Undue Influence - How The Wall Street Elite Puts The Financial System

UNDUE

INFLUENCE

How the Wall Street Elite Put

the Financial System at Risk

CHARLES R. GEISST

John Wiley & Sons, Inc.

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Copyright © 2005 by Charles R. Geisst. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data

Geisst, Charles R.

Undue influence : how the Wall Street elite put the fianancial system at

risk / Charles R. Geisst.

p. cm.

Includes bibliographical references.

ISBN 0-471-65663-1 (cloth)

1. Stock exchanges—United States. 2. Stock exchanges—Law and legislation—

United States. 3. Securities industry—Deregulation—United States. 4. Financial

crises—United States. I. Title.

HG4910.G449 2005

332.64′273—dc22

2004011590

Printed in the United States of America

10 987654321

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For Margaret and Meg

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CONTENTS

Introduction 1

Chapter One ∼ Distrust of Wall Street in the 1920s 11

Chapter Two ∼The Assault on Wall Street 59

Chapter Three ∼Continuing the Assault 109

Chapter Four ∼Three Decades of Slow Change 149

Chapter Five ∼The Reagan Years 189

Chapter Six ∼ Deregulation in the 1990s 239

Postscript ∼Is Deregulation Working? 287

Bibliography 291

Notes 295

Index 305

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INTRODUCTION

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2

I

n late 1999, a Republican congressman held a party in Wash￾ington to celebrate the passing of new legislation destined to

have a profound effect on Wall Street and the entire finan￾cial industry in the United States. Despite the date on the law,

the principle upon which it was based actually had been a cor￾nerstone of the Reagan revolution 15 years earlier. The party

seemed a bit late.

The centerpiece of the affair was a large cake bearing the

message “Glass-Steagall, RIP, 1933–1999.” Sipping champagne

with one of the new law’s sponsors, Jim Leach, Republican from

Iowa, were Alan Greenspan, chairman of the Federal Reserve

Board, and various Treasury officials and congressmen who had

been instrumental in getting the new legislation passed, finally

repealing the most talked about law of the twentieth century.

After years of failed efforts and false starts, the Banking Act of

1933, as the Glass-Steagall Act was officially known, had been

erased from the books and replaced by the Financial Services

Modernization Act of 1999, the Gramm-Leach-Bliley Act. The

champagne flowed and congratulations were offered by all. Never

before had a law had so many detractors yet been so hard to effec￾cintro_geisst.qxd 9/17/04 10:34 AM Page 2

tively replace. The battle against Glass-Steagall began in the 1930s,

revived in the 1960s, and became a major plank in the Republican

platforms of the1980s. Ironically, it was not until the end of the

century that it finally was repealed.

Since the dark days of the Depression, the Glass-Steagall Act

had come to symbolize the fundamental cornerstone of what

had become known as the social “safety net” erected by Congress to

protect the American consumer. The law provided deposit insur￾ance (left intact in 1999), allowed the Federal Reserve power to

control bank interest rates (this power was repealed in 1980 and

1982), and most importantly, separated commercial and invest￾ment banking. This last part of the act was the most contentious,

at least to the banks themselves. Any institution that accepted

deposits from customers was not permitted to underwrite cor￾porate stocks or bonds. The securities markets were consid￾ered too risky to use customer deposits for underwriting. The

conditions that caused the Crash of 1929 were not going to be

repeated again.

Over the course of the next 70 years, the Wall Street securi￾ties houses came to love Glass-Steagall because it created a virtu￾ally oligopoly among the major investment banks. They could

not be owned by, nor could they own, commercial banks so the

two sides of the banking business were indeed separated. The

most lucrative side of what was known before 1933 as banking

in general—investment banking—became the sole province of

Wall Street, paying fat salaries and bonuses and fanning the

occasional periods of speculative excess. The less lucrative, but

steadier side remained commercial banking: taking deposits,

making loans, and clearing checks. This was not exciting busi￾ness and for years it had looked enviously at Wall Street. In a

good year, all of those fat fees earned by investment bankers

could easily exceed the less spectacular fees earned by banks

doing their ordinary, run-of-the-mill business. If only the two

sides could be rejoined.

