear’s ultimate collapse. Within a year “the plumbing had stopped working” and credit ceased to flow through the financial system.

Hopes that a global financial crisis could be averted proved misplaced just six months later when Lehman Brothers, another bank that was heavily involved in the mortgage business and was even larger than Bear filed for Chapter 11 bankruptcy on September 15, 2008. The public backlash against the Bear bailout made rescuing the 158 year-old Lehman Brothers politically untenable, especially just weeks before a hotly contested presidential election.

The 2008-2009 financial crisis proved to be the most expensive in history. On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd­ Frank), one of the most sweeping financial reforms in U.S. history.

The law’s stated aim is to “promote the financial stability of the United States by improving accountability and transparency in the financial system, to end ‘too big to fail,’ to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes.” Essentially, Congress’s intent was to reduce system-wide risk and to prevent another financial collapse.

Let’s hope policy makers actually learned enough about how the economy and the financial system fit together from the 2008-2009 financial crisis to avoid future learning experiences. They would be well advised to recall the words of that prolific author, anonymous, who said, “The past is prologue: but which past?”

originally published: March 5, 2016

Not ‘too big to fail,’ too interconnected to fail

At about 12:30 a.m. on the morning of Monday, Sept. 15,2008, a press release went out from the 158- year-old investment bank Lehman Brothers announcing it was seeking bankruptcy protection. Lehman’s downfall would become the watershed event of the financial crises.

While this event may not be seared into American memories like the Sept. 11 terrorist attacks, the collapse of Lehman triggered the worst financial tsunami since the Great Depression and was a seismic shock to global financial markets.

It was the largest Chapter 11 bankruptcy in American history to that point, and triggered the longest and deepest recession in generations. Within 21 months, $17 trillion in household wealth evaporated; the unemployment rate doubled to 10.1 percent in October 2009; and the nation’s credit system froze up, costing millions of Americans their jobs, homes and savings.

The weakest recovery since World War II drags on. Despite unprecedented monetary policy in which trillions spent on quantitative easing and near-zero interest rates benefited those who wear Zegna and Ferragamo, it has not helped the average working American.

Main Street has taken a beating. Wages have been rising at the slowest pace since the 1980s, while the rising gap between workers’ productivity and their wages is diverted to stockholders and management.

The government underestimated the repercussions of letting Lehman fail by failing to anticipate the systemic risks posed by Lehman’s bankruptcy. Both Lehman’s size and its interconnectedness with companies worldwide effectively created a credit event that far surpassed the magnitude of any that had come before.

Financial firms were not “too big to fail,” they were too interconnected to fail. The companies were reliant on one another in a variety of ways that were essential to the smooth running of the financial system. The feds failed to grasp the impact of a mortgage written in California that had been sliced and diced and sold several times and ended up in the portfolio of a Norwegian pension fund.

Six months before the Lehman crisis, the feds kicked in almost $30 billion to facilitate the shotgun marriage of Bear Steams to JP Morgan. But this time they refused to backstop losses from Lehman’s toxic mortgage holdings. Why did the government step in to bail out Bear but fail to rescue Lehman, a firm twice Bear’s size?

In part, Lehman Brothers was allowed to fail because of Bear Steams. The political fallout from Bear’s bailout worked against Lehman. Public backlash against taxpayers potentially assuming Bear’s losses made rescuing Lehman Brothers politically untenable. The feds believed they could not enact a second bailout just weeks before a presidential election.

They also thought a bailout might lead other firms to expect a similar treatment. The feds were reduced to jawboning Bank of America, HSBC, Nomura Securities, and Barclay’s Bank to “rescue Lehman on their own”. This proved fruitless without government assistance.

So the second domino would fall; it would not be the last. Only days later, all hell broke loose and the feds had another change of heart; they opened their checkbook and bailed out insurance giant AIG, which was on the verge of collapse. Since there were no “white knights” with sufficiently deep pockets to buy AIG, they had only one option: To effectively “nationalize” the company. They provided an $80 billion credit line from the Federal Reserve, plus additional loans and other direct investments that eventually totaled more than $170 billion, in exchange for an 80 percent equity stake in its ownership.

So the die was cast. Henceforth, the feds would be the business community’s sugar daddy; passing out allowance money by the billions to unruly children such as General Motors and Chrysler, while trying to keep them from squandering too much of it on “tooth-rotting candy” in the form of huge bonuses and lavish perks for top management.

To paraphrase Ralph Waldo Emerson: “A foolish inconsistency is the hobgoblin of little minds”.

Originally Published: September 5, 2015

A glossary to the Great Recession

Five years ago this month, a financial meltdown didn’t merely plunge America into the Great Recession, it drove the country into the worst economic crisis since the 1930s. It’s not hyperbole to call the 2008 meltdown one of the most critical events in American history.

This was a cataclysm far worse than any natural disaster in the nation’s experience and it has given rise to its own terminology.

Financial Meltdown: A biblical-style plague that drained nearly 60 percent of the stock market’s value and killed off other financial and credit markets in the process. Banks and other businesses either vanished into bankruptcy as the nation’s credit system froze up and forced the federal government to spend $2.8 trillion and commit another $8.2 trillion in taxpayer funds to bail out major corporations like General Motors, Chrysler, Citigroup, Bank of America, AIG, and a host of other “too-big-to-fail” private-sector institutions even as those taxpayers were themselves crippled by some $11 trillion of wealth and eight million jobs being wiped out.

