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250 pages
ISBN: 1594032610
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“The verdict of the jury in the Insull case came as a surprise to most people. This may be because they had not heard the testimony at the trial, as the jury had…. [Insull] had built up an enormous structure of interlocking securities, which fell with a great crash and ruined thousands of investors. The question was, however, whether in the process anything criminal had been done, and the jury decided that there had not been.”
—editorial, New York Times, November 26, 1934
“This was about the real costs for normal people who suffered because of the machinations in the executive suites at Enron…. Many long-standing employees … lost huge chunks of their retirement funds and still face an uncertain old age. We hope the jury’s verdict deters other corporate kingpins from breaking the rules.”
—editorial, New York Times, May 26, 2006
AFTER THE FALL
Introduction
On June 14, 1935, the disgraced titan Samuel Insull left court a free but broken man. The former utility executive had won acquittal at three separate fraud trials stemming from the collapse of his Chicago-based electricity giant in 1932, a collapse precipitated by complex, unregulated financial engineering. “He is without money and faces life anew, perhaps to take a job,” the New York Times observed.[i] He would die three years later in near-poverty in a foreign city.
Insull’s acquittals, seen in one light, were bitter failures for the government and the American public. President Franklin Roosevelt himself had identified Insull as a public face of the Great Depression even before taking office, calling him a “reckless promoter” whose “hand is against every man’s”[ii] in September 1932. Yet the government had compiled and presented thousands of pages of evidence and hours of witness testimony to no avail.
Seventy-one years later, in another case of a fallen energy company, Enron, the government would fare better. On May 25, 2006, two of the firm’s former executives also left court broken men—not free to skulk away in ignominy, as Insull had been, but convicted of twenty-five counts of fraud and other crimes. Former Enron CEO Kenneth Lay, the marquee defendant, died weeks later. Jeffrey Skilling, also a former CEO, was soon sentenced to more than twenty-four years. It seemed that the government had succeeded in dispatching the two men who represented another era of corporate misdeeds and, just as important, protected the public by preventing similar wrongdoing in the future. “The jury has spoken and they have sent an unmistakable message to boardrooms across the country that … no matter how rich and powerful you are, you have to play by the rules,” a prosecutor said.[iii]
Yet the two verdicts, separated by nearly three-quarters of a century, paint a misleading picture of government effectiveness in protecting the broader economy from the financial system. The government’s success in prosecuting the Enron defendants obscured a larger threat to the economy that the criminal-justice system could not address, while the government’s failure in the Insull case was insignificant compared with its achievements in crafting a regulatory framework for the markets that would serve the nation enormously well.
Yes, prosecutors had lost their case against Insull. But by the time the juries had served up their acquittals, Washington had already correctly diagnosed, and the public understood, the larger problem surrounding the company’s collapse—not a sudden outbreak of greed and immorality, but the systemic failure of financial capitalism to regulate itself. The judge in the third Insull trial, John C. Knox, put it best: “We must consider the peculiar situation and conditions of 1931–32 when these transactions took place. Many persons who thought they were exercising good judgment then later found they were wrong.”[iv]
The searing experience of the late 1920s and the Depression that followed showed that the world of finance, if left completely unrestrained, threatens the free market itself. In the twenties, bankers, corporate executives like Insull, and investors expected only more good times—and acted accordingly. They borrowed against every last dollar of expected future profit, and then some, leaving themselves no leeway if those future profits faltered even slightly. In wringing ever more from tomorrow’s profits for today, they trusted themselves to design financial structures many magnitudes more complex than straightforward stocks and bonds.
Most potently, banks and investment firms lent freely for the purpose of making bets on stock securities. The lending allowed the fevers of short-term speculation to affect credit creation—that is, the long-term business of borrowing and lending. Borrowing and lending are vital to any healthy economy because some companies always need to borrow, at least modestly, in order to grow. Infusing credit creation with excessive speculation, then, made the entire economy vulnerable to a financial crisis. But bankers, largely free of regulations, didn’t understand the risks that they were taking. “Young men thought they could do anything,” Albert Gordon, an executive who had helped rescue one Wall Street firm, Kidder Peabody, from the depths of the Great Depression, later said.[v]
When something finally went wrong, starting in 1929, it wasn’t only the rarefied financial world that suffered. The bankers had used the public’s savings—the hard-earned dollars of regular Americans—as fuel for their financial experiments. People stopped trusting their neighborhood banks, which fell victim to the crisis. Without customer deposits to lend out, surviving banks couldn’t make new loans or recoup their losses on the old ones. The infrastructure of money and credit disintegrated.