The banking law did not survive the passing of the twentieth

century, but other parts of the safety net did. The Securities Act

INTRODUCTION 3

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of 1933 and the Securities Exchange Act of 1934 both remain as

survivors of the 1930s because they aimed at reforming the prac￾tices of the securities industry rather than dividing it in the name

of consumer protection. But the 1933 act had some gaping holes

in it, acknowledged even when it was passed, that managed to

remain plugged until the 1990s. Then, a wave of accounting

fraud hit some of the “New Era” companies most conspicuous

during the 1990s’ bull market, and financial collapse followed.

The unfortunate part of the financial meltdown was that it was

caused in no small part by the deregulation that preceded it. The

plaster had cracked, but it was the banks that were fueling

the speculative fires of the mid- to late 1990s. The Gramm-Leach￾Bliley Act officially was passed in 1999, but its effects had been felt

for several years before since the Federal Reserve had allowed all

of the deregulation mentioned in it to already occur on a de

facto basis for almost 10 years. The market meltdown and scan￾dals that followed were the most serious since 1929.

A larger question remained unanswered in the post–bear

market debris left by a deregulated banking system: How was it

possible that another series of scandals so similar to the one 70

years before could occur after decades of regulatory and legal

developments? Part of the answer was obvious. Investors were still

as gullible as ever, hoping to make a quick killing in the market.

It was as if everyone had heard the old stories about the vast

amount of wealth created during the nineteenth century and

was only waiting for a New Era to begin. Many investors knew

about the great American fortunes made in the Gilded Age and

the Jazz Age. Now, new technologies were being used that could

usher in a similar era of unforeseen riches almost a hundred

years later. The frenzy that followed was natural. Cautionary voices

were still heard in the marketplace, as they had been in the late

1920s, but not very loudly. The best that the Federal Reserve

chairman could do was to call the period one of “irrational exu￾berance.” The major policy tool at his disposal for calming the

markets never was used. In 1930, the Fed was loudly blamed for

not stopping the market roller coaster. In 2001, the worst con￾4 UNDUE INFLUENCE

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demnation it faced was that it had not seen the problem coming

quickly enough.

The market collapse of 2001 was caused by a successful cam￾paign by Wall Street and bankers in collaboration with like￾minded individuals in the Clinton administration and Congress,

many of whom with strong ties to the Street, to erase the Depres￾sion era laws constraining the markets. They inherited the senti￾ment from the generation of Republicans preceding them who

wanted to abolish the banking laws in the name of free market

ideology. When Congress passed the Gramm-Leach-Bliley Act in

1999, it represented one of the most successful campaigns by an

odd combination of Republicans, New Democrats, and others

ostensibly interested in free markets to put their imprint on the

financial markets. The move also helped revise American his￾tory, adding to the ideological fervor of free marketers, proving

that the same capitalist system that defeated Soviet Communism

could certainly get rid of some cumbersome Roosevelt era laws. Un￾fortunately, the result was the market collapse in the new century.

Activists opposed the deregulatory bill, fearing that large

banks would ignore minorities and local communities in favor of

corporate customers. In addition to Alan Greenspan, the Clinton

administration broadly supported it, including Treasury secre￾tary Robert Rubin, along with legislators from the other side of

the aisle, including Senator Phil Gramm of Texas. It also had

wide support from other parts of the financial services industry,

especially among insurance companies and smaller financial

companies, which assumed that it would allow them to be bought

by larger banks. Once the bill was introduced, the juggernaut

began for its quick passing.

While the details were being negotiated, a portent of things

to come occurred. A Connecticut-based hedge fund—Long-Term

Capital Management—began to totter in the summer of 1998.

The fund, which used borrowed money to accumulate massive

positions in bonds and stocks, was teetering on the verge of fail￾ure when the Fed stepped in to help it shore up its positions.

The fund also claimed to have an all-star cast of academic and

INTRODUCTION 5

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professional stars on its roster who knew how to mitigate risk

while searching for arbitrage profits. They were the embodiment

of modern risk management techniques, the kinds that made the

old separation of commercial and investment banking “obso￾lete.” The banks had loaned so much money to the fund that a

default would have placed all of them under severe pressure. The

action was the first by the Fed to help bail out a nonbank, and it

attracted wide attention. The Fed’s quick actions helped sidestep

a nagging question.

In many ways, Long-Term Capital Management was a surro￾gate for the New Era. It was neither a securities house nor a bank,

but because of its massive positions it qualified for Fed attention.

Why it actually needed the help was asked frequently. In the new

environment, risk management tools were considered adequate

to contain the risk that these large institutions acquired. What

happened at the hedge fund? Where were the risk managers

when traders began accumulating positions so large that a mar￾ket shock, like the one that occurred in the summer of 1998

prompted by the Russian default, could bring the fund to the

brink of insolvency? After the fund was bailed out, the question

was no longer asked.