Economic Crisis: What we seem to be stuck in right now. Middle America struggles with rising food and gas prices, finding or keeping a job and simply keeping their heads above water. The rich get richer and everyone else gets poorer. It is marked by an economy that can’t seem to grow its way out of a paper bag. Instead of early retirement, countless Americans will have to keep working until they drop because half the value of their 401(k) vanished into thin air. Paying for their children’s college education is entirely out of reach.

Lascivines: The CEOs of these firms were the modem equivalent of saloonkeepers in classic Westerns who paid the usual “gaudy ladies” to hover at the bar and sweet talk us into drinking overpriced, watered-down whiskey while their painted eyes promised that we can “take them upstairs” later.

Rocket Scientists: Bright young nerds with Ph.D.s in math or physics from major universities who found that earning a decent living in the academic world was tougher than earning a decent living by becoming the intellectual equivalent of Broadway actors. Their technical backgrounds let them quickly master the intricacies of”Quantitative Finance Theory” and engineer all kinds of wild derivative securities that are too complicated for most people to understand, but very profitable for their employers.

Master of the Universe (actually the reincarnation of 1980s terminology): An infantile term of “respect” for anyone in the financial industry who’s aggressive enough to generate big dollars for his firm (by hook or crook).

Is it any wonder that increasing numbers of outraged Americans are screaming that there ought to be laws against allowing just anybody to hold senior positions in industries so important to the public welfare? Shouldn’t they be required to possess licenses testifying to their qualifications, like physicians and lawyers? Accountants are prohibited from expressing formal opinions about the “adequacy” of corporate financial statements until they’ve passed the Certified Public Accountants exam and worked in their field for a number of years. Why not have the same kind of rigorous licensing requirements for top management jobs in critical industries, including administering competency tests to all graduates of MBA programs.

After all, the senior managers at Lehman Brothers, Merrill Lynch, Bear Steams, AIG and so many other financial-services firms were totally clueless to the dangers of undue risk, excessive leverage and abusing lax regulations, all while being more outrageously overpaid than top managers in any of the world’s other major industries.

Americans can’t forget the financial meltdown of 2008 because they are still dealing with its effects. Like any victims, two things that would help them process the trauma would be for those responsible for it to finally be brought to justice and for safeguards to be put in place to prevent a reoccurrence.

originally published: September 14, 2013

JPMorgan Chase shows how little we have learned

Just when you thought America’s megabanks were safe and sound, JPMorgan Chase disclosed that it had lost at least $2 billion in just six weeks. The loss was suffered on high-risk investments in a portfolio of complex financial instruments known as derivatives. Ironically , it was incurred by a trading group within the bank that was supposed to manage the risks the bank takes with its own money.

So goes life in the fast lane. We have been led to believe that speculating in credit derivatives was a thing of the past. Not to worry; it’s all under control.

This shocking loss at one of the better-managed financial institutions has revived the debate about whether megabanks can be trusted to handle risk in the era of “too big to fail.” It shows that megabanks like JPMorgan Chase with so many moving parts, too much leverage and too much risk taking may have become too big to be effectively managed. Put differently, megabanks may be too big to succeed.

The loss also shows the market for the complex financial instruments known as derivatives remains opaque. So much for the financial industry’s argument about the dangers of too much regulation.

This loss is a major embarrassment to a firm that came through the 2008 financial crisis in much better financial shape than its peers by steering clear of risky investments that hurt many other megabanks.

While the loss did not cause anything close to the panic that followed the September 2008 failure of Lehman Brothers, it did shake the financial industry’s confidence. Stock in the bank, which is the  nation’s largest, lost 8 percent of its value in minutes. Fitch Rating Agency downgraded the bank’s credit rating by one notch. Standard & Poor’s revised its outlook on the firm to “negative,” suggesting a credit rating downgrade could follow. Other American financial institutions have also suffered losses.

You all remember the fall of 2008, when the roof fell in because too many financial institutions discovered that their investment portfolios were stuffed full of monopoly money derivative securities that were impossible to value for balance-sheet purposes. The derivative boom spread to the nation’s housing markets, where the subsequent meltdown brought Wall Street’s troubles to Main Street – with a vengeance.

These derivative securities were designed by the bright young Ph.D.’s in math or physics who found that it was a lot harder to earn a decent living in academia than earning a fabulous living on Wall Street. Their technical backgrounds let them quickly master the intricacies of quantitative finance theory and engineer all kinds of wild new derivative securities that were too complicated for most people to understand but very profitable for their employers.

So are derivatives tools of the devil? Or as Warren Buffett says, “weapons of mass destruction”? Not inherently.

Rather, they are extremely useful tools for transferring risk between willing buyers and sellers at mutually agreeable prices. And since the world is full of people with very different risk tolerances, derivatives can serve a highly valuable economic purpose.

The catch is that buyers and sellers of derivatives must be more than merely willing. They must also understand what the risk is really all about and how transferring risk doesn’t make it go away, no matter how many times it’s transferred, or to whom.

It is astonishing how few so-called financial executives and regulators understand what risk is really all about. They get carried away by the excitement of trading, let themselves believe they are participating in a no-lose game of boosting profits with no downside.

Until they wake up one morning to find themselves drowning in huge losses, while the rest us are left holding the bag amid a shattered economy. Let’s hope that isn’t what happens again this time.

We need to implement the Volcker Rule immediately to eliminate proprietary trading at commercial banks, and federally backed banks should be forbidden to engage risky trading practices. Of course, it may not be a bad idea to consider making the financial system less dependent on regulators and make banks small enough to fail.

originally published: May 15, 2012