It took a decade for the economy to recover from the shock that American finance had administered to it. During the 1930s, FDR and his policy wonks inevitably committed policy errors that contributed to the delay. But they also designed regulations to protect financiers from themselves and, more important, to protect the economy from financiers’ future mistakes. By 1935, when Insull walked free, the Roosevelt administration had spent two and a half years building the consistent rules that free financial markets need to function effectively and support a free economy.
Because failing banks had helped cripple the economy, policymakers created a mechanism for bad banks to fail in an orderly fashion without imperiling the rest of the economy. Guarantees of small banking deposits through the new Federal Deposit Insurance Corporation (FDIC) assured ordinary citizens that they wouldn’t lose their savings when banks did fail. These regulations made it less likely that masses of people would once again suck the economy’s lifeblood—money and credit—out of the banks. By saving small depositors and thus the overall system from panic, regulators ensured that bad banks could continue to go out of business, allowing the market to help discipline their risk-taking.
Regulators also forced financial institutions to decide whether they wanted to be in the securities business or the banking business, and thereby separated the relatively sober world of long-term bank lending and borrowing from the often-frenzied world of underwriting and trading stocks and bonds. This separation gave banks some insulation—but not immunity—from the short-term shocks, whether from exuberant optimism or abject pessimism, of future economic cycles.
Washington wisely did not banish risk-taking in the financial world. FDR understood that financial sophistication had helped drive American economic growth after World War I, attracting the world’s money to U.S. shores. Instead, policymakers imposed clear, consistent limits on risk-taking in the securities business, which remained freer than the banking business.
New regulations prohibited securities firms and their customers from borrowing excessively to purchase securities, whose values could swing wildly. These restraints on speculative borrowing reduced the risk that debt supported by securities wouldn’t be repaid if the value of the securities plummeted, thus straining the financial system. The government also imposed an obligation of full and fair disclosure on the securities industry, requiring companies that wished to raise money by selling stocks or bonds to the public to explain—soberly, clearly, and regularly—the financial, business, and economic risks that the companies and their investors faced. The public could make investments with its eyes open.
Taken together, these regulatory reforms enabled the financial and business worlds to continue to innovate and take risks, so long as those risks didn’t endanger the broader economy and so long as the risk-takers disclosed their activities. The system worked well, more or less, for over half a century, helping propel American capital markets to even greater dominance after World War II. The world’s investors knew that their wealth was safest in America, in part because of fair regulations.
Starting in the 1980s, the regulatory infrastructure started to decay. In 1984, the government stepped in to rescue a large commercial bank, Continental Illinois, extending protection not just to the bank’s insured depositors but also to all its other lenders, including big corporate depositors whose accounts exceeded FDIC limits as well as global bondholders. The event proved a watershed, and it set a now-familiar precedent: “too big to fail.” Big, complicated financial institutions outgrew the government’s ability to impose the market’s verdict on them by shutting them down, since too much was at stake for the economy if they went under. Uninsured lenders to big banks no longer worried that they would lose their investment; the government would intervene if things spiraled out of control. As a result, financial innovations proceeded without the natural checks and balances of market forces. Banks became adept at turning their insulation from disorderly failure into insulation from market discipline.
Innovations in finance, mostly in the world of credit, blurred the thirties-drawn line between banking and the securities industry. Financial firms learned how to turn long-term debt, such as corporate bonds and mortgages, into tradeable securities. In doing so, they made the vital business of credit creation more vulnerable to short-term gyrations between optimism and pessimism.