Even in the face of the hedge fund’s problems, pressure con￾tinued to build for Gramm-Leach-Bliley to pass quickly. There

was much at stake. Assuming Glass-Steagall would eventually be

replaced, the Fed allowed Travelers Insurance and Citibank to

merge, creating Citigroup. The new giant financial services com￾pany was on borrowed time since the old law had to be repealed.

Regulators assumed that Citigroup was fait accompli and that

the repeal was imminent. When it became clear that the bill was

about to pass, questions arose about the protections that the

Glass-Steagall Act provided.

If banks and other financial services firms now were to be

under the same roof, then customers’ deposits again were at risk

because a firm or individual trader could make an error in judg￾ment, putting the company’s assets at risk. It had happened

many times before. In the 1990s alone, financial fiascos erupted

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in Orange County, California, and many smaller communities

around the country over the use of derivatives packaged with

exotic securities. Baring Brothers in London was destroyed by a

single rogue trader accompanied by some very bad management.

Often, the instruments that put these institutions at risk were the

same ones that were used to prevent risk in the first place. But

Wall Street and its regulators always provided the same stock

answer to questions about the basic soundness of financial insti￾tutions. Modern risk management techniques made failures at

large institutions less likely than in the past. The examples just

cited were nothing more than statistical aberrations. Risk man￾agement reigned supreme in the New Era.

The marketplace would not be dissuaded from “moderniz￾ing” despite the spotty historical record. The Financial Services

Modernization Act passed in late 1999, sweeping away the restric￾tive parts of the 1933 law. The Travelers/Citicorp merger was

officially recognized as the biggest financial merger of the cen￾tury. Other significant mergers occurred between financial insti￾tutions in its wake, but it was the Travelers/Citicorp deal that

marked the high water mark of the deregulatory movement in

the United States.

The dismantling of Glass-Steagall, gradual though it was,

marked a low point for consumer advocates and traditionalists

in banking circles who believed that a little regulation is a good

thing. The New Deal penchant for regulating institutions finally

gave way to regulation in the form of dos and don’ts. Institutions

were now free to engage in activities that in the past had been

proscribed because of chicanery, fraud, and amalgamation of

financial power. The safeguards remaining were mainly rules

proscribing certain kinds of financial behavior. Structural restric￾tions were swept away. The brave new world merging Wall Street

and the banks finally had been attained after decades of failed

attempts. And the payoffs for the prophets of the big deal and

facilitators of the deregulation trend were substantial.

In the wake of deregulation, much debris has already begun

to wash ashore. Many of the large banks suffered serious losses

INTRODUCTION 7

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after the Enron and WorldCom affairs because they had loaned

the companies money and provided investment banking services,

a doubling of exposure unthinkable in the old era. Securities ana￾lysts were literally caught with their trousers down around their

proverbial ankles when their glowing research was shown to be

nothing more than sales hyperbole on behalf of less than credit￾worthy companies that their banks wanted to court. But most

importantly, the old firewalls that existed between the different

types of banking have fallen in favor of greater efficiency and

profitability.

Bankers and regulators embraced lack of regulation as an

ideological principle rather than a practical one. They have gath￾ered much support from the free market ideologues, who assid￾uously have been working for years to dismantle the last vestiges

of the New Deal. The breaking down of the barriers also has given

those who favor privatizing Social Security much heart and indi￾rect support. Unfortunately for them, the market fiasco beginning

in 2001 has helped the issue recede for the time being. But it is

clear that deregulation of the banking industry has been by far

the most successful part of the overall drive to change the history

of the past 75 years.

The history of the deregulation movement begins in the

grassroots movements of the pre-World War I years when Pro￾gressives were able to make outlandish claims about business

and government. Their simple conclusion at the time was that

business and finance needed regulation, not the laissez faire atti￾tude that characterized Wall Street and the banks until that time.

The reason for their success was simple. Although their claims

about the behavior of big business during the Jazz Age were

often outlandish, they were also often on the mark. After the

Crash of 1929, they appeared to have been proven correct and

the ball began rolling for serious reform.

Since the first years of the twentieth century, Wall Street and

the East Coast establishment had been at loggerheads with the

rest of the country. Wall Street was the home of high finance—

“finance capitalism” as it was then known—and the legacy of the

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