The financial world also found ways to avoid the government’s borrowing limits on speculation. Because Depression-era regulations restrained them from borrowing unreservedly to speculate on stocks, financiers created financial instruments in the derivatives world that escaped the regulations. Often, such innovations also escaped Depression-era disclosure requirements. The public and the media, and even regulators, had a hard time identifying, understanding, and quantifying the changes. Financiers’ experiments with making tradeable securities out of long-term debt—from junk bonds at an investment bank, Drexel Burnham Lambert, to mortgage-backed securities at a hedge fund, Askin Capital Management—caused miniature financial explosions that Washington should have seen as warnings but instead regarded as aberrations. Similar eruptions in unregulated derivatives competed, just as vainly, for attention.
In 1998, a mix of the two—unbridled derivatives creation and speculation on long-term credit—created a near disaster. An obscure hedge fund, Long-Term Capital Management, proved that though not a large bank, it, too, was too complex to fail through the normal bankruptcy process that governs nonbank failures. The fund’s opaque endeavors, enabled by unregulated borrowing, nearly brought down the financial world and the economy. Three years later, Enron demonstrated how easy it was to use modern innovations to create credit out of nothing but blind trust and proved how eagerly the nation’s biggest financial firms had enabled such spurious credit creation. Enron’s collapse showed how quickly it could all fall apart when the trust vanished.
The government treated the failures that the increasingly fragile system served up from time to time as discrete matters best addressed with one-off, extraordinary solutions, from weekend financial rescues to criminal prosecutions. Mainstream thinkers said that financial markets didn’t need much regulation. Alan Greenspan, who took the helm of the Federal Reserve in 1987, told lawmakers and the public that financial companies, powered by a rational motive not to lose money, could police themselves and one another, using new financial innovations to decrease risk, not increase it. The financial world operated increasingly freely under a long-running illusion that elegant modern theories and technologies made the creation of nearly all manner of credit—lending to corporations and consumers alike—perfectly safe. Yet with each new innovation, financiers left themselves even less room for error, were the tiniest thing to go wrong—just as they had done in the twenties.
Thanks to the illusion of safety, financiers were able to manufacture vast amounts of debt, and they encouraged Americans to become more dependent on borrowing, whether on credit cards or against the value of their homes. In this way, ordinary Americans, too, became more vulnerable to any eventual sharp decline in the availability of credit.
Bankers had accomplished the opposite of what they, and regulators, had thought they were doing. They hadn’t created safety out of danger, but danger out of safety, eventually turning the most sober investment that many people make—the purchase of a home—into a risky bet. The financiers made mortgage lending, for many investors, seem risk-free, meaning that money became available for anyone to get a mortgage for any house, regardless of ability to repay the debt. When more money is available to buy something, the price of that item goes up. Once the risks emerged from behind the veneer of safety and the easy credit tightened, the plunge proved more disorienting than the rise.
The inevitable financial catastrophe reminded us of something that we had forgotten. When financial markets are too free, they will eventually destroy themselves and damage everything around them. Starting in 2007, the financial world slipped loose from its carefully constructed illusions. One financial institution after another collapsed seemingly overnight.
By 2008, sober-minded people feared that the government, with all its modern knowledge and powers, would not be able to prevent another Depression. To avoid the severe economic disruptions that cascading failures of financial firms would cause, the government, on behalf of taxpayers, effectively took over all risk in finance. Private investors, having so thoroughly miscalculated the risk that they had freely undertaken, no longer wanted any part. Policymakers from both parties, starting in the Bush administration, felt that they had no choice but to use trillions of taxpayer dollars to protect failed firms and their lenders from their tremendous losses. Much of the financial industry now depended on its ability to hold the economy hostage just to stay afloat.
The financial crisis should not have come as a surprise. It is the natural result of two and a half decades of decisions and nondecisions that made the financial regulatory system irrelevant. Nor are creative solutions necessary to prevent another such catastrophe. The same regulatory philosophy that protected the post-Depression economy and created the conditions for prosperity afterward would have prevented the postmillennial financial meltdown. It can work again, if policymakers apply it to the financial system that exists today.
First, no private company in a free-market economy should be too big or too interconnected to other firms to fail. The government must once again create a credible, consistent way in which failed financial companies can go out of business, with lenders to those companies taking losses as well as shareholders, if warranted, without dragging the economy down with them. Second, the government must once again insulate the core economic functions of long-term borrowing and lending from potential short-term excesses. Third, the government must reimpose clear, well-defined limits on activities such as borrowing for speculation. Last, the government must make sure that markets do not become opaque over time as new financial creations escape existing reporting requirements. Financiers must disclose the scope of their innovations to the public and to investors. Creative financial risk-taking then can flourish within these reasonable limits.
Washington must understand—from the facts at the core of the financial crisis—that consistent, predictable regulation of financial firms and markets is a prerequisite for a free-market economy, not a barrier to it. Consider the price that our economy is now paying for our failure to regulate the markets prudently. Government’s extraordinary interventions have put it in control of the financial industry, replacing the private sector in one of the most vital functions of a free economy: deciding which people, companies, and projects deserve investment, and on what terms.
This development is a threat to the market economy. The financiers and investors who decide which businesses, new and old, are worthy of investment must make decisions based on their judgments of the risks and rewards involved. They won’t judge effectively if they have an implicit understanding that the government will save them from their bad decisions. They certainly cannot do so if they have an eye toward the political concessions that a government guarantor inevitably demands. Washington cannot solve this problem by extricating itself from its direct role as lender, guarantor, and sometimes part-owner of financial firms as the immediate crisis eases. Financial companies and their own lenders will know that, absent credible regulations to the contrary, the government will once again save the industry in the next crisis. Such distortion of market incentives harms the private sector’s free assumption of financial and economic risk, which powered the American economy to its industrial and technological heights and has helped hundreds of millions of people around the world escape poverty.
The government’s response to the financial crisis has further damaged free markets by altering the global perception that investors in America can expect fair treatment according to a predictable and consistent rule of law. Washington has used its new leverage over the financial sector to intervene arbitrarily in cases like the Chrysler and General Motors bankruptcies, upsetting precedents for treating creditors to bankrupt firms that date back centuries.
The very real damage is done. But the nation must make sure that it does not turn these episodes, too, into precedents, which show the world that we don’t trust markets to work the way that they should. At the height of the financial crisis, American leaders’ loss of faith in free markets was so troubling that the former prime minister of the once-Communist state of Estonia felt the need to take to the pages of capitalism’s organ, the Wall Street Journal, to remind readers that the biggest threat to the economy was the perception that markets had failed. “Actually, it is not markets that have failed, but governments, which did not fulfill their role of … creating and guaranteeing market rules,” Mart Laar wrote.[vi] If the nation fails to understand this truth, it may lose its status as a global steward of the world’s wealth, as investors worry that personal contacts and political power matter more than laws and rules.
Ordinary citizens do not share Washington’s new distrust of markets. Throughout the financial crisis, they have consistently defended free enterprise. They have opposed bailout after bailout, even bailouts meant to help their next-door neighbors who couldn’t afford their mortgages. Many politicians and executives have misinterpreted public anger as anti-rich and anti-capitalism. But the public has grasped—better than sophisticated financiers—what healthy capitalism requires. Americans enjoy seeing success rewarded with great wealth—as long as they aren’t forced to subsidize failure.
Americans don’t want their government picking winners or losers in the economy. Just the opposite: the public wants the government to do its job of rationally regulating financial markets so that financial markets can then rationally manage the private distribution of capital, funding good businesses that power the economy. The nation finds itself in its current weakened position largely because of a crisis created by unregulated financial capitalism. It’s sad that we could have prevented the crisis, but it’s also good news—for we know how to prevent the next one.
[ii] Governor Franklin D. Roosevelt, speech to the Commonwealth Club, San Francisco, September 23, 1932.
[iii] Alexei Barrionuevo, “Two Chiefs Are Convicted in Fraud and Conspiracy Trial,” New York Times, May 26, 2006.
[iv] “Last Court Hurdle Cleared by Insull.”
[v] Douglas Martin, “Albert Gordon, Who Rebuilt Kidder Peabody, Dies at 107,” New York Times, May 2, 2009.
[vi] Mart Laar, “Freedom Is Still the Best Policy,” Wall Street Journal, February 13, 2009.
From Poverty to Prosperity
Intangible Assets, Hidden Liabilities and the Lasting Triumph Over Scarcity
(hardcover)
